The Lesser-Known Way to Tap Your 401(k) Before 59 1/2 Penalty-Free

Many savers learn the hard way that using a 401(k) to build a retirement nest egg can have a major drawback — early withdrawal penalties. Generally speaking, withdrawals from a 401(k) are penalized 10% when taken before age 59 1/2.

But thanks to a lesser-known rule, you may be able to take a penalty-free 401(k) withdrawal at a slightly younger age. And that flexibility may come in handy if you end up leaving your job in your mid-50s.

Image source: Getty Images.

How the rule of 55 works

The rule of 55 allows 401(k) savers to take penalty-free withdrawals under certain circumstances. Specifically, you must leave your job the year you turn 55 or later, and you must only withdraw funds from the 401(k) plan sponsored by the employer you’ve separated from at 55 or later.

If you follow these rules, you may be able to avoid a penalty for tapping your own savings. But there are some nuances to be aware of.

First, the rule of 55 does not apply to old 401(k)s, IRAs, or other tax-advantaged retirement accounts. Secondly, while the rule of 55 waives the early withdrawal penalty, it doesn’t get rid of income taxes on your distribution.

Withdrawals from a traditional 401(k) are generally taxed as ordinary income. This applies at any age. But if you’re looking to retire early and tap your 401(k) to the tune of $80,000 a year to cover your expenses, you shouldn’t expect to net $80,000 a year after paying your tax obligation.

Should you use the rule of 55?

The rule of 55 could come in handy if you’ve accumulated a large amount of savings by 55 and don’t wish to continue working. It could also be helpful if you’re laid off at 55 and need your 401(k) to cover your essential costs while you look for work.

But you should be careful when taking advantage of this option. If you haven’t met your long-term savings goals, withdrawing from your 401(k) at 55 (or another age before 59 1/2) means you’ll have that much less money left in your retirement account to benefit from compound growth.

For example, let’s say you’ve lost your job at 55 but aren’t ready to retire. If you’re able to cut expenses and tap your emergency savings while looking for work, that may be a better option than withdrawing from your 401(k) penalty-free using the rule of 55.

Either way, though, it’s important to know that the rule exists in case you need to take advantage of it.