The idea of retiring early is especially buzzy right now, especially among younger people. If you Google “early retirement” you will likely see sensational stories about young couples leaving the workforce in their 30s although the more attainable target for most people is mid to late 50s. The idea of leaving the grind of a 9-5 job while you still have your health is certainly an appealing one. However, there are a few things to take into consideration when determining whether or not this is a good goal for you personally.
What is Retirement?
Before considering anything else, you should probably define what retirement is to you. The original definition of the term “to retire” is “to put out of use”. I very much doubt that your dream is to become useless! What you want retirement to look like will determine what you need to do financially to get there. For example, if your dream is to travel the country in an RV then your steps to retirement are probably going to look different than someone who wants to buy an oceanside condo on the beach. A used RV will likely cost less to purchase and maintain than a luxury condo on the Gulf of Mexico. Once you have a handle on what retirement looks like your financial advisor can help you craft a plan to get there.
It should come as no surprise that in order to retire earlier you will need to save more in the present. Your ability to fit extra savings into your budget is what will make or break your ability to retire earlier than average. For example, if a 30yr old making $55,000 a year contributes 6% to their 401k and receives a 3% employer match and averages an aggressive 8% return, they could very well have around $1,000,000 by the time they turn 67 (full retirement age for social security). By contrast, if that same person opted to retire 10 years earlier at age 57, their account balance would be around $440,000. Less than half the amount! In order for that individual to have the $1,000,000 in their retirement account by age 57 they would need to increase their retirement contributions to about 21% (18% after the employer match) or a total of $11,448 a year. Your budget and the opportunity cost of saving that much of your income should be weighed against your desire to retire early[i].
Retirement Account Withdrawals
Retirement accounts such as IRA’s or 401(k)’s are great tools for saving for your eventual retirement. As we have discussed in this blog at length in the past, these types of accounts allow you to save and invest your money tax deferred (or tax free via Roth contributions) for use in retirement. Where that becomes a problem for the “retire early” crowd is that the IRS tax rules regarding withdrawals from retirement accounts don’t really accommodate for early retirement. When you contribute to a retirement account, the IRS says that in exchange for certain tax benefits you must keep those funds in your retirement account until you reach age 59 ½ or else you will need to pay a 10% penalty in addition to taxes on your withdrawal. If you are inclined to retire sometime before that age, this is not ideal.
There are a couple of exceptions to this rule when withdrawing from Roth IRA’s or 401(k)’s. In a Roth IRA you have the ability to withdraw your contributions from the account prior to age 59 ½ without paying taxes or an additional penalty. However, withdrawing investment gains will still result in the IRS penalty in most circumstances[ii]. Likewise, some 401(k) plans allow for what are called “hardship withdrawals”. As the name suggests, these are withdrawals that take place as a result of a specific financial hardship. The IRS is quite picky about what can and cannot be considered a hardship withdrawal and has scrutinized these types of withdrawals more closely in recent years. It is important to note that while these withdrawals may avoid the 10% early withdrawal penalty, they likely will not sidestep income taxes in a pre-tax 401(k). Retiring before 59 ½ and without the cashflow to pay the bills without withdrawing from your retirement accounts could prove very costly and drastically change your retirement outlook.
After you turn 59 ½ you no longer have the issue of paying IRS penalties for early withdrawals. However, unless you have additional income from another source, you will still need to make withdrawals to supplement your income. This is especially true if you have not yet reached the age when you can begin taking social security, which begins at age 62. Also, while you are able to begin taking social security at 62, you have the potential of higher social security payments if you wait to begin drawing social security until full retirement age, 67. Therefore, if by necessity you begin taking payments at 62 you could be missing out on substantially higher payments at your full retirement age. As a side note, Medicare coverage also doesn’t begin until age 62 which means if you retire before then you will likely need to find a personal, often more expensive plan on the marketplace.
The point of today’s post is not to say that every person to retires early is making the wrong choice or is foolish. The point is that, however easy the internet makes it sound, there are quite a few variables at play when it comes to shortening your time in the workforce. Of course, if you have any questions about when you can afford to retire or what retirement could look like for you, give us a shout!
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. The purchase of certain securities may be required to effect some of the strategies. Investing involves risks including possible loss of principal.
[i] This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.
[ii] A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.