Retiring early is a dream for many, but jumping the gun by retiring too early can leave you pinching pennies at the end of your life when your savings run dry. Before you decide to retire, it's important to make sure all of your finances are in order to avoid this grim picture.
Here are four questions you should be able to answer "yes" to if you're truly ready for a premature retirement.
1. Are your debts paid off?
It's not that you can't retire with debt, but it is taking a risk.
You'll have to pay those balances using your retirement savings, and there are several ways that can backfire. If it's revolving debt, like credit cards, the debt could spiral out of control and you could end up spending your life's savings just to get rid of the balance. If you are still paying off your house and an unexpected expense arises, like sudden illness, you may have no choice but to drain your retirement accounts to keep from losing the roof over your head.
It's best to go into retirement debt-free, so before you take the plunge when you still have a mortgage or credit card bills, consider delaying retirement until you've paid down the debt.
2. Do you have more savings than you need for your retirement goals?
It's impossible to predict exactly how much you will need for retirement because there are so many variables, including your life expectancy, investment rate of return and the inflation rate. But you can, and should, make a realistic estimate how much you'll need to live on.
Begin by estimating your life expectancy. Average life expectancy is currently 78.7 years, but yours may be lower or higher based on your current health, genes and lifestyle choices.
Next, consider inflation. Your money today won't go as far tomorrow. A good estimate for inflation is 3% per year.
Once you have these numbers, calculate your expected annual living expenses in retirement, remembering to add 3% for inflation each year. So if your living expenses this year were $35,000, next year, they would be $36,050, and so on. Continue this process for every year from now until the end of your estimated life expectancy. Or you can just use a retirement calculator. Add some cushion to this amount in case your money doesn't go as far as you'd hoped or you encounter unexpected costs.
Finally, subtract the amount you expect to receive from Social Security and any employer 401(k) match to figure out how much you need to save on your own.
3. Do you have a plan for healthcare?
Your retirement savings isn't just for general living expenses. It also has to be enough to protect you when unexpected expenses arise, like a serious illness or need for long-term care. The average couple retiring at age 65 today will need $280,000 to cover healthcare costs throughout their retirement, according to Fidelity. If you plan to retire before you're 65, you'll need even more.
Medicare will cover some of your medical costs in retirement, but you won't even qualify until you're 65. If you retire before then, you'll need health insurance either through a spouse or by purchasing a policy on your own.
Even when you do qualify for Medicare, it won't cover everything. There are still deductibles and copays that could add up to thousands of dollars if you become seriously ill or injured. If you haven't given much thought to the cost of medical care in the past, you should reevaluate your retirement savings goal to make sure you'd have health costs covered and delay retirement until you've saved that much.
4. Can you make withdrawals without penalty?
With few exceptions, you cannot withdraw money from your retirement accounts unless you're 59 1/2 or older. Violating this rule will result in a 10% early withdrawal penalty, in addition to owing income tax on the distribution. Unless you absolutely have to, this is not a good idea. If 59 1/2 is a long way off for you, you may be better off opening a non-retirement investment account and storing some money there or otherwise leave it in your savings account. You can live off of this until you're eligible to take retirement account distributions without penalty.
If you can definitively answer "yes" to these four questions, congratulations! You're on track for a happy early retirement. But if you're not, you're better off waiting a little while longer until you're really financially ready.