Tapping Your 401(k) at 55? You May Regret That

If you plan to dip into your 401(k) at 55, you can do so without a hefty tax penalty in certain circumstances. But should you? A recent MassMutual survey found that the average age for Americans to retire is 62. But some workers opt to end their careers much sooner.

The benefits of retiring early are many. You can travel, be present for grandchildren, and enjoy your time without the constraints of a job.

But retiring early can pose challenges. First, it requires a certain level of savings. And even if you have the funds, there’s the question of whether you can access them without taking a financial hit.

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Traditional IRAs and 401(k) plans offer big tax incentives, but they force savers to wait until age 59½ to take withdrawals. Tapping one of these plans early typically means facing a 10% early withdrawal penalty, which is incentive enough to leave that money alone, even if it means having to work longer.

There’s a special rule, however, that applies to 401(k) plans that may give you penalty-free access to your savings starting at age 55. But whether it’s a good idea to tap your 401(k) at 55 is a different story. Even with that rule, you may run into some hiccups.

Tap your 401(k) at 55? Your savings have limited flexibility

In the context of 401(k) plans, there’s a concept known as the rule of 55. It allows you to tap a 401(k) without penalty if you separate from the employer sponsoring that plan during the calendar year in which you turn 55 or later.

Being able to access your 401(k) at 55 without penalty might seem like a great solution to your early retirement plans. But there are some pitfalls you might encounter.

First, this rule only applies to the 401(k) plan sponsored by the company you’re separating from at 55 or later. It doesn’t apply to old 401(k)s or funds in an IRA.

So, say you’re sitting on $3 million in retirement savings at 55, $2.7 million of that is in an IRA and $300,000 is in your most current 401(k). At 55, if you were to leave the job sponsoring your 401(k), you’d get penalty-free access to only about one-tenth of your total savings. Whether that’s enough to cover your expenses until age 59½ depends on you.

The other issue is that when you retire at 55, your money generally needs to last longer than if you retire in your 60s. By removing funds from your 401(k) at 55, you lose out on valuable years of compounding in that account.

Also, remember that while the rule of 55 gives you penalty-free access to your 401(k), it doesn’t eliminate taxes on your withdrawals. Those could be substantial during your first year of withdrawals in particular.

Say you turn 55 this year and work for a good part of it. You could take a 401(k) withdrawal without a penalty before the year is up. But that, combined with your work-related income, could push you into a higher tax bracket than you want to land in.

Think twice before retiring in your mid-50s

You may have options for accessing your retirement savings at 55. But you should know that retiring in your mid-50s is a potentially risky move, even if you have a nice amount of money saved up at that point.

For one thing, at 55, you’re a minimum of seven years shy of being able to collect Social Security. That could put a lot of pressure on your savings.

You’re also, generally speaking, a solid 10 years away from being eligible for Medicare, which means you’ll need to pay to put health coverage in place. The high cost of healthcare is apt to eat into your savings and lead to larger withdrawals.

Before you retire at 55, think carefully about why that’s appealing to you. If you have specific plans that a job might impede, like traveling, you may want to talk to your employer about taking a sabbatical rather than retiring outright. That could afford you the opportunity to travel while your health is still optimal, without having to live off of your 401(k) right away.

If your desire to retire at 55 stems from burnout, you may want to consider a career shift into less stressful work. Or, talk to your employer about transitioning to a part-time work schedule.

These aren’t options you have to explore. And it may be that you’ve saved enough to retire at 55 without worry. But if you have concerns, it’s worth looking at alternatives that allow you to keep earning a paycheck a bit longer while giving your savings extra time to grow.

Read More

• Will Retiring Early Make You Happier? It's Complicated
• Early Retirement Withdrawal Strategies for the Long Haul
• Five Early Retirement Mistakes to Avoid
• The Rule of 55: One Way to Fund Early Retirement