Ah, the bliss of retirement. Whether your retirement dreams include a glitzy life of cruises, casinos, and cabarets, or a more mellow blend of sleeping in late, reading, and spending lazy afternoons with your family, you'd probably like to get started on it sooner rather than later. Unfortunately, before you can retire, you need to come up with a way to pay for those dreams.
Planning for early retirement
A good retirement plan is important for everyone, but it's absolutely critical if you want to retire early. (In this article, I'm defining "early retirement" as somewhere between age 60 and 65.) If you want to retire early, you'll be cutting out a few more years of saving and adding a few more years of spending down your nest egg. To make that work, you'll need to have a lot more money saved up -- and reaching that ambitious target will require a disciplined plan of saving money and investing it wisely.
Saving for longevity
The earlier you retire, the longer your retirement will be, and thus the longer your retirement savings will have to last. And Americans are living longer than ever these days. According to the Social Security Administration, the average woman turning 65 today can expect to live until she's 86.6 years old. Assuming that woman had retired at age 60, then her retirement savings would need to last at least 27 years just to get her through her expected lifespan. If she lived longer than average, as most people would prefer to do, those savings would need to stretch even further. Anyone retiring early needs to plan for a retirement of at least 30 years.
The 4% rule might not do it
For years, retirees and retirement planners have used the "4% rule" to plan out their retirement distributions. The 4% rule says that retirees can safely take about 4% of their retirement savings each year without depleting those savings. Thus a retiree with exactly $1 million saved could take $40,000 out of their savings each year without fear of running out of money. It's generally agreed that they could even adjust their withdrawals for inflation, taking out a little more each year to keep up with rising prices.
However, the 4% rule was designed for a 30-year retirement. If there's a chance you'll be retired longer than that, then you should try to live on a somewhat lower percentage. So how much can you safely take?
If you had a crystal ball that told you what would happen to the stock market, inflation, interest rates, and the economy during the course of your retirement, you'd know exactly how much you could draw from your retirement accounts every year without running out of savings. But we mere mortals simply need to plan our distributions conservatively to ensure that there's no conceivable scenario in which we'll go broke. A conservative retirement distribution plan is also likely to leave substantial funds for your heirs to enjoy.
In order to come up with a solid plan, you should consider consulting a financial planner who has experience with retirees. Failing that, try to adjust your distribution for the year based upon your portfolio's performance. If it boomed over the last year, you should be OK taking that 4%. If your investments barely kept up with inflation or even dropped in value, take substantially less -- maybe 3% or so. You may have to tighten your budget just a tad, but those extra years of freedom and financial security will be well worth it.
Will that be enough?
Planning to limit yourself to as little as 3% of your retirement savings per year means that you'll have to save a considerable amount of money in those retirement accounts. If you save $1 million, you'll be able to safely take $30,000 per year -- not exactly the kind of income that would allow you to live the high life. Of course, some years you'll be able to take more, but remember: Planning conservatively is the way to ensure that you'll have enough money, no matter what happens to the stock market. So if you're sure you can live on such a small income in the bad years, you can safely use that total as a basis for determining how much you'll need to save for retirement.
Required minimum distributions: the flaw in your perfect plan
Before you relax and congratulate yourself on your wonderful early-retirement plan, there's one more important factor to consider: required minimum distributions, or RMDs. One of the biggest benefits of retirement accounts like traditional IRAs and 401(k)s is that you don't need to pay income taxes on the money you put into those accounts. However, you do have to pay income taxes on your withdrawals, and the IRS is only willing to wait so long before it collects the taxes on your money. That's why when you hit age 70-1/2, you will be required to take an RMD out of your tax-deferred retirement accounts every year -- or face severe tax penalties. These RMDs are based upon your predicted lifespan and how much you have in your accounts; they don't take into account how well your investments have performed or what the market is doing. So if your first RMD happens to be in a year when your investments have tanked, you could be forced to take a bigger bite out of your capital than you'd like to.
How to get around RMDs
There is one way to get around the RMD problem, although it does come at a price. Traditional tax-deferred retirement accounts have RMD requirements, but Roth accounts do not, because you've already paid the taxes on the money in those accounts. Thus, if you put the majority of your retirement contributions into Roth accounts or convert your tax-deferred accounts into Roth accounts before you retire, you'll have little or no RMDs to worry about.
The price you pay for dodging the RMD bullet is that you'll have to pay taxes on those contributions up front; money you contribute to Roth accounts is not deductible. Furthermore, if you convert a traditional retirement account to a Roth account, you're required to pay the income taxes on those funds at the time you do the conversion. This strategy requires careful planning (and possibly the help of a tax advisor) to keep you from losing your shirt in extra income taxes, but it can make an early retirement considerably more workable. As a bonus, when you take the money out of your Roth accounts during retirement, you won't have to pay taxes on it -- so the income from those accounts will stretch a lot further. That can make enough of a difference to turn your 3% distribution into something you can live on quite comfortably.