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5 Things To Know Before Retiring Early  Thumbnail

5 Things To Know Before Retiring Early

Early retirement may seem like a dream come true. However, you need to be well prepared if you want to retire early to avoid complications. Here are five things to consider before taking the leap.

1. Will You Have Enough Money for Your Entire Retirement?

Retirees tend to spend more money than expected, especially in early retirement when your health allows for increased activities and you don’t have work to fill the calendar. You might spend more on travel, home renovations, or other retirement-related lifestyle changes. Sticking to a budget early in retirement might not be a high priority compared to enjoying your free time, but you need to consider the later years even as you’re enjoying the early ones. Making a spending plan with plenty of room for travel and other things you finally have time for – while being mindful of your potential future healthcare and other needs – should help you strike a balance.

With medical advancements we have the ability to live even longer lives. The oldest living person is about to turn 117! This means that you might need to make your savings last longer than previously expected. If you talk to any group of retirees or pre-retirees, the prospect of outliving their money is likely to be one of their top concerns (use this calculator to get an estimate based on your lifestyle and family history). . If your retirement lasts 20, 30, 40 or even 50 years, how well do you think your retirement savings will hold up? What financial steps could you take in retirement (and prior to retirement) to try to prevent those savings from eroding?1

Some retirees address the gap in their finances by working part time in their 50s, 60s, and 70s. The income from this work can be an economic lifesaver for retirees – not to mention providing a great way for retirees to prioritize purpose-oriented activity after their primary career ends, which can boost retiree mental health and cognitive outcomes in some cases. What if you worked part-time and earned $20,000–$30,000 a year? You might effectively give your retirement savings five or ten more years to grow.1 This “coast-FIRE” approach could add decades to a portfolio’s longevity.

2. When it Comes to Future Healthcare Costs, You Can Never Save Too Much

Healthcare costs can be high before Medicare starts. Until then, you will have to pay for private health insurance, which can be costly (in many cases $2,400 or more per month for a couple, even for a high-deductible plan), so one of the benefits of remaining employed is maintaining subsidized workplace insurance coverage. 

How many people retire with a dedicated account or lump sum to address future health costs? Some retirees end up winging it, paying their out-of-pocket expenses out of income, Social Security benefits, and savings. If you have a high-deductible hath plan now,   fully funding your HSA and investing those contributions rather than spending it down each year will give you funds to help cover those future healthcare costs.

There is no easy answer for retirees preparing to address future healthcare costs. Staying active and fit (and prioritizing mental health) may lead to long-term healthcare savings, but tomorrow’s retirees may already have some physical ailments. Planning for future health costs is always a good idea, especially if you want to retire early.

3. You Might Face Penalties If You Take Early Withdrawals

If you retire before age 59½, you will likely pay a 10% early withdrawal penalty on most tax-deferred accounts (with a few exceptions) should you choose to take withdrawals from these accounts. You will also owe income taxes on the amount you withdraw from traditional accounts funded with pre-tax contributions.1

Since the Roth IRA came into effect in 1998, its popularity has soared. It has become a fixture in many retirement planning strategies because it offers savers so many potential advantages.

With Roth IRAs, investors make contributions with after-tax dollars. Any potential earnings on investments within a Roth IRA are not considered part of the account owner’s income and, therefore, are not subject to income tax. Instead, they accumulate on a tax-deferred basis and are tax free when withdrawn from the Roth if the distribution qualifies. With a Roth IRA, you can have a tax-free retirement income. A Roth IRA also allows you to withdraw the contributions prior to age 59½ without the 10% early withdrawal penalty, but doing so also hinders the long-term tax-free growth of the account.

4. Compound Interest Needs Time to Work

The longer you work and save for retirement, the more money you will have. If you retire early, the power of compounding interest diminishes because your investments will not continue to grow. Compounding interest works best for those who start saving early and save for as long as possible before withdrawing.

There is an old saying that compound interest “is the most powerful force in the universe,” and there is some truth to this. What makes compound interest special? Compound interest means that you earn interest not only on your principal investment but also on previous growth. The results are not terribly impressive in the short term, but over 30 years or more, compound interest can produce a handsome return.

Great minds have been fascinated by compound interest for generations. Founding Father Benjamin Franklin believed that a penny saved was a penny earned, and he decided to put this belief to the test. At his death in 1790, he bequeathed £1,000 each to the cities of Boston and Philadelphia for the purpose of building trade schools and public works projects after 100 years had passed. Compound interest did the trick, netting $572,000 for those cities in 1891.2

If you invest a sum of money and leave it alone for an extended period, compounded annual growth (dividends plus asset value) will cause your money to grow just as Franklin’s did, assuming it is invested prudently. For example, $7,000 left alone in an investment for 30 years at a 7% annual compounded growth rate would increase to over $50,000. If you were to add money to the account over time, the compounded growth would continue to accrue and would create a healthy supplement to whatever other retirement plans you may have. 

Let’s say that you started with $7,000 (the current Roth IRA limit) in an account with an expected growth rate of 7% and added $7,000 per year ($583.33 monthly). In 40 years, if you kept up your deposits, the account would hold nearly $1.5 million.3 If that is reduced to 30 years, the ending account value would be closer to $714,500 – a difference of more than double in just 10 years – which illustrates the power and importance of time in compound growth.

These are hypothetical situations; you may contribute more or less money as time passes, and your account may earn a different amount of interest. Keep inflation in mind as well. A million dollars doesn’t go as far today as it did 40 years ago, and it may not seem like a lot of money once you’re ready to retire. The compounding stops if you take the money out of the bank or investment early.

5. Your House is Not Necessarily an Investment

You will need to live somewhere in retirement, whether you rent or own your home. Homeownership has associated costs, especially if you plan to sell the house at some point, including making additions and improvements like putting on a new roof. It all adds up.

Is the house you are in now an investment that you might use to finance early retirement? If you buy a house to flip it or as a rental property, the answer could be yes. If you buy a home to live in with hopes of selling it later, the answer may be no. Your home is an expression of your lifestyle, a wonderful setting for your life, and a place where you can enjoy privacy and comfort. As an investment, though, it is essentially illiquid, and its rate of return is uncertain.

Home values do not automatically increase over time. Over the decades, real estate values have risen, and they may keep growing over the short term, but perhaps not as quickly as some owners hope. An investment portfolio, unlike your home, does not need upkeep. You will never need to repair, reroof, or repaint a portfolio. Houses need maintenance over time, which can eat into your gains. You must also pay property taxes and insurance, and possibly homeowners association fees. If you envision your home as an income-producing asset during your retirement, that means playing landlord on some level. Many are not ready to take that step or incur that risk.

Remember that home values tend to increase gradually. If you see your home as an investment, consider it a long-term one. While every household is different, be careful if you plan to use your house to fund your early retirement.

The Short Version: Look Before You Leap

Early retirement is possible if you can finance your lifestyle from the day you quit working. It’s a worthwhile goal for anyone willing to take the steps to make it both feasible and relatively uncomplicated. You can take these steps in tandem with your trusted financial professional, someone who has helped others pursue similar goals and can tell you which situations to investigate and which ones to avoid.

  1. https://www.aarp.org/retirement/planning-for-retirement/info-2021/pre-early-retirement-reality-check.html
  2. https://www.laphamsquarterly.org/future/trust-issues
  3. http://www.moneychimp.com/calculator/compound_interest_calculator.htm

This content is developed from sources believed to be providing accurate information, and provided by Strategic Financial Planning, Inc. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered legal, investment, or tax advice.