To win at any game, you first have to know the rules. That’s true for everything from Monopoly to your 401(k). Managing your 401(k) is certainly no game. But there’s a little-known rule about it that could be a real blessing in a financial crisis.
To win at any game you first have to know the rules. That’s true for everything from Monopoly to your 401k. Managing your 401k is certainly no game. It’s serious business. Today Rob West talks about a little-known rule about your 401k that could be a real blessing in a financial crisis.
If you have a 401k retirement plan you know it’s filled with rules that most people aren’t fond of, but the one we’re talking about today is an exception. It’s the so-called “Rule of 55.”
Normally, you’re not allowed to withdraw money from your 401k without incurring a 10% penalty until you reach age 59 ½. But the rule of 55 is a special IRS provision that waives the penalty once you reach 55 or older. The rule of 55 also applies to 403b retirement accounts, the equivalent plan for non-profit organizations.
How does it work? It only applies in a few specific conditions. For example, if you’re 55 or older and leave your job, you can withdraw funds without the penalty. But you can’t take advantage of the rule if you’re still working at the company where you have the 401k or 403b.
And, you have to leave that job in the calendar year you turn 55 or later to get a penalty-free distribution. But if you’re a public safety worker, such as a police officer, firefighter, or air traffic controller, the rule actually kicks in at age 50.
If you leave or lose your job before the eligible age you miss out on the rule entirely. You won’t be able to take a penalty-free withdrawal until you reach the usual age of 59 ½.
And, as with all exceptions to the 10% penalty, the rule of 55 still has tax implications. It doesn’t get you out of paying taxes on your withdrawals which are considered income on your federal return, and probably your state return if your state has an income tax.
All of that can be confusing, so maybe it is be easier to talk about when the rule doesn’t apply. For starters, it doesn’t apply to retirement plans from previous employers. It has to be the 401(k) at your current or latest job to be eligible.
Also, it doesn’t apply to individual retirement accounts, either a traditional or a Roth IRA. For those you’d still have to be 59 ½ before making penalty-free withdrawals.
However, there’s a way around the provision that excludes previous 401k or 403b accounts. You can roll those funds over from a previous account to your current one if your employer accepts rollovers. Not all do, so check with your HR department to find out.
Then, once you’ve completed the rollover all of the money in your current account - including the transferred amount - will be available if you make an early withdrawal under the rule of 55.
Of course just because you can do something doesn’t mean you should. In almost all cases, tapping into your 401k is not advisable because you’re essentially robbing your future and giving up not just the money but the time you’ve invested in building up those funds.
You may be able to replace the funds eventually, but you can never get back the time, which is critical for long term, compounding gains in your portfolio. You’re essentially starting over, but with less time before retirement. So you want to avoid early withdrawals if at all possible, even if you can do it without the 10% penalty under the rule of 55.
Proverbs 13:11 teaches, “Wealth gained hastily will dwindle, but whoever gathers little by little will increase it.”
So when would it be okay to take an early withdrawal from a 401k?
Only if you simply have no other choice. You can only use the rule of 55 if you’re no longer with the employer where you had the account. In some cases that probably means you’ve lost your job or a significant part of your income due to your hours being cut. Even then, you should delay as long as possible before making an early withdrawal from your 401k.
You can use the MayDay Budget, available at MoneyWise.org. It’ll help you prioritize your spending. And keep in mind that you should have an adequate emergency fund of 3 to 6 months’ living expenses saved up before financial calamity strikes. You want to exhaust that before making a withdrawal from your 401k or 403b. And the Mayday Budget will help you make those emergency dollars go further.
On this program, Rob also answers listener questions:
Will capital gains tax be owed if you sold your primary residence but had rented out a portion of it while you were living there?
If you have just changed a years-old life insurance policy for $10,000 into permanent insurance and you have discovered it no longer has any value, can you stop paying into it?
What's the best way to transfer ownership of your home to an adult child prior to your death if you are done with dealing with the property and they will live in it?
Will working part time increase your Social Security payments if you are currently receiving disability payments?
If you co-signed a $30,000 loan with your son who is no longer talking to you and has changed his name, how can you remove your name from the loan?
Could a Kingdom Advisor assist you with marketing a substantial amount of jewelry you designed on Ebay, if you are not computer-savvy?
If you start taking Social Security benefits prior to Full Retirement Age and they are reduced based on earned income, can you later reclaim the full benefit?
Remember, you can call in to ask your questions most days at (800) 525-7000 or email them to Questions@MoneyWise.org. Also, visit our website at MoneyWise.org where you can connect with a MoneyWise Coach, join the MoneyWise Community, and even download the free MoneyWise app.
