A whole lot of people are hoping to make an early exit from the workforce. Through relentless savings and investing—begun early in life—they hope to accumulate enough money to begin early retirement as early as age 40. Not all plan to retire that young. More common ages might be 50 or 55, which provides an extra decade or so to save and invest even more money.
On paper this works smoothly. If you start at age 25, saving $15,000 each year in a tax sheltered retirement plan, and investing it with an average annual rate of return of 8% (among some other minor considerations), you’ll have $1,143,549 by the time you turn 50. Using the safe withdrawal rate of 4% per year, that will give you a dependable annual income of $45,742.
That will be a good position to be in, whether or not you decide to retire. And you may decide that you don’t want to, based on one or more of the “glitches” below.
Early Withdrawal Penalties Before Age 59 1/2
Let’s start off with some good news first. Withdrawals from tax sheltered retirement plans are not subject to FICA taxes. That means you’ll save at least 7.65% compared to wage income, and 15.3% compared to self-employment income.
Now the not so good news . . . .
Part of the appeal of early retirement is fueled by tax sheltered retirement plans like 401k’s, 403B’s and individual retirement accounts with their tax deferral feature. Not only are your savings contributions tax deferred, but the income earned in the account is too. Your savings and earnings accumulate without regard to the tax consequences. For people who pay combined federal and state income taxes of 30%, 40% or more, this is huge.
But the tax deferral sword is one that cuts both ways, and the cut is most severe for early retirees.
Once you begin withdrawing funds from a tax sheltered retirement plan the distributed amounts are added to your taxable income. In addition, any amounts withdrawn prior to turning 59 ½ incur a 10% early withdrawal penalty. If you’re planning on early retirement, this penalty is something you’ll need to be ready for.
How to Prepare for the Early Withdrawal Penalty
There are at least two ways to deal with this glitch. Both involve non-tax-sheltered savings. The first is to have an amount saved that will cover the penalty directly. In our example above, with an annual income of $45,742, you’ll be subject to a penalty of $4,574 each year until you turn 59 ½. If you plan to retire at 50, you could save an amount equal to 9 ½ years of penalties in a non-sheltered account, or $43,453, and pay the penalties out of that.
The second alternative, if you don’t want to pay the penalty at all, is to have money saved in non-sheltered accounts that will cover your income needs until you turn 59 ½ and the penalty no longer applies. That would require an additional amount of $434,549.
That’s a lot of extra savings of course, but it comes with a couple of extra benefits and they’re significant. Since the money is accumulated in non-sheltered accounts, withdrawal will not require the payment of income tax. And since you’ll be living on non-retirement money, you’ll have an extra 9 ½ years for your actual retirement accounts to continue to grow.
Big cost sure, but equally big benefits too.
No Social Security, No Pension
When preparing for retirement, many people factor Social Security and/or pension income into the mix. If you plan to retire early you won’t have either. The earliest you can collect Social Security is age 62, and the most generous pension plans usually won’t pay benefits before you turn 55.
How to Prepare for Missing Social Security and Pension Income
If full retirement won’t be possible absent third party benefit payments you may have to lower your expectations and consider semi-retirement instead. There are various ways to do this including:
- Reducing your current job to part-time status.
- Entering a completely different career—a fun one—on a part-time basis.
- Having your own business.
- Building semi-passive investment income sources, like rental real estate.
There are bonuses here too. A part-time earned income will add extra flexibility to your early retirement plans and give you a Plan B in case of investment hiccups. In addition, numbers 3 and 4 will provide you with an additional asset to sell to raise more assets for retirement when you decide you want your retirement to be full-time.
This will be the toughest glitch to deal with. Most people won’t be able to retire just because of the cost of health insurance. When you retire, there’s no more employer subsidized health insurance plan—the cost of the plan is paid entirely by you. Medicare won’t be available until you turn 65, which means that if you retire at 50, you’ll need to be prepared to pay 100% of your health insurance for 15 years.
Preparing for Health Insurance Coverage Before Medicare Kicks In
There are no easy options here. Private health insurance is expensive and hard to get, especially when you’re over 50. But here are some options to consider:
- Plan to maintain some sort of employment arrangement where you can get group health insurance; there are employers that offer health insurance coverage to part-time employees that might be an option.
- Maintain some sort of connection to a business that offers a group plan for its officers or employees.
- Investigate health insurance coverage offered by organizations you’re affiliated with, such as the American Association of Retired Persons (AARP) or Triple A (AAA).
- Adjust your retirement income expectations to allow plenty of room for a large monthly health insurance premium.
Between now and your anticipated retirement age, do your best to keep yourself in good health. Not only will that make health insurance cheaper and easier to get, but it will also keep your living expenses low, at least in regard to medical bills.
As appealing as early retirement is, it’s actually more complicated than normal retirement. There are a few extra hurdles you need to clear, but with some flexibility and extra effort you can make it happen.
Can you think of other glitches that early retirement could bring? Leave a comment and let us know!