Retirement doesn’t look the same as it used to. Many workers want to take a step back from the workforce long before age 65, yet many fail to do the proper planning ahead of time that makes early retirement possible.
Retiring early brings many complexities into the equation, and one of the biggest is health care costs. Over the past twenty years, medical care costs have grown an average of 3.5% per year.1
You also have to consider where your investments are located, as some accounts enforce penalties for early withdrawals. There’s a lot to think about, but this article walks through a few of the most important things to consider when thinking about early retirement.
Health Insurance Planning
One of the most significant expenses to plan for in early retirement is health insurance. Since Medicare doesn’t kick in until the age of 65, you need to bridge the coverage gap. If you’re lucky enough to have an employer providing retiree medical benefits, this may not be too much concern. However, many companies don’t offer this luxury, leaving many hopeful retirees searching for options.
If your spouse is still working, you may be able to access their insurance, which would reduce the potential costs. For those who’ve struck out on the first two options, one of the last resorts is to purchase marketplace insurance. Created alongside the Affordable Care Act, allows individuals to browse insurance policies based on their personal information and preferences. Depending on your situation, you may be able to qualify for tax credits that lower your monthly premium payments. However, these credits are income-dependent, so you must plan your income carefully and keep it below specified levels.
Roth Conversions & Retirement Funds
It may be advantageous if you’ve accumulated a healthy retirement nest egg to convert some of the pre-tax funds to a Roth account over several years to minimize the overall tax bill. Because your income would be lower than when you were working, you can move some tax-deferred funds to a Roth account, pay the taxes now at a lower rate, and then take advantage of the tax-free income throughout your retirement. The Roth account would also not be subject to RMDs, giving you more income flexibility in the future.
To take a different route, when you withdraw funds from a 401(k) prior to reaching age 59 1/2, you typically incur a 10% penalty, and you’re required to pay income taxes on the funds. However, some 401(k) plans allow participants to withdraw funds penalty-free after reaching age 55, giving you an extra 4 1/2 years to use the income as needed. While you should prioritize using funds from accounts that don’t incur a penalty or offer tax benefits, the Rule of 55 can help you avoid the 10% penalty.
For those who have additional tax-deferred retirement accounts, you may be able to take advantage of a Substantially Equal Periodic Payment (SEPP) plan. This allows you to withdraw funds prior to age 59 1/2 without penalty, and you must choose between three different distribution methods. Once you begin taking payments, there is minimal flexibility other than the fact that you’re allowed to change the distribution method one time after starting the plan. You’re unable to continue funding the retirement account once the distribution begins, and the SEPP plan guidelines last until you reach age 59 1/2 or the plan has been active for five years, whichever is later.
Additionally, if you’ve built up a substantial portfolio in a taxable investment account, you can withdraw funds without penalty after paying capital gains tax. You also have the ability to tap into cash reserves to help cover a lack of earned income.
It’s Not All About the Money
When thinking about early retirement, it’s easy to get caught up in the data and numbers. While they’re important, you need to consider what early retirement will look like to you. There are unlimited reasons why you may want to do so, but take some time to truly think about what you want your day-to-day and month-to-month lifestyle to look like. This will help you determine if it’s the right choice to make, and if so, you can then outline a retirement budget. This will give you a more accurate picture of what you need to prepare for financially.
Early retirement is not for everyone. Many moving pieces must be carefully evaluated. You need to understand where you’re at financially and the current tax rules so that you can make an informed decision. A financial advisor can help you talk through the possibility of early retirement and ultimately help you make the best financial decision for yourself.
1. Peterson Foundation. Why Are Americans Paying More for Healthcare? February 16, 2022. Peter G. Peterson Foundation.
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