When asked what you want your retirement to look like, there is a never-ending list of answers. Some people want to travel the world, others strive to build fulfilling encore careers, and others can’t wait to live on their terms. Many itch to leave the 9-5 grind and endeavor to retire early.
Northwestern Mutual’s 2020 Planning and Progress survey found that the pandemic altered retirement plans for 30% of the population, with 10% considering retiring earlier than planned.
Early retirement is a wonderful goal. But too often, people only focus on the joys of a work-free life and don’t consider their finances’ role in helping them achieve it.
When considering retiring early, many people aim to call it quits anywhere from 50 to 55. But most retirement accounts don’t let you begin to withdraw funds until at least 59 ½. Finance pros refer to this gap as the bridge period.
- How can you supplement retirement income and other vital costs like healthcare when retiring early?
- How will you use your time meaningfully?
- Can you make your early retirement vision a reality?
Today, we’ll explore the top three elements you should consider on your journey to early retirement.
Understanding the Bridge Period: A Key Concept in Early Retirement Planning
The bridge period is the gap between the age you retire and the age you can draw from your retirement accounts. In most circumstances, you also can’t enroll in Social Security until at least 62, though it might be best to wait until your full retirement age (likely near 67) to start collecting benefits.
But don’t you have to wait until 59 ½ to access your retirement accounts? Not necessarily.
Let’s look at ways you can tap your retirement accounts early.
Can You Make Early Withdrawals from Retirement Accounts Penalty-Free?
Breaking Down the Rule of 55
The Rule of 55 allows you to withdraw funds from your employer-sponsored retirement account (401k, 403b, etc.) penalty-free at 55. Remember that this rule only applies if you leave your employer any time during or after you turn 55. So, if you retire at 54, you won’t be able to take advantage of penalty-free withdrawals. Old 401(k)s at other companies also don’t qualify; you can only withdraw funds from the account with your current employer.
Look Into Rule 72(t)
While you can withdraw from your 401k at 55 without penalty (assuming you are fully retired), you can’t touch your IRA without a penalty until you turn 59 ½ unless you take advantage of Rule 72(t). The IRS established Rule 72(t) to provide exceptions to early distribution from an IRA and other tax-advantaged retirement accounts. If you follow the strict parameters, you may be able to take funds from an IRA penalty-free (though you’ll still be on the hook for income taxes).
To comply with the rule, you must take at least five of what the IRS calls substantially equal to periodic payments (SEPPs). Determining what those payments look like depends on your life expectancy, a process the IRS spells out in painstaking detail.
The bottom line?
The 72(t) rule requires a substantial commitment and is only suitable for some investors. Before initiating, make sure you meet with your advisor and tax professional.
While there are specific rules and exceptions, it’s important to remember that you have options. For instance, you can access 401k funds without a penalty for qualifying expenses before you turn 55. You can also withdraw from your IRA penalty-free for some qualifying medical, education, and home expenses. Exploring the 72t calculation can help you understand your options for taking IRA distributions before 59 ½ without penalty.
Utilize Your Roth IRA
Roth IRAs have a 5-year rule, which allows you to make penalty-free withdrawals if it’s been at least five years since you contributed to any Roth IRA. You can enroll in Social Security before 62 if you collect a survivor benefit or apply for disability benefits.
Even though there are numerous withdrawal exceptions, they remain just that: exceptions. You want to build your early retirement income plan on something other than exceptions. Planning for your income to support your desired lifestyle before quitting your day job is crucial.
Three Critical Tips for Mastering the Bridge Period
Preparing for financial independence during the bridge period is a crucial step towards early retirement. By retiring early, you compress 10-15 years of savings into a shorter timeframe. As most individuals reach their peak earning years between 50 and 60, it’s crucial to ensure you’re on track to meet your retirement goals and not miss out on valuable investment opportunities.
There are three essential areas you need to plan for in this period:
- Income
- Healthcare
- Your lifestyle
Let’s take a look at how to prepare for each.
Plan Your Income
You can only begin withdrawing money from your 401k when you turn 55. Withdraw before then, and you are looking at a 10% penalty plus income taxes on the total distribution amount unless you are fully retired. Some other circumstances permit early withdrawal, such as 401k loans, Coronavirus-related funds, and some medical needs—check in with your team before initiating early distributions.
Most people looking to retire by 55 will need a plan to supplement their income until they can access their other retirement vehicles, such as an IRA, pension (check with your plan for specific withdrawal requirements), Social Security, etc. That is at least four and a half years of living expenses to plan and prepare for.
Focus on Curating a Diversified Portfolio of Financial Assets
Look at your asset allocation (how you invest your money). Has your risk tolerance and capacity changed? How can your current investment habits help you live the life you want, even if you retire early? Are you adequately diversified within each portfolio?
Double Down on Investment Vehicles Outside Tax-Sheltered Retirement Plans
Unless you fall into an exception, you can’t touch most of your retirement accounts until 59 ½. Before you retire early, instead of solely focusing on ramping up retirement savings, consider other investment vehicles like your brokerage account, real estate, and other alternative investments (should they be appropriate for your situation). You can draw funds from your brokerage account whenever you want. While you’ll be responsible for capital gains tax, you aren’t facing a hefty penalty.
Increase Your Cash Reserve
For example, saving at the local bank can help bridge the gap. While there will always be an ongoing debate on the role cash should play in your investments, it’s crucial to understand how much cash you have and may need in the bridge period.
Make the Most of Your Roth IRA
Aside from building up your other investment accounts, using your Roth IRA could be an excellent way to access your savings. Roth dollars are invaluable for many retirees, as qualified distributions remain tax-free.
If your Roth IRA has been open for at least five years, you can start withdrawing money from it before you turn 59 ½, assuming you withdraw the contributions and not the account’s growth. What does that mean? While you can withdraw money from your Roth IRA penalty-free before midnight (or you turn 59 ½), you can only withdraw what you contributed. Say you made a $10,000 deposit to a Roth IRA in August 2016. After five years of compounding, your bounty grows to over $14,000. You can only withdraw your initial $10,000 deposit; touch anything above that, and you’ll face a 10% penalty and income tax on the entire distribution.
You can even initiate regular conversions from your 401k or traditional IRA into a Roth IRA to build up that fund and increase your bridge period budget. This strategy is called a Roth IRA conversion ladder and can help supplement your income. You will likely need to pay ordinary income tax on the amount converted. Additionally, every conversion adheres to its own “five-year” clock. To build up enough capital and ensure you have enough time to draw the money penalty-free, it’s best to initiate these plans well before retirement.
Rollovers present significant tax implications, and in the bridge period, taxes are critical. You want to remain conscious of your tax efficiency throughout the bridge period. Proactive tax planning throughout the year can help you make tax-smart decisions beyond April 15. Before implementation, review any idea or strategy with your financial planner and tax professional.
Plan Your Health Coverage
Healthcare is among the most relevant topics for retirees. Medicare is one of the available options for those retiring at 65. However, for those who want to retire early, more careful planning is needed to ensure they retain the right level of coverage.
Here are a few options to consider before you qualify for Medicare:
- Remain on your current plan (if your employer allows it). Recognize that you’ll likely need to foot the entire bill. Until now, your employer has most likely sponsored a significant portion of your premiums, up to 80% or higher. So, what was a $500 cost now could spring to a $1500 cost, pushing the envelope of what you want to spend.
- COBRA coverage. COBRA allows you to retain the same coverage but often comes with a massive spike in premiums. While convenient, it is a short-term solution, only guaranteed for 18 months.
- Add yourself to your spouse’s plan. What type of coverage do they have? How much will it cost? Is there a high-deductible option so you can continue contributing to your HSA?
- Shop around for policies on the marketplace. Insurance providers consider many factors when setting coverage prices, such as where you live, how much you make, your age, and your income. Make sure to read the fine print. What’s covered, and what’s not?
This is a question of balancing cost with quality of coverage. Remember, health insurance will be a large part of your budget when you retire early, so you must account for that when planning your income and expenses.
Plan Your Lifestyle
Retiring early comes with its emotional highs and lows. On the one hand, you don’t have to stick to a rigid schedule, allowing you to pursue your passions meaningfully. But on the other hand, you might experience an identity shift and need to work harder to fill your days with the things you love.
What will you do with your newfound freedom?
Now’s the time to identify activities, hobbies, or work that bring you joy. Think about what a typical day will look like. You don’t want to be so busy that you feel like you’re “working” all the time, but you also don’t want to be so sedentary that you’re bored.
Consider these ideas for filling your time meaningfully:
- Pursue hobbies you’ve always wanted to try.
- Volunteer for causes you’re passionate about.
- Spend time with family and friends.
- Travel and explore new places.
- Engage in physical activities to stay healthy.
Use Your Financial Plan to Build a Life You Love
If early retirement is your top priority, now is the time to start planning. Infusing your goals into your financial plan can help you and your financial professionals create a strategy that works.
Our team at TFS is passionate about aligning your finances with your values. Ready to take control of your financial plan? Please set up a time to talk with our team today.
Disclaimers and additional information
Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Federal tax laws are complex and subject to change. This information does not substitute for specific individualized tax or legal advice. Neither FSC Securities Corp nor its registered representatives offer tax or legal advice. As with all matters of a tax or legal nature, you should consult your tax or legal counsel for advice.
72(t) programs are complicated and not appropriate for all investors. It is recommended that investors seek the advice of a professional tax preparer before setting up distributions to determine suitability. Once established, changes or modifications to a 72(t) program may incur
severe penalties from the IRS. 72(t) distributions from a qualified plan are still subject to normal taxation. Investors should note that distributions taken under a 72(t) program may be subject to surrender charges and/or early redemption fees based on the type of investments held within the qualified plan.
Borrowers have five years to repay a 401(k) loan. If you lose or switch jobs, the loan must be repaid, usually within 60 to 90 days. The IRS will count the loan as a taxable distribution if you don’t pay it back on time. You will owe income taxes, plus a 10% federal income tax penalty if you’re younger than 59 1/2, on the unpaid balance.
If you convert a traditional IRA to a Roth IRA, you will owe ordinary income taxes on any previously deducted traditional IRA contributions and all earnings. A conversion may place you in a higher tax bracket than you are now. Because Roth IRA conversions may not be appropriate for all investors and individual situations vary, we suggest you discuss tax issues with a qualified tax advisor.
