How To Retire Early With the Rule of 55 and 72(t) Distributions 

We all regularly hear about the retirement crisis and that many Americans approaching retirement age have under-saved.

While that is a situation many people face, it’s not everyone. Others have been diligent savers with IRAs and 401(k)s and have tidy nest eggs. 

The catch? They can’t take that money out until they reach 59½ without paying a penalty — although there are exceptions.

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Retirement Savings and the Early Withdrawal Penalty

One feature of traditional retirement plans like 401(k)s and IRAs is the early withdrawal penalty. 

It makes sense: If you want to encourage people to save for retirement with tax advantages, you don’t want people to raid those funds at every opportunity. 

If you tap into traditional retirement accounts before age 59½, not only will you pay ordinary income taxes, but you will also pay a 10% early withdrawal penalty to the IRS.

It’s a situation many successful savers find themselves in — sizable retirement accounts, a waning interest or declining health to continue their career, and years to go before they turn 59½. 

Luckily there are a couple of IRS rules that don’t penalize you for saving well and retiring early. 

READ MORE: ​​IRA vs. 401(k): Which One Is Better for You?

What Is the Rule of 55?

The rule of 55 is an exception to the IRS early withdrawal penalty that allows workers to withdraw funds from either a 401(k) or 403(b) without the penalty. 

While most 401(k) plans offer this benefit, it is not required by law, so consult your plan documents for your specific situation.

There are also IRS restrictions to how it works: 

• The rule of 55 applies to the 401(k) or 403(b) at your current employer the year you turn age 55 or older. 
• Prior employer 401(k)s that you haven’t rolled over and IRAs are not covered. (If you haven’t yet rolled over an old 401(k), a service like Capitalize can help.) 
• You must also separate from your employer, either voluntarily or involuntarily, to begin distributions.

While those distributions will be subject to tax, they are not subject to the 10% penalty. 

READ MORE: How To Save for Retirement

What Is a 72(t) Distribution?

What happens if you’ve been a supersaver and are younger than 55? You can use a rule 72(t) distribution to access retirement funds penalty-free. 

Unlike the Rule of 55, there’s no age limit and the 72(t) applies to both current and former employer 401(k)s and IRAs. But that’s where the easy ends with a 72(t).

There are several restrictions to taking 72(t) distributions and some significant penalties for getting it wrong — so getting professional help isn’t a bad idea. 

• You will need to set up a series of substantially equal periodic payments, aka SEPPs. 
• You’ll have to take the distribution on at least an annual basis.
• You cannot change the amount for at least five years or until you turn 59½ — whichever is longer.

What that means is that if you set up a 72(t) distribution at age 49, you’re going to take it for a decade until you’re 59½. If you set it up at 57, you will take the distribution until you’re 62. 

Changing your mind mid-stream is possible, but you’ll pay a 10% penalty on all the funds you’ve already withdrawn.

The inflexibility of this arrangement and the potential for large penalties make this method one to approach with caution.

The IRS currently recognizes three methods for calculating your SEPP and will not accept any other method, however reasonable. 

1. Required minimum distribution or life expectancy method 

This method uses your account balance divided by your life expectancy factor as published by the IRS to determine your annual required minimum distribution (RMD), quite like RMDs at age 73. 

This method results in the smallest annual payments. Of particular concern is that the amount can vary from year to year based on market performance and your life expectancy factor — that could leave you with spending shortfalls during down markets.

2. Fixed annuity method

This method uses a calculation of your life expectancy from the IRS mortality table and a “reasonable interest rate.” 

“Reasonable” is defined as the greater of 5% or up to 120% of the published Federal Mid-Term Rate from the month of the valuation. 

The annuity method will result in a higher annual payout than the RMD method, but smaller than the amortization method. The payment amount is fixed annually. 

Of particular concern is the inflexibility of the payment amount regardless of spending needs or market performance.  

3. Amortization Method

This method results in the largest distributions and is based on your life expectancy from IRS tables and an approved “reasonable” interest rate. 

Like the annuity method, “reasonable” is the greater of 5% or up to 120% of the published Federal Mid-Term Rate the month of the valuation. 

Also like the annuity method, the payment amount is fixed for the duration, regardless of spending needs or market performance.

READ MORE: How Much You Need to Retire: The Ultimate Guide

FAQs

Can you apply the rule of 55 before age 55?

For most folks, no. However, if you’re a public safety employee like a police officer, firefighter, air traffic controller, or similar, most plans will allow you to start penalty-free early retirement distributions at age 50.

Can you take a rule of 55 distribution and get another job?

Yes, if you leave your current employer at age 55 or older and take a rule of 55 distribution, you can get another job. You can even contribute to a subsequent employer’s 401(k).

Can I leave my job before age 55 and start a rule of 55 distribution once I turn 55?

No, the rule of 55 only applies to your current employer 401(k) or 403(b) and you must separate service during the calendar year you turn 55 or older. 

TL;DR: Rule of 55 and 72(t) Distributions 

Taking early retirement distributions is nothing to be taken lightly. Starting early distributions raises the risk you could run out of money later in retirement. 

SEPPs mean mandatory withdrawals, possibly during down markets, and fixed payments might not handle unexpected large expenses. 

While both methods can allow access to funds prior to the 59½ penalty, that does nothing to alleviate risks later in retirement.

Both methods are best approached with professional tax help, particularly a 72(t) distribution where you can put events in motion that aren’t easily or cheaply reversed. 

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