Retire Early!

For years the standard age to retire was 65, perhaps that was because full retirement age for social security was age 65 and Medicare started at age 65. But now the full retirement age has moved to age 67. More and more people are wanting to retire early. Maybe at 50, 55 or 60. And if you are wanting to retire early there is a lot to consider here. 

Retiring early CAN be achieved with proper planning

Most people will come up with an amount they think they need saved up in order to retire. some folks will say, Oh, if I just had 1 million dollars, or some other amount, saved up then I can retire. Well, I think that is not the way to look at it. You really need to start with figuring out what INCOME you will need in retirement. To figure that out, I would start with what is your current living expense, NOT your income, but what does it take for you to pay the power bill, groceries, gas , eating out and just normal shopping. Don’t count debt payments like mortgages, loans, credit card debt. And don’t count what you are currently saving in your 401k or other investments. Because, when you retire you won’t be contributing to a 401k, and you shouldn’t have any debt.

Once you arrive at that figure I would add to it, to account for the lifestyle spending you would have each month. Maybe you will be playing more golf or tennis each week. Or traveling each month. Now that you have that figure, we need to move to the next step, which is where is the money going to come from? The earliest you can collect social security benefits is 62, so if you retire before 62 then you will have to rely on your investments and savings. Preferably, you would want to have 3 types of accounts at your disposal to pull from. A taxable or brokerage account, a tax deferred account like a 401k or IRA and a tax-free account like a Roth IRA. This is important because if you will be drawing off these accounts to live on, they are taxed differently. 

Which account you withdraw from makes a difference

If you are under 59 ½ and withdraw money from your 401k or IRA then there would be a 10% penalty and you would pay tax on the whole amount. When it comes to withdrawing money from your accounts for income, typically I recommend drawing from the taxable or brokerage account first. This is because there is no 10% penalty and it would be taxed at capital gains tax rate, on any gains realized, which is lower than ordinary income tax rate. But what if all your retirement savings is in a 401k and you need to withdraw from it before age 59 ½?.

Accessing money before age 59 1/2

A couple of ideas here. One is the rule of 55. The rule of 55 works like this, in the year of you turning 55 or later and leaving your employer, you can access monies from your 401k without incurring the 10% penalty. There is no limit of what you can pull out, but it must be from your current employer plan. If you have an old 401k plan it doesn’t work. You would still pay taxes on the amount withdrawn but you would avoid the 10% penalty. But you have to be 55 or over to make this work and it doesn't work with IRA's only 401k's. You could also use the 72-t rule to access money from your 401k or IRA before age 59 ½ without the 10% penalty. If you take substantially equal periodic payments over 5 years, then the 10% penalty is waived. There are IRS calculations for this, so get with your financial advisor or tax professional before implementing this strategy.

The 4% rule

So, the idea of your withdrawal strategy is bridging the gap between when you retire and when social security benefits and perhaps pensions will be available. Now the question would be, what is a sustainable rate to withdraw. Many planners will refer to the 4% rule on this. By withdrawing 4% of the account value in year one and adjusting for inflation each year, then the risk of running out of money is negligible. But this could be different for you. You may need to withdraw more than that until social security kicks in. Everyone is going to be different. There is software out there that can calculate these scenarios and give you simulations of what your degree of success would be. This is where we can get to what your NUMBER is. For example, if you require $6,000 a month in retirement and follow the 4% rule, then multiply the annual amount needed of $72,000 by 25 which is 1.8 million. However, I would say this could be adjusted. Because maybe your withdrawal rate will be higher in the earlier years and then adjusted downward once social security or pensions kick in. By the way you should strive to be debt free in retirement. Get the house paid off, no credit card debt or other loans. This will free up extra cash flow, because the last thing you need is debt in retirement. After all, you want to enjoy yourself in retirement and not be encumbered with debt.

What about health insurance?

The next thing to consider if you want to retire early is health insurance. How will you maintain your health insurance? Here are some options to consider. First, if your spouse would still be working you could piggyback on their coverage. But what if both you and your spouse retire early, then look into your employer group coverage. Do they offer continuation of coverage? Some employer plans will cover you even after you retire up until Medicare age. If that’s not an option, look into the marketplace plans. You may qualify for a subsidy, especially if you will be living off your brokerage account that would be taxed at capital gains tax rate and not ordinary income tax rate. Also, check out an HSA. If you had an HSA account with your employer before you retired then you could use that coupled with a high deductible health insurance plan to bridge the gap to Medicare, this could lower your health insurance premiums.  Or what about picking up a part time job that offers health insurance. Many well known companies offer health insurance to part time workers.

Pay attention to your investments

The next thing to consider if you want to retire early is to have a couple of years of the income you will need in retirement saved up in cash. That way you could withdraw from that instead of tapping into your investments. This could avoid the sequence of returns risk. So, think about it. If in the year you retire the market declines and you’re withdrawing from your investments, then that’s a double whammy. So, by withdrawing from that savings account first it could give your investments time to recover. Speaking of investments, look at how your portfolio is allocated. Now is not the time to have speculative investments. You may want to consider reallocating the portfolio that would be more in line with not only your risk tolerance but also your risk capacity.

Hey look, Early retirement is certainly a bold financial goal, but it can be accomplished with the proper planning. 

Keith Wilson

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice. Please seek a professional tax advisor. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.

Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.