Ask The Financial Planner: Retiring early? Understanding the Rule of 55

handsome mature man smiling in warm hat and jacket looking aside. Green forest on background

Q: I’ve worked hard and done a good job saving and investing. I want to retire early. What do I need to know?

Even for those who might love their work, the thought of retiring early can seem awfully appealing—and awfully tempting. Say you were to retire at the age of 55, instead of waiting until you are in your 60s. You’d have that much more time for travel, for golf, for spending time with family—for doing whatever it is you dream of doing once your working life is over.

The happy news for those with a 401(k) is that there is a provision for retiring at 55—and it’s called, appropriately enough, the Rule of 55. However, not just anyone can up and decide to retire at this early stage. It’s important to know what the rules actually are—and the penalties.

The Rules of Early Retirement

Normally, of course, the 401(k) holder has to wait until age 59 before he or she may begin withdrawing funds without any kind of a penalty. By following the Rule of 55, you’re allowed to withdraw early while avoiding those penalties—but you’ve got to meet the right criteria:

First, the rule applies only for those who leave their job in the calendar year in which they turn 55, or later. This might mean you retire or it might mean you’re fired or laid off, and that’s okay—but it has to be in the year of your 55th birthday.

Additionally, you can only take money from the 401(k) plan you had with your last employer. You may still have money in a 401(k) from a previous employer, but you’ll have to leave that money where it is until you hit 59—or else incur a penalty.

By the way, if you’re wondering what the early withdrawal penalty is, it’s 10 percent—which is pretty steep, and certainly not something anyone wants to have to pay just because he or she didn’t understand the early withdrawal rules!

A Bigger Problem for 401(k) Holders

There’s actually an even bigger concern here, which is simply this: Many 401(k) plans—a little less than half of them—prohibit installation payments or period withdrawals. In other words, they force you to withdraw a lump sum of your money. Not only will the taxes on this be potentially outrageous, just depending on how much you actually have to withdraw, but it also empties your account, prohibiting any further investment growth.

One oft-proposed solution is to roll the 401(k) balance into an IRA—and that makes sense if you are waiting until age 59 to retire. The IRA doesn’t allow for penalty-free withdrawals at 55, though, so what’s an account-holder to do?

One suggestion: Annuitize your IRA withdrawals. You can withdraw your money penalty-free if you set up a withdrawal schedule that will mean taking out substantively equal, periodic payments over the span of five years, or until you reach the age of 59—whichever happens to occur first.

This is a workable solution—but only if you’ve backed it up with some sound financial planning. What’s important is laying out a roadmap to early retirement well in advance—ensuring that your annuitized payments are sufficient for your needs, but also that they’re not so great they’re depleted prematurely.

Harrison Kennard is the co-founder of Stonepath Wealth Management in Ann Arbor, a Michigan-based independent wealth management firm that practices comprehensive, holistic financial planning and asset management. Location: 1925 Pauline Blvd A, Ann Arbor, MI 48103; Phone: 734.369.8143; Online: http://www.stonepathwm.com

If you have a financial question, send to Harrison harrison@stonepathwm.com

Securities offered through Registered Representatives of Cambridge Investment Research, Inc.,a Broker/Dealer, Member FINRA/ SIPC. Stonepath Wealth Management and Cambridge are not affiliated

 

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