RETIRING AT 55.

There are benefits and drawbacks, so make sure you check out all your options and can afford to take the plunge.

You love your job (well, maybe). You enjoy your colleagues. But you're working hard, and you don't know if you can keep up the pace forever--or want to. You're thinking you

TAXATION OF RETIREMENT BENEFITS

Many workers would like to quit their present job long before the traditional retirement age of 65. Some in their 50s are heading for the exits even before they turn 59 1/2, the age at which they're eligible to access the funds in their IRAs and company retirement plans without paying an early-withdrawal penalty.

But if you're careful, you can avoid this 10% penalty. An employee isn't subject to a 10% penalty tax on a complete distribution from an employer plan (including a 401(k) plan) if (i) the employee terminates employment after age 55 and (ii) receives a complete plan distribution following termination of employment. It doesn't matter if you quit, are fired, or retire, just as long as your employment termination occurs after age 55. But if you roll over a portion of your distribution to an IRA and later take distributions from the IRA before age 59 1/2, those distributions will be subject to a 10% penalty tax--unless another exception applies, which I'll get to shortly.

But it may be a big mistake to forego the IRA rollover option and pay income tax on your entire 401(k) or other employer-planned distribution just to avoid the 10% penalty tax. You should consult with a competent financial planner to determine what the best strategy is for deterring tax on your distribution. It may be best to roll over some and pay tax on some.

One solution for early retirees who want to access their IRA prior to age 59 1/2 is to follow the "substantially equal periodic payments rule." Under that rule, you can take money out of your individual retirement account without penalty as long as you agree to withdraw a set amount every year that's based on your life expectancy or the joint life expectancy of you and your retirement plan beneficiary for at least five years or until you reach age 59 1/2, whichever comes later. But penalty taxes will be recaptured by the IRS (with interest) if you alter your periodic payments before the later of age 59 1/2 or five years. Incidentally, the "substantially equal periodic payments rule" also applies to periodic withdrawals from your employer's retirement plan before age 59 1/2. An employer, however, isn't required by law to permit periodic withdrawals, and employers frown on this practice for employees who have left their jobs.

ANOTHER OPTION

There's another, less complicated choice that's available to you, but you've got to meet all of the following requirements. If you do, you can take out as much as you want without paying a 10% penalty, as long as these conditions are met:

* You must be 55 in the year you retire. You must turn 55 by Dec. 31 of that year.

* You must have a retirement plan through your employer, such as a 401(k).

* You must quit your job. You can't make an early withdrawal from your employer's retirement plan unless you "separate from service," the IRS says. Now quitting your job in the year you turn 55 may have some other repercussions. You may lose some benefits that you would otherwise get if you terminated your employment at a later date. So review this option very carefully with a financial planner. If you get the green light and meet the above criteria, you can withdraw as much or as little as you want from your 401(k) plan without paying the standard 10% early-withdrawal penalty. You can go to work for another company or even return to work for your current employer at some later date. But be careful: The strategy falls apart if you retire in the year prior to the year you attain age 55, even if you postpone receiving your retirement benefits until you reach 55.

SECOND CAREER

If you retire early, you can pursue a second career. Many people find their second career very fulfilling and wish they'd made the move sooner. They wonder why they endured a job they disliked for so many years. But a second career isn't for everyone. You've got to have some marketable skill that will enable you to find a new job or start your own business. If a second career is what you have in mind, you should thoroughly investigate the opportunities that are out there. Make sure you're being realistic. If possible, try to get a part-time job in the evening, or try moonlighting in your own business while you're still employed. That'll give you a solid basis for determining whether a second career is a realistic option.

LEISURE OPPORTUNITIES

Retiring early will allow you to pursue a variety of interests that you just don't have the time for while you're working. You can travel, do volunteer work, catch up on your reading and various hobbies--whatever. Many people spend their retirement years engaged in various leisure activities. But once again, don't take the plunge until you've given some thought to what you're going to do. Don't quit your job without a carefully thought-out plan--even if you hate your job. You could be jumping out of the frying pan and into the fire. Having nothing to do, day after day, can be quite stressful. Some people just need to keep busy but aren't self-motivated. If that's your makeup, recognize it, and deal with it--don't delude yourself into thinking you'll find ways to spend your leisure time on your own. It's not going to happen.

On the other hand, if you know exactly how you will spend your leisure time and are a self-starter, go for it! If you're not sure, try to arrange for a leave of absence, say for three months, and see how you do. Or work three days a week.

FINANCIAL CONSIDERATIONS

But before you tell your boss just what you think of your job and the company's management policies, consider these drawbacks to withdrawing the money in your retirement plan by using the age 55 exception:

* You'll owe income taxes on the money you take out. For example, say you quit your job at age 55 and take out $200,000. You'll be taxed on the entire amount in the year you take it out. The withdrawal could push you into a higher tax bracket, increasing your tax liability.

* You may not be allowed to spread out withdrawals from your 401(k) plan. Your employer may allow you to withdraw money from your retirement plan as you need it, but many employers won't agree to that because of the administrative headaches. If that's how it is with your company, you can take it all out in one lump sum, but you'll have to pay taxes on the entire amount. Alternatively, you can withdraw what you need and roll the rest into an IRA. But once it's in an IRA, you can't make penalty-free withdrawals until age 59 1/2 unless you use the "substantially equal periodic payments rule." This may not match your financial needs and put you behind the eight ball.

If you own company stock that has appreciated in value through your employer's retirement plan, you may be better off taking an immediate tax hit--including a 10% early withdrawal penalty--with appreciated shares of company stock. Here's why: If you place all your company stock into an IRA rollover, you'll be taxed at your normal income tax rate when you start liquidating the stock and pulling the money out at retirement. If instead you decide to roll the stock over into a taxable account, you'll only pay taxes on the cost basis of the stock, the amount that you paid for the stock over the years. You won't pay any taxes on the appreciation until you sell shares. And then, you'll only owe long-term capital gains taxes on the appreciation, with a maximum tax rate of 20%.

DECISIONS, DECISIONS

Retiring early is going to require you to make some hard choices. If you withdraw too much money from your 401(k) when you quit, you'll face a hefty tax bill. But if you take out too little and find it necessary to access your IRA before you turn 59 1/2, you'll have to pay a 10% penalty on any money you withdraw, along with income taxes. Unless you have a huge amount of money in your IRA, withdrawals under the "substantially equal periodic payments rule" are going to be pretty small. For example, say you've got $100,000 in an IRA and you're 55. Your life expectancy is approximately 30 years, so you can withdraw 1/30 of the $100,000 in your IRA. That comes to $3333.33 each year. That's not going to be a great help to you.

PITFALLS TO AVOID

If you withdraw your 401(k) plan money when you leave your job, you'll have just 60 days to deposit the money you don't need into an IRA. If you miss that deadline, the IRS will tax the entire amount at your ordinary income rate. A safer approach is to figure out how much you'll need and ask your employer to deposit the rest directly into an IRA. Many employers will agree to such an arrangement, eliminating the risk that you'll miss the 60-day deadline.

Retiring early and withdrawing your retirement plan money can result in a significant loss of tax-deferred earnings. Working a few more years might enable you to greatly increase the size of your nest egg.

Your post-retirement expenses may be greater than you anticipate. Many early retirees underestimate their living expenses after retirement. Sure, you'll save on commuting costs, clothing, and dry-cleaning bills, but other expenses could increase. For example, Medicare doesn't kick in until you're 65, so you may need to buy your own health insurance. And regardless of the type of insurance you have, you'll be spending more on healthcare as you grow older. If your children don't live nearby, you'll want to visit them and your grandchildren -- and that costs money. So do toys and other gifts for your grandchildren. Don't believe the conventional wisdom that you'll only need 75% of your pre-retirement income.

So who should consider retiring early and taking their money out of their retirement plan? It makes sense if you're considering leaving your current job and need just a small amount to tide you over until you turn 59 1/2. It's also a good idea if you have other sources of income, such as nonretirement savings or a part-time job.

Milton Zall is a freelance writer who specializes in taxes, investments, and HR/business issues. He is a Certified Internal Auditor and a Registered Investment Advisor.