The IRS does its part to incentivize workers to contribute funds to a 401(k) plan. Not only are contributions to a traditional 401(k) exempt from taxes up to an annual limit, but that limit is fairly generous. This year, it's $23,000 if you're under age 50 or $30,500 if you're 50 or older.
In exchange for its generosity, the IRS wants you to leave your 401(k) plan untouched until retirement age, which it defines as age 59 1/2. As such, if you take a 401(k) withdrawal before reaching that age, you'll risk losing 10% of that sum right off the bat in penalty form.
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Generally speaking, it's best to leave your 401(k) alone for as long as possible. That way, your money can grow and you won't have to worry as much about an income shortfall in retirement.
But you should also know that there may be a way to access your 401(k) penalty-free prior to age 59 1/2. It's called the rule of 55 and may be something you can use to your advantage.
How the rule of 55 works
The rule of 55 allows you to access funds from your 401(k) penalty-free if you're leaving your job (willingly or otherwise) in the calendar year in which you'll turn 55 or later. More specifically, the rule allows you to take a penalty-free withdrawal from the 401(k) plan of the sponsoring employer you're separating from at age 55 or later.
Because the rule of 55 is very specific, let's run through some scenarios so you understand fully how it works.
Let's say you just turned 55 in May and your employer has notified you this month that you're being laid off. In this case, you can tap that employer's 401(k) if you need the money to pay your living costs while you look for work or if you decide to take your money and retire early. However, if you also have an old retirement plan from a former employer, you can't withdraw from that account penalty-free at 55.
Here's another example. Let's say you turned 55 in May but left your job the past December, at which point, you stopped working completely. In this situation, you can't tap your most recent 401(k) penalty-free because you parted ways with your employer during the calendar year in which you turned 54, not 55.
Should you take out your money at 55?
If the rule of 55 applies to you, it can be tempting to access your 401(k) penalty-free. But remember, the money in that account is supposed to be earmarked for your retirement. If you withdraw it early, you'll have that much less savings to fall back on once your career fully comes to a close.
Let's say you're let go by your employer at age 55 and it's a struggle to find work elsewhere. At that point, you may have to tap your 401(k) to cover your expenses.
But let's say you find a new job three months later and therefore don't need your 401(k) to cover your living costs. In that case, it could very much pay to leave your money alone, keep it invested, and let it continue to grow until you're actually ready to retire.
This doesn't mean you should leave your money in an old employer's 401(k). A better bet may be to roll it into a new 401(k) plan, if your new employer offers one, or into an IRA.
The point, either way, is that while you can tap a 401(k) early without penalty if the rule of 55 applies to you, you may not want to do that for the sake of having adequate income in retirement. So think carefully before taking an early withdrawal, even if there's no penalty to worry about.
