Can I Use the Rule of 55 If I Get Another Job?
Considering the Rule of 55 but getting another job? Clarify how new employment impacts your eligibility for penalty-free early retirement withdrawals.
The Rule of 55 is an Internal Revenue Service (IRS) provision that allows individuals to access funds from their employer-sponsored retirement plans without incurring the 10% early withdrawal penalty. This rule often raises questions, particularly for those considering new employment after utilizing it. Understanding how re-employment interacts with the Rule of 55 is important for financial planning.
Understanding the Rule of 55
The Rule of 55 enables penalty-free withdrawals from employer-sponsored retirement accounts, such as 401(k)s, 403(b)s, and governmental 457(b) plans, before age 59½. To qualify, an individual must separate from service with their employer during or after the calendar year they turn age 55. This separation can be due to retirement, resignation, or termination.
While the Rule of 55 waives the 10% early withdrawal penalty, distributions are still subject to ordinary income tax. For example, a $20,000 withdrawal is added to your taxable income for the year, like regular wages. The rule applies specifically to the retirement plan of the employer from whom the individual separated.
The Rule of 55 does not apply to Individual Retirement Accounts (IRAs). If funds from a qualified employer plan are rolled over into an IRA, they lose their Rule of 55 eligibility. This distinction means that once funds are in an IRA, they are subject to the standard IRA withdrawal rules, which usually impose a 10% penalty for withdrawals before age 59½, unless another exception applies.
The “Separation from Service” Requirement
The Rule of 55 revolves around “separation from service.” This means an employee must have left their employer’s service, whether voluntarily or involuntarily, in the calendar year they reach age 55 or later.
Funds eligible for penalty-free withdrawal are those held in the qualified retirement plan of the employer from whom the individual separated. For instance, if an individual leaves Company A at age 55, they can access funds from Company A’s 401(k) plan. The rule does not grant access to funds from previous employers’ plans unless rolled into the most recent employer’s plan.
Separation from service is tied to the employer’s plan, not the individual’s overall employment status in the broader workforce. This distinction allows for flexibility in future employment. The IRS guidance clarifies that the separation must occur in or after the year the employee attains age 55, regardless of the specific date within that year.
Rule of 55 and New Employment Scenarios
The Rule of 55 can apply differently depending on various new employment scenarios. The applicability of the Rule of 55 hinges on which employer’s plan the funds reside in and when the separation occurred.
If an individual separates from Employer A at or after age 55, they can access funds from Employer A’s qualified plan under the Rule of 55, even if they take a new job with Employer B. The new employment with Employer B does not negate the initial “separation from service” from Employer A.
Conversely, if an individual leaves Employer A before reaching age 55, then takes a new job with Employer B, and separates from Employer B at or after age 55, the Rule of 55 applies to the qualified plan funds from Employer B. The funds from Employer A’s plan are not eligible unless rolled into Employer B’s plan before separation from Employer B.
A nuanced situation arises with re-employment by the same employer. If an individual separates from Employer A at or after age 55, begins accessing funds, and is then re-hired by Employer A, this could potentially complicate or negate the original “separation from service” for future withdrawals from that specific plan. While IRS guidance suggests employers can rehire retirees without jeopardizing plan status, the continued eligibility for Rule of 55 withdrawals from the same plan upon rehire can depend on specific plan terms and the nature of the re-employment.
It is important to remember that the Rule of 55 does not apply to traditional or Roth IRAs directly. If funds eligible for the Rule of 55 are rolled over from a qualified employer plan into an IRA, those funds typically lose their Rule of 55 eligibility. Any withdrawals from such rolled-over funds before age 59½ would then be subject to the standard 10% early withdrawal penalty, unless another specific IRA exception applies. While the 10% penalty is avoided under the Rule of 55, all distributions remain taxable as ordinary income, impacting an individual’s overall tax liability for the year.