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If you’re considering early retirement, you may want to take advantage of the Rule of 55. This lesser-known provision allows for penalty-free withdrawals from certain employer-sponsored retirement plans starting at age 55. But like most retirement rules, this opportunity comes with a few caveats.

In this episode of Money Wisdom, Nicholas J. Colantuono, CFP® breaks down the Rule of 55 so you can decide whether it’s the right move for you.

How the Rule of 55 Works

The Rule of 55 applies only to employer-sponsored plans from a former employer you leave in or after the calendar year you turn 55. If you’ve already rolled your old 401(k) or 403(b) into an IRA, the rule is no longer applicable. In fact, the Rule of 55 does not apply to any IRAs.

Who May Benefit from the Rule of 55

1. Need immediate access to retirement funds. While you’ll still owe income taxes on withdrawals, you can avoid the 10% early withdrawal penalty. That flexibility can be incredibly valuable to bridge any income gaps, especially before you’re eligible for Social Security.

2. Have significant savings in a 401(k) plan. The Rule of 55 can be quite favorable from a tax planning perspective. For instance, if you retire at 55 and begin drawing from your 401(k), you may reduce the size of the account over time. This can potentially lower future required minimum distributions (RMDs).

3. Planning a career shift. If you’re starting a new business or becoming self-employed, accessing funds earlier can provide needed liquidity. Similarly, if it takes longer than expected to find a new job, the Rule of 55 can help supplement your income needs without penalty.

Important Considerations

1. Many plans don’t allow partial withdrawals. If you’re unsure what your plan allows, make sure to confirm with your former employer. Some plans even restrict how you take distributions, so you may need to withdraw the entire account balance at once.

2. Roth earnings may be taxable. You can withdraw contributions to Roth accounts tax-free. However, any gains may be taxable if you withdraw before the five-year holding period.

3. You can continue withdrawals until 59½ even if you start saving in a new employer’s plan. This is somewhat of an unusual loophole. While it exists today, there’s always the possibility that rules could change in the future.

4. Consider the overall impact on your retirement savings. These decisions can come with long-term tax implications. Make sure to carefully plan your strategy with the guidance of a financial professional.

Curious how your 401(k) fits into your investment strategy? Get your free Ultimate 401(k) Guide by texting “GUIDE” to 800-757-0436.