As a general rule-of-thumb, it’s wise to rollover your employer retirement plan into an IRA, after you’ve left your employer and are no longer getting a contribution match. IRA’s give you more control than your employer plan – control to invest without all the fees of a company plan, control to select from a vast array of investment options, and control over your tax withholdings. In other words, your investments have the opportunity to perform better outside of your employer plan, net of the fees that are baked into the plan.
But there are circumstances where it may be best not to roll it over! The most common reason for this is called the Rule of 55.
Now, typically if you were to withdraw money from either a roth or tax-deferred account before the age of 59 1/2, you would have to pay a 10% penalty on that withdrawal (on top of the taxes).
But! If you have a 401k (or 403b or 408) with an employer, and you leave the employer when you’re 55 or older, you can take distributions from the account without incurring the 10% penalty! Now, you would still have to pay taxes on the withdrawal. But it would be penalty-free.
Let’s look at an example.
Let’s say you’re 56 years old, you’re wanting to retire, so you quit your job. The majority of your retirement savings are held within your 401k. You decide to rollover that 401k into an IRA. But then you need to withdraw money out of that IRA to live on. When you rolled over that 401k, you then forfeited the ability to make penalty-free withdrawals of your retirement savings. So now any funds you withdraw would incur a 10% fee on top of the taxes.
While in most cases it’s optimal to rollover your 401k into an IRA, if you might need to make withdrawals from your retirement accounts prior to age 59 1/2, it’s worth considering the Rule of 55.
- Your company must allow these early withdrawals – check and make sure.
- The Rule of 55 begins the year you have your 55th birthday. You could technically still be 54.
- The Rule of 55 only applies with the employer that you leave when you’re 55 or older. Old 401k’s from your younger years would not be eligible. This is one of the main reasons you should rollover old 401k plans.
- It doesn’t matter whether you were laid off, fired, or quit. As long as you’ve left the employer, you’re eligible for penalty-free withdrawals.
- IRA’s are not eligible for the Rule of 55.
- You can go back to work after utilizing the Rule of 55. But penalty-free withdrawals could only come from the 401k you began withdrawing from.
- The Rule of 55 becomes the Rule of 50 if you work in one of the following professions: police officer, EMT, firefighter, correctional officer, or air traffic controller.
- While you know the current tax rate, it also might be prudent to use the Rule of 55 to minimize RMD’s down the road by rolling your 401k over into a roth IRA.
- Consider waiting until January the year after to make the actual withdrawal, in order to avoid further increasing your taxable income the year you were still earning from your job.