The rule of 55 can benefit workers who have an employer-sponsored retirement account such as a 401(k) and are looking to retire early or need access to the funds if they’ve lost their job near the end of their career. It can be a lifeline for those workers who need cash flow and don’t have other good alternatives.

Here’s how the rule of 55 works and whether you should consider it using it.

What is the rule of 55?

The rule of 55 is an IRS provision that allows workers who leave their job for any reason to start taking penalty-free distributions from their current employer’s retirement plan in or after the year they reach age 55. It provides those looking to retire earlier than normal or those who need the cash flow a way to take distributions from their retirement plans sooner than is typically allowed.

Taking a distribution from a tax-qualified retirement plan, such as a 401(k), prior to age 59½ is generally subject to a 10 percent early withdrawal tax penalty. However, the IRS rule of 55 may allow you to receive a distribution in the year you reach age 55 or later (and before age 59½) without triggering the early penalty if your plan provides for such distributions.

Any distribution would still be subject to an income tax withholding rate of 20 percent, however. (If it turns out that 20 percent is more than you owe based on your total taxable income, you’ll get a refund after filing your yearly tax return.)

It’s important to note that the of 55 is not available at all for traditional or Roth IRAs.

How to use the rule of 55 to retire early

Many companies have retirement plans that allow employees to take advantage of the rule of 55, but your company may not offer one.

“Many companies see the rule as an incentive for employees to resign in order to get a penalty-free distribution, with the unintended consequence of prematurely depleting their retirement savings,” says Paul Porretta, a compensation and benefits attorney at Troutman Pepper, a law firm based in New York City.

Here are the conditions that must be met and other things to consider before taking a rule of 55 withdrawal.

  • Retirement plan offers them. Your company must offer a qualified retirement plan such as a 401(k) or 403(a) or (b) that allows rule of 55 withdrawals.
  • In or after the year you turn 55. You leave a position (voluntarily or involuntarily) in or after the year you turn 55 years old.
  • Money must remain in the plan. You fully understand that your funds must be kept in the employer’s plan before withdrawing them and you can only withdraw from your current employer’s plan. If you roll them over to an IRA, you lose the rule of 55 tax protection.
  • Potential lost gains. You understand that taking early withdrawals means forfeiting any gains that you might otherwise have earned on your investments.
  • Reduce taxes. You can wait until the start of the next calendar year to begin rule of 55 withdrawals when your taxable income may be lower if you are not working.
  • Public safety worker. If you are a qualified public safety worker (police officer, firefighter, EMT, correctional officer or air traffic controller), you might be able to start five years early. Make sure you have a qualified plan that allows withdrawals in or after the year you turn 50 years old.

However, as with any financial decision, be sure to check with a trusted advisor or tax professional first to avoid any unforeseen consequences.

Should you use the rule of 55?

Determining whether or not to take early withdrawals under the rule of 55 will depend on your unique financial situation. You’ll want to have a clear understanding of your plan’s rules, how much you’d need to withdraw and what your annual expenses will likely be during your early retirement years. Figuring out those issues should help you know if taking an early withdrawal is the right decision for you.

Here are some situations where it’s likely taking early withdrawals would not be the right move.

  • If it would push you to a higher tax bracket. The amount of your income for the year in which you begin the withdrawal plus the early withdrawal might put you into a higher marginal tax bracket.
  • If you’re required to take a lump sum. Your plan might require a one-time lump sum withdrawal, which may force you to take more money than you want and subject you to ordinary income tax liability. These funds will no longer be available as a source of tax-advantaged retirement income.
  • If you’re younger than 55 years old. You might want to leave your current employer before a year in which you turn 55 and start taking withdrawals at age 55. Note this is NOT allowed and you will be assessed the 10 percent early withdrawal penalty.

Other important considerations

If you’re thinking of taking a rule of 55 withdrawal, you’ll also want to consider a few other things:

  • If you have funds in multiple former employer plans, the rule applies only to the plan of your current/most recent employer. If you have funds in multiple plans that you want to access using the rule of 55, be sure to roll over those funds into your current employer’s plan (if it accepts rollovers) BEFORE you leave the employer.
  • Funds from IRA plans that you might want to access early can also be rolled into your current plan (while still employed) and accessed that way.
  • If you so choose, you can continue to make withdrawals from your former employer’s plan even if you get another job before turning age 59½.
  • Be sure to time your withdrawals carefully to create a strategy that makes sense for your financial situation. Withdrawing from a taxable retirement account during a low-income year could save you in taxes, particularly if you believe your tax rate may be higher in the future.

“Bear in mind that the only real advantage of the rule of 55 is avoiding the 10 percent penalty,” says Porretta. “Meanwhile, the tax deferral is sacrificed, which may turn out to be more valuable if other financial resources that are not tax-qualified can cover expenses for the coming years, allowing you to save the 401(k)/403(b) distribution until later years.”

Other 401(k) early withdrawal exceptions

You may be able to access your retirement plan without a tax penalty in a few other ways, depending on your circumstances.

There is an exception called the 72(t) option which allows withdrawals from your 401(k) or IRA at any age without any penalty. This option is called SEPP (Substantially Equal Periodic Payments), and these payments are not subject to the 10 percent early withdrawal penalty. Once these distributions begin, they must continue for a period of five years or until you reach age 59 ½, whichever comes later.

Other circumstances that exempt you from the early withdrawal penalty include:

  • Total and permanent disability
  • Distributions made due to qualified disasters
  • Certain distributions to qualified reservists on active duty
  • Medical expenses exceeding 10 percent of adjusted gross income
  • Withdrawals made to satisfy IRS obligations

But the IRS offers still other exceptions to the early withdrawal penalty.

Bottom line

If you can wait until you turn 59½, withdrawals after that age are not typically subject to the 10 percent IRS tax penalty. However, if you are in a financially safe position to retire early, the rule of 55 may be an appropriate course of action for you.

But if you have no other choice but to begin withdrawals at age 55 until you can get another position, start a business or create income in other ways, the rule of 55 may be just the short-term lifeline you’re looking for.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.