You might have heard that you need to keep your money in your retirement accounts until you are 59½ in order to avoid the 10% early withdrawal penalty tax, but did you know that if your money is in a work retirement plan, like a 401(k), that the you can take it out earlier and still avoid the penalty?
Exception to the rule
To quote directly from the IRS website explaining this exception to the 10% early withdrawal penalty tax:
“Distributions made to you after you separated from service with your employer if the separation occurred in or after the year you reached age 55, or distributions made from a qualified governmental defined benefit plan if you were a qualified public safety employee (State or local government) who separated from service on or after you reached age 50”
55 and separation from service
If you wait until the year you turn 55, then leave your employer, you can take money out of your 401(k) or 403(b) without the 10% early withdrawal penalty tax. You will still pay income taxes of course; Uncle Sam wants that part of your retirement account. And be careful, depending on the other income you have, the amount of income taxes you owe could be even more than has been withheld, so be sure to calculate quarterly estimated taxes so that you are not caught by surprise.
If you roll your 401(k) over to an IRA rollover account, you lose this “age 55 separation from service” exception, because it only pertains to employer plans, not IRA rollovers.
50 if you are a fireman or policeman
If you are a qualified public safety employee of the state or local government, such as a police or fireman, the age is even lower – 50 years old.
In general most folks need to work and continue saving their money until their mid to late 60s so that they can save enough to retire. But for those that have been strong savers and have learned to live well beneath their means, an early retirement is a possibility.
For a lot of folks who retire as early as 55, they have resources besides retirement accounts that they tap into, for example; from the sale of a business or money they have put into regular brokerage accounts over the years after they put the maximum contributions into their retirement accounts. If you don’t have money in non-retirement accounts that can get you through to age 59 ½, then the “age 55 separation from service” exception might be the solution for you.
Run the numbers
Only in a few situations would it make sense to tap into the retirement accounts as early as 55 years old. One situation that comes to mind, is in the case of someone who has maxed out their contributions in their work plan since the time they started working, and they have a balance in their current employer’s retirement plan that is large enough to live off of for a four or more years. They have run the numbers and have enough retirement assets to live off of, however they do not have enough in non-retirement accounts to live off of until they turn 59 ½, perhaps due to putting kids through college or paying off the mortgage.
Really check your numbers to make sure that you can afford to retire at 55, taking the impact of inflation into account. Inflation has a significant impact on retirement planning. Consider that starting to spend down your portfolio at such a young age, when you could easily live another 35 or 45 more years could jeopardize your financial future. However, if once you have done the analysis you can afford to retire early, then you deserve to enjoy what you have worked so hard for and this “age 55 separation from service” exception to the 10% early withdrawal penalty tax is one way to help you do that.