What is the rule of 55 and should you use it?

(NewsNation) — Taking money out of a tax-deferred retirement plan like a 401(k) before the age of 59 ½ typically comes with a penalty, but an IRS provision known as the rule of 55 can help you avoid that.

Here's what to know.

What is the rule of 55?

The IRS rule allows workers who lose or leave their jobs to begin taking 401(k) distributions penalty-free, as long as they are 55 or older.

Normally, any withdrawals before 59 ½ are subject to a 10% tax penalty but if you qualify under the rule of 55, you don't have to pay it.

However, you'll still need to pay income tax on any withdrawals.

The rule applies to anyone who turns 55 or older during the year that they lose or leave their job. It doesn't matter if your departure was voluntary or involuntary.

Which retirement plans qualify?

The rule of 55 applies to employer-sponsored, tax-deferred retirement plans like 401(k)s and 403(b)s.

It doesn't apply to individual retirement accounts (IRAs), which typically have an early withdrawal penalty before age 59 ½.

Another point: The penalty-free early 401(k) withdrawals can only be taken from the plan you were contributing to when you left your job. In other words, if you have money in other retirement plans it needs to stay there until you turn 59½, otherwise you'll face a penalty.

The money also has to stay in your most recent employer's plan. If you roll it into an IRA, you don't avoid the penalty.

For certain public safety employees, like police officers, firefighters and air traffic controllers, the rule may apply even earlier, at age 50.

Should you use the rule of 55?

The rule of 55 can help older workers who may have been laid off later in their careers, but it's not without downsides.

Pulling money out of your retirement account means it will no longer benefit from the potential future growth that comes with compound interest. Taking distributions could also push you into a higher marginal tax bracket.

"If you retire early, or if you were laid off and need the distributions to cover living expenses, it could make sense," financial services company Charles Schwab wrote in a report. "But if you get another job and cover your costs that way, it might not make sense to begin drawing down your 401(k)."

If you do get another job after 55, you can keep withdrawing from your old 401(k) plan penalty-free, as long as it's the same one you were contributing to at the time you left.