Before you decide to retire early, make sure the numbers add up. Image source: Flickr user Joi Ito.
Many Americans would love to retire early, but there are several things early retirees need to think about that don't necessarily apply to those who retire at the "normal" age. With that in mind, here are three things you need to account for as you formulate your early-retirement strategy.
1. Early retirees can have too much money in IRAs and 401(k)s
Even if you have more than enough money to retire early, you need to make sure you'll have access to that money -- or at least enough to cover your expenses for a few years.
If you have a 401(k) and are no longer working, you should be able to tap into the money in your account so long as you're at least 55 years old without getting hit with an early-withdrawal penalty. IRA's are another matter, however. Funds in a traditional IRA generally can't be touched until you reach 59-1/2 years of age, or you'll be subject to a 10% early-withdrawal penalty from the IRS.
A Roth IRA could be the solution for early retirees. Under the rules governing this type of account, you're free to withdraw your contributions (but not any investment gains) at any time and for any reason. In other words, if you have contributed $100,000 to a Roth IRA over the years, you can withdraw that amount of money penalty-free no matter how early you retire.
Bear in mind that under the current laws you can only contribute $5,500 to your Roth IRA each year ($6,500 if you're 50 or older). So if you don't anticipate having enough money in your Roth IRA to bridge the gap between your desired retirement age and the age at which you'll have full access to your retirement funds, it may be a good idea to start putting some money in standard (non-retirement) brokerage accounts. There's no sense in retiring early just to give thousands of your hard-earned dollars to the IRS in the form of penalties, so your savings plan needs to account for the "in-between" time.
Oh, and also be sure to account for the fact that you won't receive Social Security benefits at least until you reach age 62.
2. Healthcare is a significant extra expense
Since you won't be eligible for Medicare until you turn 65, healthcare is an additional expense you'll need to account for in your early-retirement planning, unless your job allows you to keep your benefits after you leave.
Even with the Affordable Care Act, this is no small amount of money. According to healthcare.gov, a 60-year old couple can expect to pay $1,327 per month for a "gold" level plan, which translates to nearly $16,000 per year (this varies by location, but it's a good estimate). Even a more budget-friendly "silver" plan will add $1,125 to your monthly expenses.
If you're planning to retire early, hopefully you have some idea of how much your monthly expenses will be. Just remember to add the costs of healthcare to that number when determining whether you can afford to retire early.
3. Time is not on your side, so plan accordingly
The oft-cited "4% rule" of retirement basically says that if you withdraw 4% of your savings during your first year of retirement, and then give yourself cost-of-living increases in subsequent years, there's an excellent chance that your money will last as long as you do.
The problem for early retirees is that this rule assumes you'll retire at or near a "normal" retirement age -- say, 65 -- and then live for another 30 years or so at most. If you retire at 55, this means you're money needs to last an extra 10 years -- thus a 4% withdrawal rate could be too much.
It's not the 4% withdrawal rate that's the big issue, but rather the increased withdrawals you'll require as time goes on. Inflation has historically averaged around 3% per year, and assuming this average rate continues, after 30 years, you'll be withdrawing about 145% more than your initial amount. It's easy to imagine how this can begin to eat away at your nest egg, especially in your later years, when you really don't want to run out of money.
So, when determining how much money you need saved to retire early, I suggest planning on a lower initial withdrawal rate than the commonly accepted 4%. There's no set formula, but if you plan to retire at 55 (or sooner), you should probably plan to withdraw no more than 3% of your total nest egg at first. If you can't get by on that amount, either increase your savings rate or consider delaying your plans by a few years to compensate.
Can you really afford it?
My goal here is not to talk you out of early retirement. If you're determined to stop working while you're still relatively young, go for it -- I hope to retire early myself. But it's important that you consider all of the additional "baggage" that comes along with early retirement so you can make sure that you can truly afford to retire early, and that your money won't run out prematurely. In short, the more you know, the better you can plan, so use these tips to refine your early-retirement strategy -- you'll be glad you did.
