This month, I spoke with a 52-year-old who was fed up with working. He decided that 30 years of dedicated work to the same company was more than enough, and he had a significant amount in his 401(k). After discussing with his spouse, the investor thought he wanted to take his entire 401(k), move it to his bank account, and live off the cash for life.
Fortunately, we were able to find a way for the money to stretch much longer, and have the investor avoid the 10% IRS penalty on the money he worked so hard to accumulate. Here are some financial planning considerations for investors seeking to retire before the age of 59 ½.
Make Sure You Have Enough
Before discussing the sequence of withdrawals and how to minimize tax impact, it’s critical to ensure you have enough passive income and assets to meet your total income needs in retirement.
Here are some critical considerations in calculating what you’ll need:
- Investment return expectations: This will likely be 4-8% based on your risk tolerance. Usually, an all-cash or all-equity portfolio would not be expected when someone needs to draw income from it.
- Inflation expectations: Just under 3% is average for inflation over the last 100 years.
- Taxation expectations: SmartAsset has a great calculator for current taxation expectations, but keep in mind that taxation can change, especially during a longer retirement.
- Income expected in retirement: This can include rental income, gifts, ongoing business interests, pensions, and Social Security.
- Basic expenses: This is what you need to meet your non-discretionary needs. It includes housing expenses, utilities, debt servicing, and groceries.
- Expenses tied to covering employer-paid benefits: If life insurance, health insurance, or long term care insurance is covered by your employer and not portable, you will need to assess your needs and separately pay for necessary coverage. In most cases, insurance is more expensive to pursue outside of an employer plan.
- Variable expenses tied to hobbies, travel, eating out, and entertainment: If you don’t plan to be a home body during retirement, your variable expenses will likely increase because you’ll have more time for leisure.
- Aging-related medical events like long term care costs: Long term care expenses are not covered by Medicare and can be a major burden if not planned for.
Since retiring early means heavier reliance on investment portfolios and outside income sources, I would advise using low estimates for things like investment returns and income from other sources, and high estimates for everything else. This will mitigate the risk of surprise shifts in interest rates, market performance, or policy changes dismantling your entire plan.
I also wouldn’t recommend just using an online calculator or an Excel sheet to calculate on your own. Too often, I’ve seen people fail to consider a factor or miscalculate entirely. When planning for a long retirement, it’s best to consult a financial professional and ensure it is done correctly.
Retirement Accounts
Many people who’ve sought an early retirement date have had some concerns about when they can withdraw from their retirement accounts. In most cases, the rule is you’ll face a 10% tax penalty on withdrawals before the age of 59 ½. Government workers who have 457 plans can access penalty-free withdrawals if they are separated from their employer and there are some special cases where you can qualify for penalty-free withdrawals, but for most, they’ll need one of the two workarounds listed below.
Substantially Equal Periodic Payments
In the introduction, I mentioned the story of the retiring 52-year-old. IRS Rule 72(t) allows investors to avoid the 10% IRS penalty by taking what’s known as Substantially Equal Periodic Payments for the longer of five years or whenever the investor reaches age 59 ½. It must be calculated for each investor, but for the 52-year-old to take monthly withdrawals, his calculation was 5% of the total per year. On $1,000,000, he would be able to withdraw $50,000 per year without penalty.
However, if he withdrew more than the calculation allowed, he would pay a 10% IRS penalty on all of the funds he withdrew. In this case, he would need to meet this calculation guideline every year between age 52 and age 59 ½ to satisfy the requirement. Because of these strict rules, it’s best to use a financial professional to ensure you are distributing the correct calculated amount.
Rule Of 55
If you are opting for early retirement between the ages of 55 and 59 ½, you can take advantage of the Rule of 55 for only your current employer’s retirement plan. This rule allows you to take penalty-free withdrawals from your 401(k), 403(b), or similar employer-sponsored plan if you separate from service after age 55.
If the investor from the earlier example was 55, he would have likely used this rule instead of 72(t). This is particularly helpful when you’ve been at one employer for a long time and saved substantially. Unfortunately, plans from prior employers and Individual Retirement Accounts would still be subject to the 10% IRS penalty.
Nonretirement Accounts
Nonretirement investments and cash will be the most easily accessible resources when you plan to retire early. If you have substantial gains in your investment accounts, you may still be facing a high taxation situation.
Sequence Of Withdrawals
For many of my current retirees, when accessible, I advise that they aim to deplete pretax retirement accounts first, taxable retirement accounts next, and tax-free assets last. There will usually be some variation each year depending on returns and current taxation. There are three major reasons that I recommend investors drain pretax accounts first:
- Today, many Americans are paying much lower federal taxes than we’ve seen in most of history. If tax rates rise, they erode the value of your pretax retirement plans.
- Tax-free and taxable accounts are much better to inherit. If you pass away, pretax accounts are among the worst for heirs to inherit because it can add a high and unwanted tax burden.
- The more pretax retirement accounts grow, the more money you will pay taxes on in the future. The more time a tax-free account has to grow, the more tax-free money you have in the future.
Conclusion
Retiring before age 59 ½ requires careful financial planning to ensure sustainability and avoid penalties. By strategically planning based on your income needs, considering IRS rules like 72(t) and the Rule of 55, and consulting a financial professional, early retirees can optimize their income streams and minimize tax impacts, paving the way for a secure and fulfilling retirement.