“Accelerated retirements,” are on the rise and have caused a major shift to the long-running trend of working beyond 65. One reason for this trend is jobs lost during the pandemic. Many who lost jobs either elected to or were forced to retire early due to undue hardship or inability to find another job. In fact, in the 15 months after the pandemic began, about 2.5 million Americans retired – almost twice the number who retired in 2019.1
Other workers have decided to retire early because they could. 401(k) and IRA accounts have performed better than expected due to record stock values. Home values have also sky-rocketed recently. These and other factors have offered some the financial security to stop working earlier than planned.
When it comes to early retirement, however, it is important to look before you leap. Perhaps the greatest risk involved is longevity – how do you make sure that your income stream will last long enough? You should definitely stress test your income stream, including worst case scenarios such as market lows and high inflation. Make sure your plan has the flexibility and cushion to survive the storms, not just the average to good times.
Another factor to consider is when your funds will be available. Dipping into certain accounts before age 59 ½, for example, can be very costly. If made prior to age 59 ½, withdrawals made from traditional IRAs and qualified plans like 401(k) accounts are generally subject to income tax and an additional 10% penalty. Together, that can eat up 20-50% of your withdrawal depending on your tax bracket. The real cost of early withdrawals, however, comes from the lost growth on your account over time. Every dollar withdrawn today could amount to several dollars lost later.
Fortunately, there are income sources other than traditional retirement accounts. An optimal option is to live on post-tax cash and investment assets. You will generally not be subject to penalties and will only pay tax on realized gains. You should, however, be prepared to keep enough cash in savings or checking accounts to avoid having to liquidate assets at a loss or other inopportune time.
Another option is a Roth IRA. Roth IRAs generally involve fewer restrictions and penalties than traditional IRAs if you need to access them before age 59 ½ (regardless of whether or not you are retired). For example, you can generally withdraw your contributions tax free. If you withdraw earnings early, you will pay penalty and tax on those. Keep in mind, however, a major advantage of Roth accounts: they are one of few investment accounts that grow tax-free; if you dip into them early, you will forfeit a portion of this advantage.
If you have a 401(k) and retire before age 55, you can generally opt to withdraw money from it without having to pay the 10% penalty. If you happen to be a qualified public safety worker, an even lower age requirement of 50 applies. If you choose this option, it is important not to roll the account over to an IRA; if you do, you will lose this option and have to wait until age 59 ½ to avoid the penalty. You must have turned 55 during the year you leave your employer; you cannot leave at an earlier age and start penalty-free withdrawals at age 55.
Another possibility is to set up a (Rule 72(t)) annuity. IRA withdrawals taken as a series of substantially equal payments are generally not subject to the early withdrawal penalty. However, you must use an IRS-approved distribution method and be sure to calculate payments correctly based on certain factors such as life expectancy. This route generally requires professional help to ensure it is done correctly to avoid penalties.
Finally, there are some penalty-free ways to withdraw money from retirement accounts prior to age 59 ½ if you use it for certain expenses including: medical (exceeding 10% of AGI), some health insurance premiums, 3) first home purchase (up to $10,000), higher education, 4) childbirth or adoption (up to $5,000), 5) severe disability, or 6) military service. Recent laws also allowed those affected by Covid-19 to take up to $100,000 from retirement plans and IRAs penalty-free in 2020 and made similar allowances for workers in major disaster areas in 2021.
You should work closely with a tax professional before invoking these exceptions. Penalties for getting it wrong can be steep. They also often apply to limited time frames and are always subject to change. And, although it is good to be aware of them as possible opportunities, they are not reliable sources of funds to count on as part of a long-term plan.
As for Social Security, you can usually begin receiving benefits at age 62. Then, you’ll only receive partial benefits. For anyone born in 1960 or later, you are generally entitled to full benefits at age 62, but your benefits will be subject to annual “raises” if you wait until age 70.2
If you are considering early retirement, please give us a call. We would be happy to discuss your goals and income stream, stress test potential plans, and work through options for making the best of your investments.
1 Nytimes.com2021/07/02 They Didn’t Expect to Retire Early. The Pandemic Changed Their Plans.
2 Aarp.org2021/01/21 Pre-Early- Retirement-Reality-Check