Everything you need to know about retiring early
Retirement comes in all different shapes and sizes.
Here’s what you need to know if you’re considering early retirement. .
What is retirement really? Is it an age, a number on an Investment statement, or a mindset? When you break it down, retirement is a decision to trade in your income for your time.
Being prepared for retirement affords you the ability to control your own destiny and shape your own narrative. Though the road to get there is difficult and requires a lot of sacrificing. The two major characteristics nearly every early retiree has in common is: an incredible ability to save and to live below their means. This doesn’t mean living off of tuna cans and joining the F.I.R.E. community are required, instead, it’s an invitation into intentional spending, diligent saving, and consistency across decades.
Here are a few things to consider before deciding whether or not you’re ready to retire early:
Are you retiring INTO or FROM something?
Why are you wanting to retire? Is it to get away from the backbreaking 60 hour work weeks with a demanding boss that you just can’t endure anymore? Or is there a stress-free, part-time job and more time with family that is calling your name?
How you retire matters.
Let me say that again. How you retire matters.
Having a purpose and something to pour into and look forward to on the other side leads to a significantly happier retirement and better outcome.
According to a research study conducted by Boston College, they found the three largest determinants of well-being and happiness in retirement were:
• Having a reason to retire aka "Purpose"
• Having the flexibility to choose when to retire aka "Controlling the Narrative"
• Your Health
Simply choosing to get away from your old job or relocate to a new state to get a fresh start often times results in dissatisfaction as the root of the issue hasn’t been addressed.
As you’re reading this, take a moment to pause and visualize the people and things that are most important to you.
WHAT IS IT THAT YOU HAVE ALWAYS WANTED TO DO?
Starting with knowing your why, as Simon Sinek writes is the best place to start. Understand that, and the rest becomes easy in deciding how to outline a course of action to make your WHY a reality.
2. Be sure to include room for taxes and health care in your Budget
If you are considering retiring before age 65 beware of the steep costs of private health insurance will cost you as many are required to pay this out of pocket. Current laws have capped insurance costs at a percentage of household income. Though for a newly retired couple with $50,000 of household income, for example, a mid-level plan could range in price from $300-$500 a month.
Second, many people fail to remember that when taking distributions from an account, they need to factor in taxes.
If you find yourself drawing from a retirement account, you need to be sure and build in a line item for taxes. This means your distribution is going to need to be higher than the actual (NET) amount you need, to account for taxes.
Using the previous example, taking $50,000 from your retirement account would look like:
NET AMOUNT: $50,000
Less Federal Taxes at 12% - ($7,228.92)
Less CA State Taxes at 5% - ($3,102.05)
Total Taxes Paid: $10,330.97
Total GROSS Distribution: $60,330.97
TIP: Where you take your money from matters. Why? TAXES
What would this same $50,000 distribution look like from a Brokerage (Taxable) Account?
You are taxed differently depending on the type of account you pull your money from. Retirement distributions are treated the same as Ordinary Income (think your paycheck) whereas Brokerage account distributions are subject to Capital Gains tax rates.
Why is this important? Take a look at the chart below and you can see that you have a “tax-free” bucket of $83,350 if Married ($41,675 if Single) to fill up with Capital Gains and effectively not have to pay anything in federal capital gains.
Image Credit: NerdWallet3. Start building your retirement “bridge” now
You just learned about Capital Gains from the above example and the importance of having a Brokerage account. Years before you step away from your job, you should be funding your Brokerage account while saving for retirement.
Adequately funding a brokerage account will allow you to potentially:
Lower your taxable income in retirement
Have the resources to be able to choose to delay Social Security
Keep your Retirement assets growing longer and uninterrupted
Create other favorable tax planning opportunities
4. Your withdrawal rate matters
Retired Financial Planner, Bill Bengen, created a back-of-the-napkin withdrawal rule for retirees that has been the benchmark for decades. Bengen states that a retiree can withdraw 4% of the total value of their investment portfolio throughout the lifetime of their retirement without depleting their account.
Due to current market conditions, inflation and now lower future projected returns for stocks and bonds, this figure may no longer be feasible. Instead, new research suggests using a figure closer to 3.3% of your total account balance to calculate how much you can comfortably afford to live off of.
Example- Tom and Suzie have $1,500,000 in their portfolio
Using the 4% Withdrawal Rule: $1,500,000 x. 4% = $60,000 per year
Using the 3.3% Withdrawal Rule: $1,500,000 x. 4% = $49,500 per year
If you’re planning on retiring early and having a longer retirement than most, it may be beneficial to use a lower projected number and not put too much stress on your account.
5. Know your IRS Rules
Tapping your Traditional IRA account early, before the age of 59.5, will result in you needing to pay a 10% early withdrawal penalty, and oh yeah, remember those taxes from earlier? Those still apply too.
So what’s your best option? Your Brokerage Account!
Why? A more favorable tax rate and no early withdrawal penalties.
What if you don’t have a brokerage account?
Assuming you’re retired, your next best bet is to look to your 401k account as most former employers will allow you to begin taking early withdrawals starting at age 55 without penalties, though income taxes will still apply.
Certain conditions must be met and each employer is different. The most important nuance to remember when pulling from your 401k at age 55 is that the 401k account must still be a part of the group plan and with your former employer. Thus, if you decide to rollover your 401k into an IRA, the option to take eligible distributions free of penalty at age 55 goes away.
6. Avoid making BIG purchases early
Using much of the wisdom of the 4% withdrawal rule from earlier, research shows that choosing to take a big withdrawal early on in your retirement account can have a lasting negative impact on the rest of your retirement.
Why? You rob your account of being able to take full advantage of compounding interest and time.
For example, taking a $100,000+ distribution early in your retirement to pay for an RV or a year-long travel purchase immediately puts your retirement account at a disadvantage from the start. Thus, the returns in the market your account will experience, now have less power behind them.
Trace that out over the course of 20+ years and the difference can be tens of thousands, if not hundreds of thousands of dollars in lost compounded returns.
No one is saying you can’t enjoy an early retirement or have nice things, but knowing your withdrawal rate and understanding the impact that major purchases have on your account is critical to retirement success. Using Monte Carlo simulations with your financial advisor or other financial planning software solutions can help illustrate an appropriate path to retirement and sensible withdrawal rates and demonstrate how to factor paying for major purchases.
7. Be on the same page as your spouse
You are about to embark on a new season of your life and odds are:
You are going to have more time on your hands
You may potentially experience a loss of identity through no longer working
You could find yourself in a new location after having sold your house and moved across the county
Many of your friends may not be around as they could be still working
Retirement is a major shift and it’s important to work through this transition well before, during, and in retirement with your spouse. It’s important to be flexible, communicative, and adaptable as getting comfortable in retirement together is going to take some time getting used to.
Have fun with it. Be creative and make it your own.
Disclaimer: The views and opinions expressed are made as of the date of publication and are subject to change over time. The content of this website is for informational or educational purposes only. Website content is not intended as individualized investment advice, or as tax, accounting, or legal advice. It is not intended to be a recommendation or endorsement to buy or sell the specific investment. This information should not be relied upon as the sole factor in an investment-making decision. Website users are encouraged to consult with professional financial, accounting, tax, or legal advisers to address their specific needs and circumstances.