Early retirement is a dream for many. While saving enough to accomplish this goal is challenging, it’s just the beginning. Here are five challenges you must include in your early retirement planning.
It seems as if everyone these days is planning for early retirement – or at least planning to plan for early retirement.
Saving and investing a lot of money is the obvious starting point. But there are also early retirement challenges that you must be prepared for. That part of the equation is just as important as building up a sizable retirement portfolio.
Here are five of those early retirement challenges, and how you can prepare for them.
1. Health Insurance – There’s No Medicare Before Age 65
You won’t be eligible for Medicare until you turn 65. And you’ll no longer be in a position to take advantage of an employer sponsored health insurance plan. As a result, you will almost certainly have to get a private plan on your state’s health insurance exchange. WARNING: It won’t be cheap!
Under the Affordable Care Act (ACA), health insurance companies can no longer charge you a higher premium if you have pre-existing health conditions. That’s the good news. But the bad news is that they are fully allowed to charge higher premiums based on age. And since you probably will be retiring around 50 or later, you can expect those age-adjusted premiums to be pretty ugly.
What’s more, you can also expect that they will faithfully increase each and every year. Yes, we know Washington promised us lower health insurance premiums. But unfortunately, that’s not what happened. Premiums have gone sky high.
You can get an estimate of what you are health insurance premiums will be by checking out Healthcare.gov’s Health Insurance Plans and Prices page. While it can tell you what your premiums will be at a future age, it can’t tell you how much those premiums will be by the time you finally do retire.
In order to keep the premium to a minimum, plan to have a high deductible. A $6,000 deductible and $6,500 out-of-pocket maximums are common. You can combine the high deductible plan with a Health Savings Account (HSA). With an HSA, you will have a tax-sheltered way to pay your co-pays and deductibles.
There is one possible silver lining here. Since you’ll be retired, and your income will likely be lower than what it is right now, you might actually qualify for an ACA subsidy. That will lower the cost of your premium at least a little bit.
2. Accessing Retirement Savings Before Reaching 59 ½
As you probably know, accessing your retirement savings before turning 59 ½ is tricky. If you do, you will not only be subject to ordinary income tax on the amount withdrawn, but also a 10% early withdrawal penalty. That means that your tax-sheltered retirement plans won’t be a good source of income in your early retirement years.
There are a few ways that you can get around this problem:
1. Have sufficient taxable investments to draw on during the early years of your retirement. You won’t get the benefit of tax deductibility of your contributions, nor of tax deferral on your investment income. But you will be exchanging those benefits for the ability to draw down those accounts without tax consequences early in your retirement.
2. Roth IRA. One of the biggest advantages of having a Roth IRA is that you can withdraw your contributions at any time, without having to pay either income tax or the 10% penalty. However, since your contributions are limited to $5,500 per year (or $6,500 if you are 50 or older), it’s not likely that you will be able to accumulate enough money in a Roth IRA to cover your early retirement years completely.
That being the case, you can instead set up a Roth IRA conversion ladder.
Using this strategy, you convert from your other retirement accounts an annual amount that is equal to how much you think you will need to live in early retirement, on an annual basis. For example, if you expect to need $40,000 per year in early retirement, you can convert $40,000 per year from existing retirement accounts into a Roth IRA.
Unfortunately, when you do a Roth IRA conversion, you will have to pay the 10% early withdrawal penalty if you take distributions from the plan in less than five years from the conversion. The point is to set up a series of conversions five years out, with enough conversions to cover each year of early retirement.
That will enable you to get distributions from your Roth IRA each year, while fully avoiding either ordinary income tax or any early withdrawal penalties.
You can live out of your Roth IRA during the early years of your retirement, and then begin accessing your regular retirement savings once you turn 59 ½.
We should add that there are other ways to take out money early. Here’s a good list of other alternatives.
3. Outliving Your Money
This is a concern of all retirees, but especially early retirees. If you are retiring around 50, you will need to have sufficient resources to enable you to live for several decades.
Probably the best strategy to deal with that is to apply the safe withdrawal rate to your retirement assets. If you withdraw no more than 4% of your retirement savings each year, you shouldn’t outlive your money.
Of course, that requires that you must have an average annual return on your investments that is significantly higher than 4%. Since the historic rate on stocks has been something approaching 10% since 1928, a mix of stocks and bonds in your retirement portfolio should get the job done.
For example, if you put 70% of your portfolio in stocks at an average annual return of 10%, and 30% in bonds at an average annual rate of return of 2%, your portfolio should average about 7.6% per year.
Given that inflation has been averaging right around 3% per year for the past 30 years, a return of 7.6% would allow you to withdraw 4% per year for living expenses and then retain 3% for inflation, and 0.6% for real growth.
Under that scenario, you would never outlive your money.
Speaking of inflation, this is a serious problem for retirees of all ages. The income that you have today will not be sufficient in 10 or 20 years. You will have to invest for that likelihood.
Inflation has historically averaged just over 3% per year, though it has been lower in recent years.
The best way to deal with this problem is once again by using the safe withdrawal rate. You will leave some of your investment returns in your portfolio to cover inflation. But during times of particularly high inflation, you might also have to consider developing some additional income sources.
5. A Stock Market Crash
This is another of those big picture retirement scenario nightmares, much like inflation. Fortunately, stock market crashes tend to be short-term in nature. They often play out within two or three years, and then the market resumes its upturn.
The issue for retirees, however, is to minimize the damage to retirement savings from a stock market crash. Diversification – holding at least some of your portfolio in fixed income investments – is one way to do that.
But another, probably more effective way, is to have additional assets that can tide you over during bear markets. The idea is to leave your retirement portfolio alone while covering your living expenses out of non-retirement assets. This will at least help you to avoid selling portfolio assets at low prices.
In the end, none of these strategies will guarantee that you won’t have any challenges in early retirement. But they will minimize the impact of those challenges. And hopefully, they will enable you to stay retired throughout the rest of your life.