
You were a diligent saver. You always maxed out your 401k and contributed to an IRA when possible. Now you are in your 50’s and you think you are ready to retire early. But before you quit your job and sail off into the sunset you should be aware that there are several looming challenges facing those who decide to retire early.
In my experience creating financial plans for people, the three challenges I see cause issues for early retirees the most often are:
1) Inadequate savings
2) Penalties and taxes on early withdrawals from tax-deferred accounts
3) Difficulty paying for health insurance
Without knowledge of these unique issues and careful planning to address them, you may be at risk of falling short of the retirement goals you spent an entire career working and saving for.
Inadequate Savings
Let’s start with the first challenge – you saved an amount that you thought would enable you to retire, but learn you actually fell short of the amount you need to achieve your retirement goals. Although this is something all retirees could potentially face, this issue is more common for early retirees since an early retirement means fewer years of saving and more years of portfolio withdrawals to fund a longer retirement.
Though you can’t go back in time and save more along the way, you are not without options. You can always delay retirement a little longer to allow yourself to do some last minute saving. Each year you delay retirement is not just an extra year to save, but one less year of withdrawing from you portfolio to pay for your living expenses. For this reason the impact of delaying just one or two years can have a material impact on your ability to achieve your retirement goals.
Continuing to work is not an all or nothing proposition. An even better option may be to work part-time at a job that you enjoy and supplement that income with the investment assets you’ve already accumulated. I find people who choose this option commonly feel like they have the best of both worlds – they still have something to keep them active, but without the pressure of a full time job and the feeling that they need to work to make ends meet.
Penalties and Taxes on Withdrawals from Tax-Deferred Accounts
The second unique challenge you may encounter as an early retiree comes in the form of tax penalties on early withdrawals from your tax-deferred accounts. Tax-deferred savings accounts are an incredibly useful tool when it comes to retirement planning, but you must make sure to follow all the rules. If you do not wait until you are old enough (59 ½ for IRA’s or 55 for 401k’s) before you withdraw from those accounts you will have to pay taxes and penalties on the amount you withdraw. I have worked with many people who thought they made all the right moves by diligently saving in their 401k’s or IRA’s with the goal of retiring early, only to find that the penalties from the early withdrawals made them unable to retire with the lifestyle they had hoped for.
The best solution to this problem is avoid it in advance by contributing to a taxable account before you retire if you plan to retire early. By doing this, you can rely on withdrawals from your taxable account during the years before you can withdraw funds from your tax-deferred accounts penalty free. Making deliberate decisions about not only how much to save, but also which accounts to save in can increase your chances of successfully retiring early.
But of course we can’t go back in time, so if you find you are already in this situation, don’t worry, you still have options. If you are retiring before age 55 for 401ks or 59 ½ for IRA’s, you can take substantially equal period payments for the greater of 5 years or the number of years until you reach 59 ½. It sounds simple, but you are only allowed to take out a specific amount every year based on certain withdrawal rules (there are 3 to choose from) and if you take out more, the entire amount withdrawn over the years is taxable at ordinary income rates and is subject to a 10% penalty. To read more go to the IRS page on 72(t) equal periodic payments.
Another option that may be possible is keeping your 401k (not rolling it over into an IRA) at your employer if separating at 55 or later to avoid the 10% penalty on distributions. However, not all employers allow you to keep 401k’s at the company after separation from service, so this is something to check before you consider retiring early.
Health Insurance
Last but not least, health insurance premiums for the early retiree can be expensive. Many people who retire early have to buy private health insurance because coverage with their ex-employer will not continue once they have retired. Whether you can afford the extra expense that you may incur to pay for health insurance is something that will need to be addressed in any sensible retirement plan. Considering this additional expense and saving for accordingly could be crucial to retiring early. Too many times people forget about the expense of healthcare and get a shocking surprise when they start seriously considering retirement.
Final Thoughts
The best way to make sure you can retire on time with no hassle is having a retirement plan in place that considers your unique goals and financial situation. Having a retirement plan helps you avoid common mistakes and address any challenges that are unique to your situation in advance. A plan will help set a plausible savings rate, determine which accounts to save in, and account for the additional expenses incurred when considering early retirement, such as healthcare costs. This will allow you to successfully transition into the retirement lifestyle you have always dreamed of.
Disclaimer: Everything mentioned in this article was for purely educational purposes and does not represent a specific recommendation for anyone. With all tax planning decisions you should consult a CPA or tax planning professional.