A Hidden Gem of 401(k) and 403(b) plans that you need to know
For those nearing retirement, there’s often an overlooked feature of their 401(k) or 403(b) plans that could provide crucial financial flexibility for you: the ability to access those funds before age 59 1/2 without the additional 10% tax early withdrawal penalty.
If you meet specific criteria, you can tap into your retirement savings penalty-free even if you’re not quite at the traditional retirement age to be able to access those funds. This can be a game changer for people navigating the complexities and challenges of early retirement or managing unexpected financial needs in their mid to late 50s.
Let’s unpack the details.
How it works: The Age 55 Rule:
The provision that allows you this flexibility is often referred to as the “Age of 55 rule” or “Separation from service rule”. Here’s how it works:
- You must be at least age 55 (hence the name)
To qualify for penalty-free withdrawals, you must be 55 or older during the calendar year in which you plan to retire. - You must be separated from service
This means you are no longer working for your employer that sponsored your 401(k) or 403(b) plan. Whether you retired, were laid off or quit your job, this rule applies as long as you’ve left the company.
Why this matters in retirement planning:
When you’re crafting your retirement strategy, identifying your sources of income will be one of the most important factors to consider. And having access to your retirement funds before age 59 1/2 can play and important role, especially if you are wanting to retire early and are wanting to supplement your income or bridge your income before you draw social security.
Most retirement accounts, such as IRAs, have stricter rules for accessing the funds. IRAs typically don’t let you access the funds without penalty before age 59 1/2 unless you meet some kind of hardship withdrawal exception.
If you rollover your 401(k)/403(b) to your IRA after leaving your job, you’ll likely be subject to the IRA early withdrawal rules. Which means you’ll pay an additional 10% tax early withdrawal penalty, in addition to income taxes, if you access the funds before age 59 1/2.
Keeping your funds in your 401(k)/403(b) allows you to keep access to the age 55 rule if needed.
When to keep your funds in your 401k/403b:
When deciding whether to rollover your funds to an IRA or leave them in your employer-sponsored retirement plan you’ll want to consider your retirement timeline and how soon you might need to access those funds.
Here are a few scenarios where keeping your funds in your 401(k) or 403(b) might make more sense:
- You plan to retire early (before age 59 1/2): If you plan to retire early, before age 59 1/2, you may want to consider leaving your funds in your 401(k) or 403(b) until you reach age 59 1/2 so you can access those funds penalty free if or when you need to.
- You’re managing liquidity needs: If you foresee needing to make a withdrawal to cover emergencies or to supplement cash flow in retirement, it might be best to leave your funds in your retirement plan.
- You want to limit the amount of taxes you pay: As previously mentioned, if you roll your funds to an IRA and need to make a withdrawal before age 59 1/2 you will typically incur an additional 10% tax penalty. Leaving the funds in your 401(k) or 403(b) avoids this extra tax by using the age 55 rule; therefore, reducing your overall taxes paid.
How to take advantage of this Rule:
Work with a wealth advisor to help you plan out your retirement goals.
Determine when you want to retire, how much income you’ll need and what sources of income and assets you’ll have at the time of your retirement. And if it’s determined that you may need to take retirement asset withdrawals prior to age 59 1/2 your wealth advisor can help you navigate the age of 55 rule.
You’ll want to make sure any withdrawals from your 401(k)/403(b) are reported correctly on your tax returns to take advantage of the penalty-free withdrawals offered under the age of 55 rule. Therefore, it's also important to work with a trust tax professional to help you navigate the age of 55 rule.
The Bottom Line:
When you retire is an important question.
And whether to rollover your 401(k) or 403(b) to an IRA is an equally important decision than can impact when and how you retire. Before making the decision to rollover any assets, it is important to do some sort of planning or analysis to see if you’ll need access to any 401(k) or 403(b) assets prior to age 59 1/2.
Don’t rollover your assets to an IRA too quickly before doing some retirement and income planning with a trusted wealth advisor.