The ‘Father of the 401(k)’ Explains the Rule of 55—and When You Should Actually Use It
Plus, a little-known alternative if your plan doesn't allow partial withdrawals
Key Takeaways
- Ted Benna, “the father of the 401(k),” shares the pitfall of a lump-sum 401(k) withdrawal
- Smart tax strategies, like knowing when to talk to a professional, can help minimize taxes
- An underused tactic can help people under 59½ make IRA withdrawals without penalties
You don’t need us to remind you how challenging the economy is—it’s completely understandable that hardship withdrawals from 401(k)s hit a record high last year. But you may be surprised to learn that the “Rule of 55” waives the typical 10 percent early withdrawal penalty for those 55 or older who leave their jobs. And who better to explain the pros and cons of this strategy than Ted Benna, the creator of the first 401(k) plan? Keep reading for his expert insights on whether this rule could work for you.
What is the ‘Rule of 55’?
The Rule of 55 states that if you leave your job during or after the calendar year you turn 55—whether you quit, retire or are laid off—you can withdraw from your 401(k) without paying the usual 10 percent early withdrawal penalty, explains Ted Benna, the “father of the 401(k)” who created the first such plan in 1981 and authored 401(k)s & IRAs For Dummies.
Like so much in personal finance, this scenario can get a bit complicated. And there are a couple of catches. The first of which you’ve probably already guessed: If you withdraw from your 401(k) early, your long-term retirement savings take a bit of a hit and “future you” may miss out on the full potential of compounding. That’s when your investment earnings get reinvested and grow even more, creating a snowball effect over time.
If you don’t believe us, believe Albert Einstein, who reportedly called compounding the eighth wonder of the world. Though the quote may be apocryphal, it makes the point nicely. Of course, if you’re facing a financial emergency and need to tap into your 401(k), it may be a necessary trade-off, and you can always resume making contributions down the road.
The second factor to consider? “If you take money out of your 401(k) as a lump sum, it’s fully taxable, which isn’t ideal, because withdrawals are still taxed as ordinary income,” explains Benna. “Being able to take it in installments is important, but most 401(k) plans I’ve seen only allow lump-sum distributions.”
In short, he says, the real question is whether your plan allows partial withdrawals. “Unfortunately, many plans don’t offer this flexibility,” he cautions. “After you leave your employer, your options are typically: leave the money in the plan, take a lump sum or roll it over into an IRA.”
2 key factors to know about tapping the ‘Rule of 55’
Here, Benna shares the most important issues to keep in mind before withdrawing from your 401(k).
Know where the money is coming from
When it comes to taxes, not all money is created equal. “You should consider whether your contributions were pre-tax, Roth [post-tax] or a mix,” advises Benna. “Employer contributions are always pre-tax. So before making any decisions, you need to understand that breakdown.
For example, if all your contributions were pre-tax and you take a lump sum, the entire amount will be taxed as income, including your contributions, your employer’s match, and all investment gains.
That’s why Benna advises working with a tax professional. “The key is to provide them with your full financial picture and let them advise you on minimizing taxes.” (Find a fee-only tax specialist at the National Association of Personal Financial Advisors).
Consider an IRA rollover
Another option is rolling the funds into an IRA, suggests Benna. “Withdrawals before age 59½, however, are typically subject to a 10 percent penalty. That said, there’s an exception under IRS Section 72(t), which allows for ‘substantially equal periodic payments’ (SEPP).”
What does that mean exactly? “You can take structured withdrawals before age 59½, without the 10 percent penalty, as long as you follow the specific IRS rules,” says Benna.
With SEPP, he explains, you’re required to take out roughly the same amount on a set schedule—typically annually—based on an IRS-approved calculation method. The payments must continue for at least five years or until you reach age 59½, whichever is longer.
“This can be a useful alternative if your 401(k) requires a lump sum but you’d prefer steady withdrawals that are roughly the same amount,” Benna points out. One important caveat: Once you set up SEPP distributions, you can no longer contribute to that account.
The bottom line on the ‘Rule of 55’ for your 401(k)
The ‘Rule of 55’ can be a lifeline if you’re experiencing financial hardship, but it comes with trade-offs worth carefully considering. The good news? You have options—and with the right guidance from a financial professional, you can make the choice that best supports both your immediate needs and your long-term security.
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