Do you feel retirement is too far away? You’ll qualify for your full Social Security benefit at around the age of 67, though the exact age depends on your date of birth. Perhaps surprisingly, the average age of retirement is significantly lower, at 62, as noted by NerdWallet. For some, the idea of waiting until age 67, or even 62, to retire may seem challenging. Perhaps you’d like to retire as soon as possible, but unfortunately, your retirement savings are inaccessible until you reach 59 ½.
However, you just may be in luck. The Rule of 55 is a lesser-known IRS rule that states one can remove funds from that company’s 401(k) plan if they leave that company for any reason upon reaching 55 without being subject to early withdrawal penalties. However, like any retirement rule or regulation, there are nuances you have to consider to ensure that you’re truly ready to retire early at age 55.
The Rule of 55 Regulations
First, you can only access the retirement savings from your current employer’s plan. For example, if you spent fifteen years at one company where your 401(k) savings grew significantly and then switched to a new company for a few years, reaching age 55 without rolling over your previous employer’s savings, you will only have access to the funds accumulated with your current employer. Funds previously rolled over to your 401(k) from a previous employer would be accessible, however, so if you plan on using this rule upon turning 55, you may want to initiate rollovers now.
Second, not every plan provider even allows for withdrawals at 55; this could put a significant dent in your early retirement plans if you were depending on those 401(k) funds.
Third, you’ll have to pay taxes on your withdrawals, even if they’re Roth. You don’t have to pay taxes on the contributions, but any withdrawals will be a proportional mixture of contributions and gains. However, if you made those Roth contributions fewer than five years ago, you’ll be hit with an early withdrawal penalty.
Fourth, your IRA funds cannot be used until 59.5. The Rule of 55 only pertains to 401(k) and 403(b) plans.
Should You Retire Early?
Let’s assume everything is in place: your plan allows for early withdrawals under the Rule of 55, and you’re prepared to pay the taxes now. The question remains: should you retire early?
For now, let’s just stick with your 401(K) before delving into other aspects of retirement planning. By withdrawing your funds early, you’re taking away their ability to grow. What would those savings look like if you worked for at least another seven years when you can start claiming Social Security benefits or another ten years until Medicare kicks in?
Assume you have $1,000,000 in your 401(k) at age 55. If you continue to work and contribute the maximum amount each year, your savings could grow substantially by the time you reach key retirement milestones. For 2024, the maximum employee contribution is $23,000, and if you’re over 50, you can take advantage of the catch-up contribution, bringing the total to $30,500 annually.
Let’s explore two timeframes:
- 7 Years Later: Age 62
By age 62, you can start claiming Social Security benefits. If you contribute the regular maximum of $23,000 annually and keep your funds invested, your $1,000,000 could grow to approximately $1,523,616. If you make catch-up contributions, bringing your annual contribution to $30,500, your savings could grow to approximately $1,568,054. - 10 Years Later: Age 65
At age 65, you become eligible for Medicare. If you continue contributing $23,000 annually for the next ten years, your $1,000,000 could grow to approximately $1,629,005. With the catch-up contribution, your balance could reach approximately $1,705,07.
- 7 Years Later: Age 62
Even then, you might feel that $1,000,000 is enough to get by, and you’re willing to forgo future potential growth. However, there are other considerations before you make that final decision.
Amplification of Retirement Risks
In our previous example, we used two key retirement milestones—Social Security and Medicare—as checkpoints for evaluating the growth of your savings. When you retire at 55, you may gain access to your 401(k) funds, but you won’t be eligible for Social Security or Medicare yet. These benefits only become available later – unless you qualify due to a disability. Without Medicare, you’ll likely need to rely solely on private insurance to cover your medical expenses, which can be costly and may not fully meet your needs. One potential option is to elongate your workplace coverage via COBRA; your premiums will likely be higher, but you’ll avoid the inconveniences of switching health insurance providers.
Additionally, since you won’t start receiving Social Security until at least age 62, your savings will be more vulnerable during those years – one costly emergency could extinguish your savings and derail your retirement.
Other retirement risks are also greatly amplified besides medical costs. The longer you’re relying on your savings, the more your dollar will weaken over time, and the greater the chances you’ll withdraw your savings earlier than anticipated. Imagine living to the ripe old age of 100; great, right?
Now, imagine the purchasing power of your dollar 45 years from now. At a 3% annual inflation rate, your savings would lose about half of its value in 24 years, assuming zero growth. In 45 years, it would have lost approximately 70% of its value.
When It Makes Sense to Utilize the Rule of 55
Many Americans find themselves in early retirement due to unexpected events like injury, illness, or layoffs. Surprisingly, few people retire early by choice. If you’re in this situation, tapping into your 401(k) funds might make sense, especially if you don’t have other income sources.
On the other hand, if you have reliable income streams like a pension, rental income, or enough savings in your IRA or other investment accounts, you might feel more at ease withdrawing from your 401(k) early, especially if it will be beneficial to your tax strategy..
In Conclusion
While the Rule of 55 might allow you to access your 401(k) funds penalty-free if you retire early, it comes with several important considerations. First, it applies only to your current employer’s plan, plus not all plans allow for early withdrawals. Additionally, early withdrawals can significantly impact the growth of your savings and expose you to heightened financial risks, especially with the effects of inflation over time. Delaying retirement until key milestones like Social Security or Medicare can help ensure that your savings grow and remain robust throughout your retirement.
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