How do you define “retirement?” This word, and more importantly the concept, is ever-changing.
Hearing the word may evoke images of an elderly couple walking along the beach or lying in a hammock as they watch the sun set. This advertised lifestyle is usually funded by Social Security retirement benefits, private and public pensions, annuities, and distributions from after-tax brokerage and qualified retirement accounts – such as 401(k)s, 403(b)s, and IRAs.
A little background:
The traditional retirement age of 65 continues to be deeply embedded in the U.S. retirement system. The IRS defines normal retirement age (NRA) and calculates its sustainability based on life expectancy, which has increased since the Social Security system began in 1935. Most retirees born after 1959 will be eligible to receive reduced Social Security retirement benefits if starting at age 62, full benefits at age 67, and maximum benefits at age 70. Medicare health insurance benefits become available at age 65, and qualified (tax-deferred) retirement accounts can be accessed without penalty after age 59 1/2.
Defined benefit plans such as private pensions have been fading since the late 1970s, whereas defined contribution plans such as 401(k) plans have become the norm – shifting the contributions and investment risk from the employer to the employee. This tax-efficient opportunity allows wage earners to have greater control over individual retirement savings – this is wonderful news for workers who have the discipline to save aggressively and stick to a long-term investment plan. If you are reading this, you are probably one of them!
“Retirement” no longer means having to permanently leave the workforce, and I believe the concept is being replaced by Financial Independence (FI) – the ability and flexibility to cover living expenses and maintain your desired lifestyle without having to work for compensation. Many of us find great purpose in the work we do, so financial independence isn’t about not working; it’s about not having to work to support your lifestyle expenses!
What if I want to ‘retire’ before age 59 1/2?
Thankfully, there are opportunities to access funds in early retirement without being hit with penalties or limitations. A primary factor to consider when planning for retirement (in general) is which vehicles you use to invest. Just like it is important to diversify your investments, the diversification of asset location is especially critical for individuals who want to comfortably retire before age 59 1/2 – with portions of retirement assets spread across Roth, pre-tax, and after-tax brokerage accounts to achieve maximum cash flow flexibility.
Think about your financial landscape as a pizza, and your investment vehicles like pizza slices. There might be a Roth slice, pre-tax slice, and an after-tax slice. The size of the slices and the toppings (investment choices) will be different for everyone’s personal pizza, but the last thing you’d want in early retirement is for 95% of the pizza to be pre-tax and to only have access to the remaining 5% slice. Just a reminder – the IRS wants a bite!
Here are some ways to avoid hunger in early retirement and access the money you worked so hard to accumulate:
- Savings/Checking Accounts: Your bank accounts provide the ultimate liquidity (the ability to convert to cash without losing value), whether in retirement or not. They don’t receive any tax benefits or have much ability for growth, but the liquidity is invaluable when money is needed quickly.
- After-Tax Brokerage Accounts: Distributions from these investment accounts do not have age restrictions, income limits, or mandatory withdrawals. The investment growth and income can receive favorable tax treatment, including long-term capital gains and qualified dividends that are taxed at capital gains tax rates (0%, 15%, 20%), and also the ability to deduct net losses. Prioritize saving in these accounts once you have reached your “CoastFI” number – this is the level of investment assets you will need at your desired retirement age without adding future contributions (just coasting). Calculate your CoastFI number here, and challenge your assumptions.
- Roth IRAs: Direct contributions to Roth IRAs can be withdrawn at any time for any reason without taxes or penalty. This also applies to Roth 401(k) employee contributions (not earnings) that are rolled into a Roth IRA. Converting pre-tax retirement accounts into your Roth IRA is another option to make assets available in early retirement, but these taxable conversions each have their own 5-year clock until you reach age 59 1/2. The rules can be tricky, so I recommend you learn more here when considering the options. The flexibility to distribute income without taxation is most valuable in early retirement, but be careful not to fully drain your Roth IRAs in early retirement – they have the greatest potential for long-term, tax-free growth.
- Health Savings Accounts (HSAs): Like Roth IRAs, HSAs have the incredible benefit of tax-free growth. As previously detailed in the HSA article, these accounts could become your ultimate retirement amount. You could withdraw these funds tax-free in early retirement if used for medical expenses, even if the medical expenses were incurred and paid out of pocket in previous years. Keep in mind that contributions to HSAs must stop when enrolling in Medicare, but the funds can be distributed as ordinary income with no penalty if used for non-medical expenses after age 65.
- Qualified Retirement Plans: Distributions from qualified plans like 401(k)s are subject to a 10% early withdrawal penalty if the account owner is under age 59 1/2, but there are some exceptions that may be available for early retirees. The (“Rule of 55”) allows 401(k) participants who separate from service after reaching age 55 to distribute assets from the 401(k) plan without penalty. As long as you separate from service in or after the year you reach age 55, this exception applies. Mandatory federal income tax withholding of 20% is required if distributing funds from a 401(k) – with the exception of CARES Act withdrawals in year 2020. Be aware that the Rule of 55 does not apply to IRAs, so measure twice before rolling your 401(k) into an IRA. If you participate in a 457(b) plan, you will be able to access those funds in retirement before age 59 1/2 without penalty. Strategically distribute these accounts with tax consequences and opportunities in mind.
- Substantially Equal Periodic Payments (SEPP): The ’72(t) provision’ is another exception to the 10% early withdrawal penalty if needing to distribute income from pre-tax retirement accounts before reaching age 59 1/2. A series of periodic payments (still taxable as ordinary income) can be distributed from tax-deferred retirement accounts for 5 years or until reaching age 59 1/2 – whichever comes later. The periodic payment amount is determined by mortality (life expectancy) tables provided by the IRS. More details are available here.
- Passive Income: Having recurring streams of passive income (mailbox money) is available in many forms, including rental real estate, dividend and interest income, licensing and royalties, affiliate marketing, and other passive investments. These are great ways to make your money work as hard as you do. Get creative, and make sure your tax prep is on point!
- Earned Income: As previously suggested, retirement does not mean you have to stop working. The opportunity to earn income remains an option for many early retirees, even for just a few hours per week. This income could be used to pay for discretionary expenses (wants) such as travel, shopping, or gifting.
Your options to earn and save money along your path to financial independence are not limited to any article, profession, or mindset. Focus on the things you can control and never stop learning. If you need personalized help along the way, never be ashamed to ask questions or consult a fee-only fiduciary planner who has your best interest in mind.