Many people retire sooner or later than the typical age of 65. An entire movement known as FIRE (for Financial Independence Retire Early) grew up around a 1992 bestseller, which advocated a savings and investment discipline designed to enable adherents to retire relatively young.
Financial readiness is everything. Many people who opted for early retirement during COVID-19 returned to the workplace when they discovered they were not fully financially prepared.
Funding the Retirement Well
On the savings and investment side of the ledger, you can draw retirement income from five main sources, in addition to countless others:
- IRA – An IRA is an individual retirement account, held at a bank or brokerage, which lets contributors deposit funds either in lump sums or staggered installments. You can pay tax-deferred money into traditional IRAs up to age 59 ½, or after-tax funds into Roth IRAs at any time.
- 401(k) – A 401(k) is an employer-sponsored and -managed retirement account, sometimes with matching funds.
- Pension – Some companies offer a pension with tax-deferred worker contributions. Defined benefit plans are based on years of work for the company; defined contribution vehicles pay according to the plan’s performance.
- Annuity – An annuity is funded by insurance companies. It pays income streams for a specified number of years and ceases on death. Fixed annuities provide preset payments; variable annuity payouts depend on portfolio performance.
- Social Security – Social Security is a U.S. government program determined by average lifetime wages earned. Payments increase for recipients who delay receiving their checks from the earliest possible starting age of 62 until the latest of 70. Those who start earlier receive more checks in total, but the amount of each check will be smaller. The official full retirement age is 66 or 67, so benefits can be decreased by as much as 30% for early takers.
Making Ends Meet in Retirement
Think of it like losing weight. The recommended formula is to eat less and exercise more.
The math is basic: An earlier retirement means a shorter time to save and a longer stretch to eke out assets. You need to tie up various loose ends to make the early equation balance. During the pre-retirement years, you face a couple of dominant challenges: health insurance and bridge saving.
Since you cannot withdraw money from some of your retirement accounts tax-free before age 59 1/2, you may need to fund the gap. To be ready, you need enough saved as a bridge to bring you to the magic age of 59 1/2. You can use a taxable brokerage account, which allows you to withdraw money whenever you like. You will lose the tax benefits of a Roth IRA or 401(k) plan, but you will gain flexibility during those intervening years. (Read more about the Rules for Required Minimum Distributions)
Healthcare insurance is a serious consideration until Medicare kicks in at age 65. If you are still employed, you are likely paying about 18% of your plan’s premium costs, but if you stop working, you might end up paying as much as 120%. COBRA coverage may let you extend your employer’s coverage for 18-36 months, but will that last until Medicare? You might also be able to work part-time, if only for medical insurance. Meanwhile, look at marketplace plans to compare costs.
Outflows
A careful spending budget is the other step. A traditional rule of thumb suggests you can take out 4% from your savings each year, adjusting for inflation. (Recent high inflation might play havoc with that assumption, though. It would be prudent to adjust your rate of return expectations, too, from a standard 10% to a more realistic 5%-6%.) Recent retirees tend to splurge on spending in the first few years, disbursing on travel, home renovations, or relocation. However, it does make sense to pay off mortgages and HELOCs (home loans) early, to downsize your living space, or to finance significant repairs like a new roof.
Your financial planning adviser can put together a comprehensive plan for saving and spending in order to let you escape the work treadmill a few precious years ahead of time.
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