How to access your 401k prior to 59 1/2 without penalty

How to access your 401k prior to 59 1/2 without penalty

November 16, 2021
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How can I get access to my 410k?

I get this question regularly. It reminds us again how restrictive these accounts can be! The government controls your money, telling you when you can access it, and placing huge restrictions on its use.

About 31,000,000 Americans have tapped into these accounts for funds during 2020. According to CNBC, half of Americans with accounts have taken early withdrawals. 

This reduction in future assets can be a real hindrance for retirement fund growth. The idea of planning for retirement by getting a tax deduction today, and locking up your money for years is flawed on its face...yet millions continue to plan this way.

But, there is a little-known part of the IRS tax code that allows you to access your 401(k) or 403(b) prior to 59 1/2 without penalty.

Traditionally, the penalty is 10%, but the Rule of 55 gives you access without paying a penalty; however it comes with certain requirements.

If you leave your job in the calendar year you turn 55 or older for any reason and your employer has stipulated that you have the ability to tap into your plan, you can do so without penalty. Some plans may require you to withdraw your entire balance as one lump sum, which would most certainly be a bad deal.

To maximize the Rule of 55, there are a number of roll-over strategies you can use. For example, if you have an old 401(k) or IRA, you can roll those balances into your employer’s plans, and then when you separate you will have unfettered access to the total amount between age 55 and 59 ½.

If you have specific circumstances or know that you’ll have heavy cash flow needs between those ages, this is a solid, penalty-free option.

You have to get all the shifting done before you leave your employer. You won’t be able to roll over a balance after you are no longer employed.

There are some caveats. You can only withdraw funds from your most recent employer, and you can’t make penalty-free withdrawals from your IRA. The Rule of 55 is very specific and only applies to narrow circumstances.

People are retiring at younger and younger ages, and if that’s the case for you in that period between age 55 and 59 ½, the Rule of 55 is a great option. You will want to look carefully at tax brackets during those years because if you don’t you may bump into a higher tax bracket than you expect or accidentally suffer a 10% penalty.

Another reason you may want to take money out of your 401(k) using the Rule of 55 is to take advantage of historically low taxes. You can use the money to fund your lifestyle as well as your Roth IRAs and LIRPs. 

You might consider using the rule of 55 if any of the following circumstances apply:

•  You’d like to retire early. With the rule of 55, you’ll be able to get the money you need to cover expenses, and if you decide to get a job later, you can still keep taking withdrawals from the qualifying 401(k) or 403(b) as necessary. Remember that even if you don’t end up paying the extra 10% 401(k) penalty, you still have to pay regular taxes on any money you withdraw that hasn’t been taxed before.

•  You’d like to minimize or eliminate RMDs. Once you turn 72, you’ll be required to take required minimum distributions (RMDs) from most qualified retirement accounts. Depending on your situation, then, it might make sense to use the rule of 55 to reduce that amount that’s considered in your RMD calculations. Many people don't realize that every dollar you don’t take out could grow to a huge RMD situation down the road where you have no control over tax rates.

The rule of 55 isn’t the only way to avoid the 401(k) early withdrawal penalty. Other circumstances that allow you to avoid that additional 10% penalty include:

•  Total and permanent disability.

•  Medical expenses that exceed 7.5% of your adjusted gross income.

•  Withdrawals made because of an IRS levy plan.

•  Qualified disaster distributions.

•  Status as active duty and qualified reservist.

Additionally, it’s possible to set up a situation where you take substantially equal periodic payments. This is sometimes called the 72t rule (or SEPP).

With 72t, you use IRS tables to decide how much to take each year if you’re under age 59 ½. There is no penalty, but you won’t have much flexibility. You have to commit to taking those withdrawals for at least five years or until you’re 59 ½, whichever is greater. 

With the rule of 55, you have more flexibility. As long as you meet the requirements, you can take as much or as little as you want from the 401(k) without committing to a set schedule.