Retiring early is a dream for many. For others, it may be a necessity or an unexpected development. But regardless of how it comes about, you’re in the minority as most Americans today have to work longer and retire later. So how do you plan for an early retirement?
An unexpected retirement
If you are unexpectedly forced to retire before age 59½, you’ll likely need to bridge the income gap until you can access your retirement savings without penalty. For example, you can make up for the lost income by working part-time, becoming self-employed, or starting a small business. If the early retirement is the result of a disability, then find out your eligibility for disability benefits from your former employer or Social Security. And if these options are unavailable, you may need to dip into your retirement savings. In that case, you may be eligible for the 10% early withdrawal penalty waiver.1
A planned young exit from the workforce
If, instead, an early retirement was always in the cards for you, then congratulations. Only 13% of today's workers plan to retire before age 60.2 The rest wait until around 65.3 Chances are that you may now spend more of your life in retirement than you did working! This means you want to create a long-lasting stream of income. It is like drawing water from a well; you want to be careful that it doesn’t run dry. How do you do that, especially if you are retiring at a young age?
From the very beginning of your working life, you’ll want to save differently than someone who is planning to work until at least age 60. For example, as an aspiring early retiree, maximizing your annual contributions to your 401(k) might not make sense. Instead, perhaps consider adding more to a taxable account and investing up to the annual contribution limit in a Roth IRA. You’ll lose some of the tax-deferral benefits but gain something every young retiree needs—access to funds. Taxable account assets can be used at any age without penalty. And after five years, your contributions (not earnings) in a Roth can also be withdrawn without penalty or additional tax.
Other retirement accounts—like a 401(k) or traditional IRA—are subject to an additional 10% penalty until you hit age 59½, and Social Security doesn’t start until age 62 at the earliest. So if you plan on retiring before then, you probably will have to look at other ways to replace your paycheck.
Retirement income for those under 59½
Tapping into your retirement accounts too early can be very costly. For example, let’s say that you take $25,000 from your traditional IRA before you hit 59½ and you are in the 22% tax bracket. You will have to pay $8,000 in taxes and penalties (not to mention your state taxes). Not only that, but you will also miss out on continued tax-free growth and the power of compound investing.
There are typically three classes of investment accounts. They are taxed and regulated differently. This chart can help you avoid unnecessary taxes and penalties and maximize the tax-deferred benefits of your retirement accounts.
| |
Taxable Accounts |
Tax-Deferred Accounts |
Tax-Free Accounts |
| Examples |
Brokerage |
401(k), 403(b), TSP, traditional IRA |
Roth accounts |
| Age or Time Limitations |
Unrestricted |
59½ or 10% penalty |
5 years for contributions; 59½ or 10% penalty for earnings |
| Tax Benefits |
Capital gains, dividends, and interest are taxed every year; favorable tax treatment on qualified dividends and long-term capital gains |
Contributions are tax-deductible, account earnings are tax-deferred, and all distributions are taxed |
Contributions are after-tax, so all withdrawals are tax-free |
| Withdrawal Tax Considerations |
Capital gains tax (Long-term capital gains rates range from 0% to 20% at the federal level) |
Income tax (All distributions are taxed at ordinary income rates, and your tax rate can go up the more you withdraw) |
None |
Avoid penalties with these income sources
Consider obtaining income from these sources until you reach age 59½ and can access traditional retirement accounts.
- Cash savings, including savings deposits, certificates of deposit (CDs), and money markets. Cash that is earning close to no return sitting in a savings account should be your primary source to supplement retirement income. Also, consider laddering CDs so they expire at various times throughout the year. That way, you should always have access to capital if needed.
- Taxable brokerage accounts. You will not be subject to any early withdrawal penalties by drawing from your taxable accounts. And doing so allows the funds in your tax-deferred and tax-free accounts the potential to continue to grow. Another benefit of taking distributions from your taxable account is that qualified dividends and long-term capital gains are taxed at lower rates than ordinary income. (Non-qualified dividends are taxed at ordinary income rates.) This can potentially lower your lifetime tax bill.
- Home equity line of credit. Houses tend to be individuals’ most valuable assets. Depending on the prevailing interest rates, an equity line may make sense as a source of income or a backstop in an emergency.
- Cash value of life insurance. Whole-life policies—including universal or variable life—have cash values, with some exceptions. You can tap into their accumulated cash value in three ways: surrendering the policy, withdrawing a portion, or taking a policy loan. But it’s important to know how that cash accumulates. For example, variable life’s value is based on its investments in the stock market, which may be lower in a down market. Note: Reducing the cash value may lower death benefits.
- Annuities. While some annuities have high fees and lack liquidity, the right one can be used to help your money last longer. Generally, annuities provide tax-free growth and lifetime income. Therefore, the chance that you will outlive your money is reduced. And depending on the annuity you get, you can take income from it at any time and not be subject to penalties.
- Roth contributions. As mentioned earlier, your Roth contributions are available after five years. And since you contribute after-tax monies, you don’t get taxed again. However, you cannot access the earnings generated from your contributions until age 59½.
- 72(t) distributions. Penalty-free early withdrawals from an IRA or employer-sponsored retirement accounts under specific circumstances are allowed under this IRS rule. The amount from 72(t) distributions is typically a relatively small figure, so it should not be relied upon as the sole source of income. You also have to meet certain qualifications, including the requirement of taking at least five “substantially equal periodic payments.” As such, retirees should have good recordkeeping skills and attention to detail.
Longevity and sequence of returns risk
When planning for retirement, it's important to understand if your money will last for the rest of your life. According to the Social Security Administration, the life expectancy for 50-year-old men is another 25.7 years, and for women, 29.1 years.4 This means if both males and females retire at 55, they would need enough funds to last another 25 to 30 years. About one out of every four 65-year-olds today will live past age 90, and one out of 10 will live past age 95.5
Another key aspect to consider is when you retire. If you retire during a market downturn, it can significantly impact your retirement plan. This is called the “sequence of returns” risk. If you withdraw money from a portfolio that’s declining in value early in retirement, then you are at greater risk of depleting your nest egg sooner than a retiree who suffers a market downturn years later. Taking withdrawals when there is a big loss in the market means you may be taking more from your investments than you can make up. The first several years of your retirement are important, especially if you are planning for 30 years of retirement.
To help alleviate the risk of needing funds during a market downturn, we recommend setting aside three to five years’ worth of savings in a liquid account (money market or short-term government bonds) so that if the stock market tanks, you don’t have to worry about your near-term income needs or aren't forced to sell stocks at fire-sale prices.
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