When asking the question, what do 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 simply can’t wait for the day when they can live their life on their own terms.
Many people 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% looking at 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 think about the role their finances play in helping them get there.
When thinking about 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.
- What can you do to 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.
What is the bridge period?
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 take a closer 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.
Keep in mind 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. Should you follow the strict parameters, you may be able to take funds from an IRA penalty-free as well (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 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 isn’t suitable for every investor. Make sure you meet with your advisor and tax professional before initiating.
As always, there are some notable exceptions to these distribution rules.
- Before you turn 55, you can access 401k funds without a penalty for qualifying expenses, which we discuss in more detail later on.
- You can collect from your IRA penalty-free for some qualifying medical, education, and home expenses. You can also look into the 72t calculation, which helps explore your options for taking IRA distributions before 59 ½, without the penalty.
- Roth IRAs have the 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. Exceptions aren’t what you want to build your early retirement income plan on.
It’s crucial to make a plan for your income to support your desired lifestyle before you quit your day job.
Three critical tips for mastering the bridge period
It’s essential to set yourself up for financial independence in the years between when you stop working and when you can withdraw from your retirement accounts.
You have to cram an extra 10-15 years of savings into a shorter time frame by retiring early. Since most people hit their peak earning years between 50-60, you want to ensure you’re on track to reach your ideal retirement number and not leaving valuable investment opportunities on the table.
There are three essential areas you need to plan for in this period:
- Healthcare, and
- Your lifestyle.
Let’s take a look at how to prepare for each.
Plan your income
You can only begin to withdraw 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 amount of the distribution 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.
For most people looking to retire by 55, you will need a plan to supplement your income until you can access your other retirement vehicles like 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.
Let’s look at a few ideas for building up enough savings to get you through those bridge years:
- Focus on curating a diversified portfolio of financial assets.
- Take another 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 a majority 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 by saving at the local bank, for example, to 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, making use of 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 you have had your Roth IRA open for at least five years, you can start to pull 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 the clock strikes 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 of 2016. After five years of compounding, your bounty grows to just over $14,000. You can only withdraw your initial $10,000 deposit; touch anything above that, and you’ll be facing a 10% penalty and income tax on the entire distribution.
You can even look to 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 well beyond April 15.
Be sure to review any idea or strategy with your financial planner and tax professional before implementation.
Plan your health coverage
Healthcare is among the most relevant topics for retirees. For those retiring at 65, there are more options available, namely Medicare.
But for those who want to retire early, more careful planning needs to be done on the healthcare side 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.)
- Recognize that you’ll likely need to foot the entire bill. Up 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 look at a myriad of factors when setting coverage prices like where you live, how much you make, your age, how much money you make, among other elements.
You need to retain your health coverage in some shape or form after you retire. Remaining uninsured can open you up to significant health and financial risks. Even routine physicals can run hundreds of dollars without insurance, and emergency room costs are astronomical. Add in X-rays, blood tests, prescriptions, and more, and you’re potentially looking at thousands of precious dollars.
Making a plan to cover you after you retire and before you qualify for Medicare will be a vital step in your retirement plan.
Healthcare is a considerable expense that is often forgotten or overlooked by many retirees. Some are accustomed to their employer paying 100% of the premium and may be surprised when the total falls on their shoulders.
How can you make a plan to pay for it? There are several options to explore.
- Draw funds from your health savings account (HSA)
- Store up extra cash
- Re-direct funds from your current cash flow
Plan your time
You’ve done it; you’ve retired at 55. One critical question remains:
After you’re home from your once-in-a-lifetime trip or you bought your dream house, what will you do? Eventually, the euphoria of a grind-less existence will dissipate, like morning dew as it evaporates into the sky.
You need to make a fulfilling and meaningful plan for your time. Once you step away from this chapter of your life, it’s time to write a new and exhilarating one. Ask yourself,
- What activities, hobbies, work, etc., bring you joy?
- Is there something you’re really good at but haven’t been able to dedicate the time to until now?
- Do you still want to work, just in a different capacity?
- How can you better use your time to align with your broader goals and values?
Many new and seasoned retirees struggle with planning for the day-to-day and building a new routine. It’s not easy to shape a plan for this next phase, but it is critical if you want to truly make your retirement “golden.”
Use your financial plan to build a life you love
If early retirement is a top priority for you, now is the time to start planning for it. Infusing your goals into your financial plan can help you and your financial professionals create a strategy that can work for you.
Someone who wants to retire at 55 will need a different plan than someone who plans to retire at 70. Everything from retirement income planning, savings strategies, risk management, investment planning, tax planning, healthcare planning, and more will be impacted by your choice to retire early.
All of these nuances make working with a retirement financial advisor invaluable. You must cultivate a team you can trust, whose sole goal is to help you reach your goals.
Our team at TFS is passionate about aligning your finances to your values because it is designed to help you to live the life you want on your terms. Ready to take control of your financial plan? 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 is not intended to be a 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 with your tax or legal counsel for advice.
72(t) programs are complicated and are not appropriate for all investors. It is recommended that investors seek the advice of a professional tax preparer prior to 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 upon 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 converting a Traditional IRA to a Roth IRA, you will owe ordinary income taxes on any previously deducted traditional IRA contributions and on all earnings. A conversion may place you in a higher tax bracket than you are in now. Because Roth IRA conversions may not be appropriate for all investors and individual situations vary, we suggest that you discuss tax issues with a qualified tax advisor.