April 25, 2021

Retiring Early? Prepare Yourself for These Financial Challenges

Retiring early isn’t all it’s cracked up to be. Sure, you get to spend your…

Retiring early isn’t all it’s cracked up to be. Sure, you get to spend your days doing more of what you enjoy rather than watching the clock at your 9-to-5 job. But you’re also exposing yourself to a lot more financial risk because your savings will have to last you even longer. That’s not to say retiring early isn’t doable, but there are special challenges you’ll face if you decide to do so. Here’s a look at a few of them and how you can prepare yourself.

Retiring before 59 1/2: penalties on retirement account withdrawals

Even if you excel at saving and are ready to retire before your 60s, you might find accessing your nest egg difficult at first. That’s because the federal government imposes a 10% early withdrawal penalty on most retirement account withdrawals you make before 59 1/2. You probably don’t want to give away thousands of dollars unnecessarily, so you need a plan to get around this.

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If you have substantial Roth retirement savings, you can try withdrawing only your Roth IRA contributions. You’re allowed to withdraw these tax-free at any age because you already paid taxes on this money when you made the contributions. However, if you withdraw Roth IRA conversions or earnings, you could face taxes and penalties.

You can also make substantially equal periodic payments (SEPPs). This is where you make regular, equal withdrawals from your retirement account for five years or until you reach 59 1/2, whichever is longer. The IRS has formulas that determine how much you must withdraw annually, though you can choose between a few different methods. SEPPs help you avoid the early withdrawal penalty, but once you commit to this option, you have to stick to it, so it’s not right for everyone.

A third option is to save money in a taxable brokerage account. These aren’t retirement accounts so you’re free to access your funds at any time and withdraw as much or as little as you wish. You can also invest in anything you want. But these accounts don’t have the same tax breaks as retirement accounts. However, if you hold your investments for at least a year, they become subject to long-term capital gains tax, which can save you money compared to paying income tax on the same amount.

Retiring before 62: can’t claim Social Security yet

You become eligible for Social Security at 62, so if you decide to retire before this age, you’ll have to fund retirement completely on your own until then. The only real way to deal with this is to make sure you have plenty of retirement savings of your own to sustain you until you’re ready to sign up for Social Security.

If you don’t plan to sign up for Social Security right away, you may need to fund your retirement independently for even longer. However, delaying Social Security increases the size of your checks, so when you do finally apply, your checks will cover a larger percentage of your retirement expenses. 

Retiring before 65: can’t sign up for Medicare

With only a couple exceptions for those on disability or with end stage renal disease, Medicare is currently only available to adults 65 and older. So if you retire before then, you must get health insurance some other way. You may be able to stay on your former employer’s COBRA coverage for a little while or, if your spouse is still working, you may be able to rely upon their health insurance instead. You can always purchase an individual health insurance policy as well.

It’s not wise to forego health insurance and hope you don’t need it before you’re eligible for Medicare. A freak accident could leave you with hospital bills that could wipe out a substantial portion of your savings, possibly derailing your plans for retirement completely. It’s best not to take that chance.

In addition to having some type of health insurance, you should also consider stashing money in a health savings account (HSA). Money you put here reduces your taxable income for the year and if you use it for health expenses at any age, you won’t pay taxes on it at all. You can’t contribute to an HSA once you start Medicare, though you can continue to use the funds. You can also use them for non-medical expenses once you turn 65, but you will owe taxes on these withdrawals. You’re technically able to do this under 65 as well, but the 20% penalty associated with this move makes it a bad decision for most people.

If you do decide to open and contribute to an HSA, you need a high-deductible health insurance plan. That’s one with a deductible of $1,400 or more for a single individual or $2,800 or more for a family. As long as you have one of these, you may contribute up to $3,600 if you’re an individual or $7,200 for a family in 2021.

You’ll never be able to anticipate all the financial curveballs retirement will throw at you, but you can prepare for the three above challenges to some extent. Review the list above and consider which of these challenges you’ll face. Then, make alterations to your retirement plan, if necessary, so you aren’t blindsided by unexpected costs once you quit the workforce.