Retirement Answers

Jacob: 00:00

Are you wanting to retire before 60, but you're worried about it because you don't want to create any penalties for early distributions from your retirement accounts? Well, today I want to explain how you can access the funds in your employer retirement plan before 59.5 without penalty by using the rule of 55. Hey, friends, welcome back to another episode of Retirement Answers. My name is Jacob Duke. I'm your host here as always.

Jacob: 00:21

I'm a certified financial planner and the owner of River Tree Wealth, a retirement planning firm where we help people just like you plan smarter and retire better. And one of the biggest questions that we get is how to retire early without creating these additional 10% penalties on distributions out of tax deferred accounts early. And there are a few solutions to this problem, but the one that I want to focus on today is the rule of 55. So here's what we're going do. I'm gonna define the problem and kind of explain why this rule can be helpful and the importance of it, the rules and the kind of the requirements that you need to know in order to do it correctly.

Jacob: 00:51

And and then also maybe some alternatives here to the rule of 55 and kind of how it fits into your your greater plan. So let's just go ahead and jump in and talk about why the rule of 55 is important to understand and how it might fit into your early retirement plan. So if you take money out of a tax deferred retirement account, such as an IRA or a four zero one ks or four zero three B or your TSP, guess what? You are going to take that money out before 59.5, and you're gonna have an additional 10% penalty for an early distribution on top of the normal tax rate that you might have there. So that's why this rule is helpful or important to know about is because it might create the option for you to take money from a tax deferred source before fifty nine and a half without the additional penalty.

Jacob: 01:31

So let's talk about the rules and some of the things you've got to know in order to do this correctly. So the first thing is, is the age and the timing of when you retire. So what a lot of people get wrong is they think they have to be 55 at the time that they retire. And that is not true. You do not have to be 55 at the moment that you separate from service and retire.

Jacob: 01:51

You should have to be 55 within the year, the calendar year of retirement in order to qualify for the rule of 55. So for example, let's say that your birthday is in October, and you're gonna be 55 in October, but you retire in March earlier in the year when you're still 54. Guess what? You still qualify for the rule of 55, even though you were not 55 at the time of retirement, you were 54, but because you would be 55 by the end of the calendar year in which you retired, you still qualify and are eligible for the rule of 55 moving forward. Now, let's say, let's go back to the same example and say instead of 55 is what you would be in October, let's say you would be 54.

Jacob: 02:30

Guess what, if you retire and don't go back to work on your 50 birthday, you're never going to be eligible for the rule of 55, no matter what. Once you're 55 or 56 or 57, it doesn't matter because you separated from service before the year in which you turned 55. So it's important to understand the timing and kind of the age requirements for qualifying for this. You don't have to be 55 at the time of retirement, but you do have to be 55 by the end of the calendar year in which you retire. So that's the first thing.

Jacob: 02:57

The second thing to know is that this only applies to the plan that you're actually separating from at the time. So if you've got multiple old four zero one ks's out there from old jobs, let's say three different ones, and now you're in your fourth job, has a current four zero one ks plan, you cannot use the rule of 55 on any of those three previous plans that were old jobs, you can only use this provision on your current employer's plan that you're separating from at age 55 or later. So that's important, you can only use the one that you're most recently been working at, you have to use your current plan, not any old ones. So that's number two. Number three is, is the rule of 55 never works or applies with IRAs.

Jacob: 03:35

So think about traditional IRAs or SEP or simple IRAs. You cannot use this provision with an IRA. It only works with employer sponsored plans like 401ks or 403bs. You have to have an employer sponsored plan, not an IRA to do this. So the issue that comes up here is whenever someone retires, let's say they qualify otherwise based on the age requirements, but then they go ahead and they roll over their money from their four zero one ks into their IRA, thinking that's a good thing, which most of the time that is right, you create flexibility and different investment options and have optionality there.

Jacob: 04:08

But if you do that in this instance, you were giving up the ability to do the rule 55 because here's the thing, you're like, oh, I accidentally rolled my money into my IRA, I'm just gonna roll it back into my four zero one ks and then I'll solve the problem and I can do the rule 55. But the problem is, is you can't roll that money back into the four zero one ks because you are no longer an employee of that company, they won't allow you to do it. You can only do the role in function whenever you are currently employed with that current plan. So since you would be retired and separated from service, once you roll that money out, you can't roll it back into an employer plan. So that's an important thing.

Jacob: 04:39

Avoid that rollover trap into an IRA. It's a big one that a lot of people mess up or get wrong as they think, oh, I can do this rule of 55 with any different account type, doesn't really matter. Nope, it has to be an employer plan. And then finally, you have to make sure that your specific employer plan actually allows rule of 55 distributions. And here's why the rule 55 is allowed by law, but that does not mean that your specific plan allows it under the plan document.

Jacob: 05:07

So you've got to check and make sure that your specific retirement plan actually allows you to take money out under this rule of 55 provision and have the 10% penalty waived. Now, here's why this is important because whenever you do take a distribution like this, you're going to receive a ten ninety nine in the year in which you take that distribution showing, hey, you owe taxes on that. Now, whenever the employer or the plan actually fills out the ten ninety nine and reports this, they have a few options. Code one on that ten ninety nine just means it is an early distribution and there's no exceptions to that being the case. So if you take money under 59.5 and the employer does not know about an exception to that rule, then they're gonna mark code one, meaning you owe the additional 10% penalty on that distribution.

Jacob: 05:51

Now, code two is what they hopefully are going to mark on the form, but the key is they have to have the option to even mark code two per their plan document. So code two is that it's an early distribution, but an exception might apply. So the key here is that code two is what would be marked in this scenario on the ten ninety nine, but you've got to make sure that the employer plan actually is allowed to mark code two per their plan document. So that's the hard part about this is you've got to make sure your plan specifically allows it just because the IRS allows it does not mean that your specific plan will. So you've got to check on that.

Jacob: 06:25

So those are a few rules here that are important to understand and to know. And one extra one is that for public safety folks that are out there, so like police and fire and EMTs, guess what? You actually can start doing this provision at age 50 rather than 55. So you get an extra five years to be able to use money out of a tax deferred four zero one ks or four zero three b most likely if you're public safety, you can take that money out at 50 and beyond using this rule of 55 because you're a public safety employee. That's the only exception really to this rule.

Jacob: 06:58

But just know that if you do fall into that category. So those are the rules. That's how this works. Now, what are some alternatives maybe to the rule 55 that you might use otherwise? Well, if you've got a bunch of cash set aside, guess what?

Jacob: 07:11

You can take that cash and use it. It's not in a retirement account. So you can just use that money tax and penalty free. One of the big things I like to do, especially with folks who are thinking about early retirement, or they kind of know that's what they want to do is building up that after tax brokerage account. I talk about this one all the time.

Jacob: 07:26

It creates so much freedom for you as you build out your retirement plan. It helps you actually take money from your account, receive dividends and interest potentially tax free, depending on how much other taxable income you might have, but you can do tax gain harvesting, tax loss harvesting, and create flexibility for yourself without penalty for sure, even if it does create some taxes, no penalties because it's not a retirement account. So there are other options there around brokerage accounts and kind of after tax dollars. Now, if you don't have a four zero one ks plan, you could actually take distributions from your IRAs without penalty by using the rule 72t, which applies to IRAs, which is basically gonna say that you have to take substantially equal periodic payments from your account. So you can't just kind of pick and choose how much you do or don't wanna take every single year, every so often, like you can with the rule of 55.

Jacob: 08:17

The rule of 55 is very flexible. You can take whatever amount of money you want at any given point. You don't have to take something out every single year. If you don't want to, you can take some out this year and none for the next two years and then more when you get to 58, like you can do more things with the rule of 55, but rule 72t with your IRAs, they require substantially equal periodic payments. Okay, and so you've got to take the same amount out and there's different kind of calculations, three different options there.

Jacob: 08:45

I'm not going to get into it because it's really confusing, but you've got to take out essentially the same amount of money every single year until you get to 59 and a half or for five years. So that's a different rule, but it is a different option if you only have IRAs. Just know that you do have the ability to take money out penalty free from a tax deferred source like an IRA, it just has different rules and it's a lot more restrictive than the rule of 55. So if you've got the option, just kind of little pointer here, if you've got the option between rule of 55 with your current employer plan, and then also you've got some IRAs with money in it, you could do 72t distributions from the IRA. I would choose personally, I would choose the four zero one ks and the rule of 55 because of the flexibility.

Jacob: 09:26

Okay, that's so just an extra little tip there that you might want to consider if you're thinking about it. So the rule of 55 can be an awesome way for you to retire early and have access to funds without that 10% early distribution penalty. The key there is you're always going to pay taxes and how that would work on your tax return as normal income taxes, but you're not having that additional 10% penalty for early distributions if you qualify under all these different rules that I've mentioned. So evaluate it with your plan, see how it fits together and see if you can use this to your advantage and maybe you can actually retire earlier than you thought if you're able to do this. Hopefully that's something that might kind of spark your imagination or give you a little bit of a courage to say, oh, maybe I can retire before 60.

Jacob: 10:08

Let's see if that's an option from do I have enough money? If we can answer that question, yes, then you start have to figure out how do we actually get the money out of our accounts if we only have this tax deferred four zero one ks or employer plan. So hopefully this is helpful. Hopefully it makes sense. And you kind of understand your options around the rule of 55.

Jacob: 10:25

Let me know if you have any questions. And if you want a copy of the important numbers PDF for 2025 that I always talk about, again, you can click on the link down in the show notes and I'll have that sent over to you immediately. So thank you so much for tuning into this week's episode. We will talk to you again next week. Hey, it's Jacob again, and I wanted to remind you that nothing discussed in today's episode is meant to be financial, legal or tax advice.

Jacob: 10:49

Retirement Answers is for educational purposes only. Thanks for tuning in to this week's episode. I look forward to talking with you again next week.