As the world changed over the last two years, so has the
workforce. Employees are re-thinking how they want to spend their time after
being away from their family or losing loved ones to the pandemic. According to
SHRM.org, in 2021, 47.8 million workers quit their jobs — an average of more
than 4 million per month, the highest average on record. Of those workers, some
don’t plan to return to work, opting for an early retirement instead.
If you are one of those people or plan to leave the
workforce early, you may be wondering how to recreate your paycheck after you
leave the workforce. In this article, we’ll explore some of the options
available.
Accessing Retirement Accounts Before Age 59 1/2
Many people know that you can’t access your retirement
accounts without penalty until you are age 59 ½. If you plan to retire earlier,
you’ll need to determine what funds you can access without risking the 10%
penalty.
First, you can fund your needs by using the 72(t) rule,
which allows penalty-free withdrawals from IRAs and other retirement accounts,
like 401(k) and 403(b) plans. The 72(t) rule, also known as the substantially
equal period payments or SEPP, may appear in the summary plan description of
your employer plan. Before you retire, you will need to determine if:
You can retire early and start withdrawing from retirement
accounts, and
That a 72(t)-distribution is sufficient to cover your living
expenses (assuming no other buckets to pull from).
You’ll also need to follow certain rules, which include:
Scheduling annual payments (at a minimum)
Not withdrawing funds from your current employer’s plan (you
must be retired)
Taking payments over a course of five years, or until you
reach age 59 ½, whichever comes later.
The payment amount must be based on one of the approved IRS
methods: required minimum distribution, fixed amortization, or fixed
annuitization.
If you need to access your retirement accounts before you
hit age 59 ½ and are planning on using the 72(t) method, then you should calculate
how much you are eligible to withdraw based on each of these methods. Basic
calculators will give you an idea of what your payment might look like.
Remember, even if you use 72(t) you are only exempt from the 10% penalty. Any
withdrawal will still be subject to ordinary income tax.
If the 72(t) doesn’t fit your needs and you retire in the
year you turn age 55 (or after), the “Rule of 55” allows retirees to access
their 401(k) without having to pay a 10% penalty, and without the complexity of
the 72(t) calculations. Of course, you must follow a few rules to get access
without paying penalties:
First, you must keep your funds invested in your 401(k) and
take the withdrawals from there (the Rule of 55 is not available for those with
IRAs). Also, you can only withdraw funds from your current employer plan (or
the employer you just retired from).
Some plans allow participants to roll old 401(k)s into their
current employer’s plan so they can use the “Rule of 55” on a larger balance.
That would help if you were only at your last employer for a few years before
retiring and you don’t have enough built up within your plan. Not all employer
plans allow this, so double-check with your employer before you put in your two
weeks’ notice on your 55th birthday.
A few other exceptions will allow you to access retirement
accounts, like disability or death. But if you are retiring and healthy, your
options are limited to 72(t) and the Rule of 55.
Tapping Other Buckets
As you can see, getting around the standard IRS rules is
complicated. Luckily, if you want to ensure you have funds to retire before age
60, you have other options!
If you are age 30, 40, or 50 and plan to retire early,
consider saving outside of your standard pre-tax retirement vehicles. If you
have taxable assets (think after-tax monies, like an individual, joint, or
revocable trust account), you have ultimate flexibility on when to tap those
resources, because no age limits prevent you from getting access to your funds.
The downside to taxable accounts is that they are taxable,
meaning you are going to get a Form 1099 on these accounts every year (assuming
you earn capital gains or dividends) and will owe taxes annually. You’ll have
fewer tax advantages as you are accumulating, but you’ll have the flexibility
you may need as you enter early retirement.
The reality is that you can save a good amount into
employer-sponsored plans annually and get the tax advantages associated with
them. However, if you want to retire early and plan to live another 30+ years,
you will likely need more than just your employer-sponsored plan to fund your
lifestyle. The earlier you start building up all of your savings “buckets,” the
better off you’ll be.
I have ignored the advantages of Roth IRAs for this
discussion, even though they can be one of the best long-term savings vehicles
available. Why? If you plan to leave some of your assets to children or other
beneficiaries, you may not want to touch your Roth, even if you can. That’s
because you can pass Roth money on to the next generation tax-free. If you
don’t plan to pass on your wealth and do want to tap your Roth IRA, you can
always get access to your contributions anytime, penalty-free and tax-free. Try
to tap those earnings before age 59 ½ and you’ll find more complex rules to
follow. You can reference those here.
Other Strategies to Consider
Healthcare often keeps people working even if they’d like to
retire. The cost of private-pay health insurance can be a significant part of
your budget if you choose to retire before you qualify for Medicare. Planning
ahead, though, can help you keep those costs manageable.
One tactic includes saving money in a health savings
account, or HSA, throughout your working years. Those with a qualifying
high-deductible health plan may be eligible to contribute dollars to an HSA up
to the annual maximum, and get a tax deduction on those contributions. For
high-income earners, this is usually one of the only tax deductions available
after your employer plan. If you can save into an HSA, invest the funds during
your working years, and avoid using them for your pre-retirement healthcare
expenses, you’ll have another bucket you can tap for healthcare expenses. If
you choose to retire and go on COBRA coverage, you can pay your premiums from
your HSA account.
Another strategy that will help you retire early and save on
healthcare premiums is to fund a taxable account. This will not only allow you
to potentially avoid the restrictions of the Rule of 55 or a 72(t)
distribution, it also will allow you to keep your income low and qualify for
subsidized healthcare on the marketplace. Without subsidies, a married couple
can expect to pay $18,930/year in private healthcare premiums. This figure does
not include out of pocket costs if you have a health event.
To qualify for subsidized healthcare, you must be between
100% to 400% of the federal poverty line, meaning a couple can qualify with
income up to $73,240 in 2022. Even if you need an annual income of $100,000,
you can generally accomplish it by living off a taxable account and qualifying
for healthcare subsidies. You must think ahead, however. If you want to retire
at age 50 and want to qualify for healthcare subsidies for 10 years, you will
need a significant amount of money in taxable account to fund your needs.
Potential Pitfalls
If you plan to retire early and you are healthy, the budget
you used while you were working may not cover your plans for extra activities
in retirement. Be sure to factor in travel and hobbies you plan to pursue.
While you may be able to save money by eating at home and not spending on your
wardrobe, I find that many people end up spending more as they enter
retirement.
Remember, your retirement may last 30-40 years, so be honest
with yourself about your budget and the rate of return you can assume for your
investments. Assume a higher rate of inflation (especially for healthcare
costs), a reasonable rate of return, increased tax rates, and that you will
continue to help your adult children if you know you always have.
Preparing for Early Retirement
Many people assume that if they can retire early
financially, they should. But even if your projections seem sound and you’re
financially ready for retirement, you may not be emotionally ready, or have a
vision of how you’ll spend your time. Without a plan for how you’ll stay busy,
you may retire and panic.
Before you make this major life change, envision a typical
day. How will you spend your time? Who will you spend it with? While having
enough money is important, it’s not the only component of a successful
retirement. In my experience, those who take a holistic view of their
retirement plans tend to be happier in the long run.
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