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What Is the Rule of 55?

Your 401(k) account is likely one of the most valuable assets you have, so it's essential to know when and how you can access it. These accounts are intended to fund your retirement, and as such you can access them penalty-free when you reach age 59½. In most cases, taking money out of your 401(k) before then will cost you a pretty penny: Early withdrawals come with a 10% penalty.

There are a few exceptions, however, and one of them could help you if you want or need to retire early. The Rule of 55 is an IRS provision that allows you to withdraw funds from your 401(k) or 403(b) without a penalty at age 55 or older. Read on to find out how it works.

Can I Withdraw From My 401(k) at 55 Without a Penalty?

If you leave your job at age 55 or older and want to access your 401(k) funds, the Rule of 55 allows you to do so without penalty. Whether you've been laid off, fired or simply quit doesn't matter—only the timing does. Per the IRS rule, you must leave your employer in the calendar year you turn 55 or later to get a penalty-free distribution. (The rule kicks in at age 50 for public safety workers, such as firefighters, air traffic controllers and police officers.) So, for example, if you lost your job before the eligible age, you would not be able to withdraw from that employer's 401(k) early; you'd need to wait until you turned 59½.

It's also important to remember that while you can avoid the 10% penalty, the rule doesn't free you from your IRS obligations. Distributions from your 401(k) are considered income and are subject to federal taxes.

When Does the Rule Not Apply?

The Rule of 55 doesn't apply to any retirement plans from previous employers. Only the 401(k) you've invested in at your current job is eligible. Additionally, the Rule of 55 doesn't work for individual retirement accounts (IRAs), including traditional, Roth and rollover accounts. You'll have to wait until age 59½ to access those assets without penalty.

There's a way around this, however: You could roll over the funds from your former 401(k) and IRA plans into your current 401(k). Note that the process can be complicated, and not all employers accept rollovers. Before initiating a transfer, talk to your human resources representative and consult with a tax advisor to avoid unnecessary headaches. If you are allowed to make the transfer, all the funds in your current 401(k), including the transferred amount, will be available if you take early distribution using the Rule of 55.

Is It a Good Idea to Use the Rule of 55?

Just because you can take distributions from your 401(k) or 403(b) early doesn't mean you should. Depending on your financial situation, it might be better to let your money continue to grow. Holding off withdrawals could help you better position yourself for a financially sound future. If you're tempted to withdraw retirement funds before you're eligible, instead consider finding another job, drawing from your savings or using other sources of income until you need to tap into your retirement savings.

If you decide to begin withdrawing funds from your 401(k) early, the long-term value of your portfolio will likely decrease. It's essential that you time your withdrawals carefully and take into account how much they would cost you in taxes. To create a strategy that makes sense in your situation, consider working with a financial advisor or a retirement planner.

Will My Credit Score Be Impacted if I Withdraw Early?

Withdrawing funds from your 401(k) early won't impact your credit directly since the credit bureaus don't track activity on your retirement accounts.

Making an early withdrawal can indirectly affect your credit when you use the money to pay down outstanding debt. It may seem like an easy way to ease a debt burden or boost your credit, but in most cases, this shouldn't be the only reason to withdraw funds from your 401(k). Such a move should only be considered in a financial emergency when you have exhausted all other options.

The Bottom Line

In some cases, it might make sense to take advantage of the Rule of 55 and withdraw money from your 401(k) or 403(b) before age 59½. But it's generally recommended to let your money grow in your retirement accounts as long as you can.

There are many factors to consider before withdrawing from your 401(k) early, including taxes, life expectancy, savings and investment accounts, and more. If you're thinking of using the Rule of 55, consult with a financial professional to see if it's indeed the best option for you.