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What You Need to Know to Retire Early at 55

Most Americans consider age 65 the normal age of retirement because it was the full retirement age for Social Security Benefits until 1983. But the goal of retiring early has gained widespread popularity in recent years. In this article, we’ll cover what you need to know to retire early at 55.

From formulating a budget to creating tax-efficient retirement income, there are a lot of factors and variables to consider prior to making such an important decision. Making major mistakes will result in lifestyle restrictions or a forced return to the labor force.

Retirement is your reward for a lifetime of hard work and saving money. So let’s talk about how to retire early – and stay retired.

Planning to Retire Early at 55

Knowing exactly how you will spend your time in retirement will be critical to your success. When every day is Saturday there is a high likelihood that you will be spending more money.

Your retirement account withdrawals need to be reasonable to ensure you don’t outlive your savings and investments. Inflation is another obstacle you need to overcome. Your retirement plan needs to account for the higher cost of goods and services in future years.

Thus, having a step-by-step plan to overcome these types of obstacles is necessary. 

How Much Do I Need to Retire Comfortably?

One common goal that everyone has is maximizing their quality of life in retirement. This means spending money confidently, without fear, worry, or anxiety. 

Traveling the world will require more financial resources than playing bridge or having coffee with friends every day. Consider traveling costs to visit your children and gifts to grandchildren. What does your bucket list look like? Make sure to create a good framework detailing all of your retirement goals.

Mapping out your daily, weekly, and monthly lifestyle goals will assist in determining what a comfortable retirement will feel like. Knowing your expenses is the first step in determining your withdrawal rate. Your withdrawal rate is the amount withdrawn divided by the value of your retirement portfolio.

How Will My Expenses Change in Retirement?

Most retirees don’t take time to create a monthly or annual budget. We recommend creating a pre-retirement budget as well as a retirement budget. This will force you to see how expenses will change, line item by line item.

Retiring at 55 can increase your expenses. Health insurance is one of the most important considerations when factoring in higher expenses.

Losing employer-sponsored health coverage is costly until Medicare eligibility kicks in. Paying for health care costs out of your own pocket is unsustainable. For married couples, deciding whether one spouse works longer to retain affordable health coverage is a conversation worth having.

Some families have children entering college when they plan to retire. This can increase expenses dramatically at the same time employment income disappears. Planning for this change in expenses is paramount to a sound financial plan.

Some things are beyond your control. It is important to focus on what you can control now.

What is the Tax Rate on My Retirement Income?

When creating retirement income, how much you get to keep after taxes is what really matters. It’s important to understand how income and capital gains tax rates work. Having a sound financial plan will help you determine how to withdraw the money you need from retirement accounts – while paying the least amount of tax.

Taxable, tax-deferred, and tax-free accounts are the three primary types of accounts you can withdraw from. Withdrawals from tax-deferred accounts like Traditional IRAs increase your ordinary income tax rate. Tax-free withdrawals from Roth IRAs are just that, tax-free.

2021 Ordinary Income and Capital Gain tax rates for Single and Married Filing Jointly Taxpayers

Non-retirement accounts are subject to short-term and long-term capital gains tax rates. Selling an appreciated asset held for less than one year is called a short-term capital gain. Short-term capital gains are taxed at your marginal income tax rate. Assets held for longer than one year are taxed at more favorable long-term capital gain tax rates.

Selling an asset that has gone down in value from when you purchased it results in a capital loss. You can use a capital loss to offset a capital gain. This can be beneficial in reducing your tax liability every year. So just knowing which position to sell in an account can have major tax implications for you.

How Much Money Do I Need to Retire Early at 55?

The key question that every retiree wants to know is how much they can spend in retirement without outliving their nest egg. The challenge with retiring at 55 is that the earliest you can begin Social Security Benefits is age 62.

While many retirees that work for a state or federal government have pensions, the earliest age you can begin benefits can range anywhere from 55 to 65. But drawing your pension at 55 can substantially reduce your benefit.

It may make more sense to rely on retirement account withdrawals and delay your pension start date. These are some of the difficult, yet important decisions that need thorough analysis to ensure that you maximize your income in retirement.

Beyond the Four Percent Rule: How Much Can You Spend in Retirement?

The “four percent rule” states that no more than 4.2% should be withdrawn annually (adjusted for inflation) to ensure you don’t outlive your retirement savings. However, this popular rule of thumb is based on a retirement age of 65. Retiring early at age 55 requires the withdrawal rate to be lower.

It really depends on a number of factors, but you may only be able to draw 2-3% in your 50’s, 4% in your 60’s, and 5% or greater in your 70’s. Having a retirement plan that addresses the timing of your retirement income benefits, retirement account withdrawals, and limits tax liabilities will help optimize your financial decisions.

How Do I Generate Income in Retirement?

The biggest challenge when you retire early at 55 is bridging the income gap until Social Security or Pension eligibility. For married couples, coordinating retirement dates with their spouse is important. Extending group health insurance coverage helps reduce expenses until Medicare eligibility. Another option is part-time work or consulting, depending on your goals and skills.

Many retirees pursue entrepreneurial passions they never had a chance to realize during their working years. A lifetime hobby or passion can now have space to blossom into a business and provide supplemental retirement income.

Real estate investors should evaluate their real estate portfolios as they approach retirement. The goal is to invest/retain properties that produce higher income in retirement.

Social Security Benefit Reductions for Early Retirement

Social Security eligibility begins when you reach age 62. But drawing benefits early will reduce your payouts by 20-30%. Delaying retirement benefits to age 70 can increase benefits by as much as 30%!

If you work while receiving benefits prior to reaching your full retirement age, the Social Security Administration will reduce your benefits depending on how much employment income you earn. For example, at full retirement age, they deduct $1 in benefits for every $3 you earn above $50,520. This matters if you plan to work again in one form or another. If you do, it might pay to delay Social Security even if you retire early.

You also want to ensure that you have worked for 40 quarters (10 years) to become eligible for Social Security Benefits. If you are short, it makes a lot of sense to postpone your early retirement at 55 and consider a later age.

How Do I Avoid an Early Withdrawal Penalty from my 401K or IRA?

Retirement accounts have early withdrawal penalties that are prohibitive by design. The intention of having tax-free and tax-deferred growth is to help Americans save more effectively for retirement. By nature, this helps alleviate reliance on programs such as Social Security.

Rules on retirement accounts restrict withdrawals for non-retirement-related purposes. However, there are some exceptions and strategies that can be extremely valuable for early retirees.

Roth IRA Taxes and Penalties

Retirement Account Early Withdrawal Penalties – The 59 ½ Rule

Withdrawals from retirement accounts are subject to a 10% withdrawal penalty prior to reaching age 59 and 1/2. This penalty is taken out of the distribution amount prior to assessing the amount of the taxable distribution.

Eligible withdrawals prior to age 59 1/2 are limited to the following exceptions:

  • First-time home purchases
  • Educational expenses
  • Birth or adoption related expenses
  • Disability
  • Death
  • Medical expenses

Remember that distributions from all tax-deferred accounts like IRA’s and 401K’s are taxed at ordinary income tax rates.

Using the Rule of 55 to take Early 401K Withdrawals

A great strategy for accessing money from retirement accounts when you retire at 55 is the Rule of 55. If you are laid off or retire early at 55, the IRS waives the 10% penalty for early distributions from 401k or 403b plans. For public service employees, the rule applies in the calendar year they reach age 50.

The IRS Rule of 55

Not all employer-sponsored retirement plans support the rule of 55 and some plans require that proceeds be taken in a lump sum.

It is advised that you check with your plan provider prior to making this important decision.

It’s also worth mentioning that the rule of 55 does not apply to old 401ks from previous employers or IRA accounts. It only applies to 401k or 403b plans with your current employer.

Can I Avoid Penalties for Early IRA Withdrawals?

Another strategy to avoid penalties for early retirement distributions is Rule 72(t). This rule allows penalty-free withdrawals from retirement accounts, with some caveats. Individuals must take five “substantially equal periodic payments” (SEPP).

The amount varies upon life expectancy calculations. The IRS has three approved methods of calculation. You must also adhere to the SEPP schedule for a minimum of five years or until the age of 59 1/2. Rule 72(t) applies to IRAs as well as 401k and 403b plans.

Are Roth IRA Distributions Subject to the Early Withdrawal Penalty?

You can always withdraw contributions from a Roth IRA with no penalty at any age. At age 59½, you can withdraw both contributions and earnings with no penalty, provided your Roth IRA has been open for at least five tax years.

This five-year rule governing Roth IRAs applies to three scenarios:

  • You withdraw earnings from your Roth IRA.
  • Convert a Traditional IRA to a Roth IRA.
  • Inherit a Roth IRA

Roth IRAs offer more accessibility than other retirement accounts, but also provide tax-free growth. It’s better to use them as a last resort if possible.

How to Invest When Retiring Early at 55

The asset allocation of your portfolio should become more conservative as you near retirement. This rationale is based upon time horizons. You can withstand volatility and recover from loss when you have a longer time horizon.

When you reach retirement you need your portfolio to provide retirement income. This means that you need some safety in your portfolio to fund these income needs.

Investing Safely for Early Retirement

Fixed income (bonds) are considered to be a “safer” asset class than stocks. Fixed income plays a major role in diversification and wealth preservation.

Historically, bonds have an inverse relationship with stocks. During market downturns when most stocks decrease in value, investment-grade bonds increase in value. This makes them ideal positions to liquidate if stocks are down to provide the income needed in retirement.

In addition to being a hedge against stock declines, bonds pay higher interest than cash. One mistake that some retirees make is having large cash positions in retirement. Cash historically does not keep pace with inflation and is a poor way to invest in the long-term.

Should I Still Invest in Stocks if I Retire Early at 55?

The average retirement represents a long time horizon anywhere from 20-30 years. But if you want to retire at 55, you need to plan for a timeframe of 40 years. This longer time frame is sufficient to absorb risk while participating in upside growth. Think of the stocks in your portfolio as the money you will spend 10 to 20 years down the road.

A well-diversified portfolio should include stocks from a number of different asset classes. You want to have exposure to small, medium, and large companies. Your portfolio should also hold international stocks in addition to U.S. stocks. Holding different types of asset classes in your portfolio spreads the risk around.

Important Strategies for your Retirement Investment Portfolio

Asset location (different from asset allocation) involves determining which accounts to house assets. For example, Roth IRAs provide tax-free distributions making them ideal for high-risk/return asset classes. You want to position low-risk/low-return asset classes in accounts with the highest tax rates like Traditional IRAs.

Rebalancing your portfolio is an important investment management strategy that should be performed consistently. Stock returns outpace bond returns in the long run. If you don’t rebalance your portfolio, the percentage of stocks in your portfolio will continue to increase, making it riskier than you originally intended.

Tax-loss harvesting is another technique to reduce your taxable income. In taxable accounts, selling an asset at a loss and purchasing another will create a realized loss. These losses can then be used to offset gains in the current year or carried forward indefinitely.

What Else to Consider Before You Retire Early at 55

As we have discussed, there are a number of things to contemplate when deciding to retire early. Forming a retirement budget, minimizing taxes, and navigating the complexity of retirement account rules are primary considerations.

Since everyone’s situation is different, there will always be unique situations that require more difficult decisions to be made. Now let’s take a look at some of these situations and some unforeseen risks that could throw a wrench in your plans.

Paying Off Your Mortgage Early vs. Investing: Which Is Best?

Many baby boomers make it a goal to be debt-free by the time they retire at 55. While that may feel like a great decision psychologically, it isn’t necessarily the best financial decision. Leveraging “good debt” like mortgages can really help you out financially. Over the last 20 years, mortgage rates have hovered around 3-4%.

From 1926-2020, the average return of portfolio invested 60% in stocks and 40% in bonds averages over 9% per year. It’s easy to see why utilizing a mortgage and letting your money grow in your investment portfolio is a good long-term strategy. Having a mortgage may make you feel uncomfortable, but changing your perspective about carrying debt can make all the difference in retirement.

Pay off mortgage or invest in stocks?

Mortgages aren’t the only type of liability retirees have to deal with upon retirement. Some retirees also have children entering college at the same time they retire. In the absence of a 529 plan or college fund, this added expense can cause a significant strain on cash flows. These decisions are integral to your success if you want to retire at 55.

The Five Most Common Retirement Risks You Should Know

There are five main risks every prospective retiree should plan for prior to retirement. Neglecting these risks could inhibit you from your goal to retire early at 55.

Market Risk

A decline in asset values similar to the Great Recession of 2008 is a good example of market risk. At the same time, you can’t be too conservative in retirement. Having a well-diversified portfolio that takes into account your retirement income needs is key.

Longevity and Mortality Risk

The risk of outliving your assets is what every retiree fears. Another risk related to longevity is premature death. This can impact your spouse and any other dependants in your household.

These risks can dictate whether to purchase/retain any life insurance policies. They may also assist you in making decisions like when to take Social Security benefits and pensions.

Health Risk

More trips to the doctor should be accounted for in retirement. We already discussed the higher cost of purchasing your own healthcare before you become eligible for Medicare. But you also have to account for more frequent doctor visits, co-pays, and deductibles.

Health risks increase as you grow older so make sure this is planned for in your retirement expenses. These costs should be higher in your budget until Medicare eligibility at age 65.

Event Risk

There are some events that could have low odds of occurring, but you still want to be prepared in case they do. A long-term care event such as Alzheimer’s could require round-the-clock care for years. Self-insuring this risk is cost-prohibitive for most people. Regular health insurance will not provide coverage against this event.

Relying on an inheritance without 100% certainty could be another example. An earthquake in California could devastate most retirees as only 13% of California homeowners have earthquake insurance.

We can’t predict what curveballs life will throw next. At the very least, you will want to know how certain types of these events will impact you financially.

Tax and Policy Risk

One thing that will be consistent during your retirement is frequent legislative changes. Changes to retirement account rules and the tax code can change year to year. One example is the Tax Cuts and Jobs Reconciliation Act (TCJA) bill that was passed in 2018. In 2020, we saw the SECURE and CARES Acts passed, which had a dramatic impact on retirement distribution rules.

Making sure you have a short and long-term tax plan may be the most important factor in maximizing retirement income. Once a plan is in place, it’s important to keep on top of the policy and tax changes every year and adjust your retirement plan accordingly.

Should I Hire a Financial Advisor or Do it Myself?

We covered a lot up to this point and you should have a pretty good idea of what it takes to retire early at 55. But here’s the million-dollar question:

Do I have the expertise to understand, implement, and monitor every facet of my finances in retirement – and do I really want to?

When making this decision, be honest with yourself and think about the repercussions of making mistakes. Keep in mind that the long time horizon in retirement compounds any mistakes you make. A large amount of personal finance knowledge and expertise is needed, which can increase your margin for error.

Will you really spend the time to keep up on changes to the economic, legislative, and tax landscapes? Is this something you are really interested in doing? If the answer is no, then it probably makes sense to consult with a few financial planners. At the very least, you will be able to get a good sense of the planning work that’s needed after speaking with them.

A Certified Financial Planner™ (CFP®) can help you custom tailor a comprehensive plan that helps you accomplish all of your goals. Above all, a CFP® will provide invaluable peace of mind when things change. Remember that your retirement plan will need to be adjusted on an ongoing basis.

It pays to have an experienced guide on the most important journey of your life.

Final Thoughts on Retiring Early at 55

Early retirement at age 55 is an idea that continues to grow in popularity. Ultimately, it means accumulating enough financial resources to live off for another 5-10 years. A successful early retirement plan hinges upon organization and preparation and is the blueprint to accomplishing your goals.

Making adjustments to your plan on a year-to-year basis is equally as important as formulating a good initial plan. There will be constant change and unpredictability with a number of things that are out of your control. How you react to these changes will play a big part in successfully retiring early at 55.

A Guide To U.S. Taxes

The United States has one of the most complex tax systems in the world. This guide to U.S. taxes will familiarize you with the types of taxes Americans pay. Raising revenue for the federal government is the primary purpose of our tax system. It comprises 40 percent of all money the U.S. Treasury takes in. Roughly half of all tax revenue is in the form of income tax. Yet, there are many different types of taxes that Americans pay.  The better you can understand taxes, the more you can reduce taxes.

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One common goal that all Americans share is to retire as early as they can. Maximizing your retirement income will give you the option to do so as early as possible. During our working years, we are constantly juggling the responsibilities of supporting a family, career growth, and paying down the mortgage.

But retirement is a time to focus on yourself and do the things in life you have always wanted to do. Prior to retirement, we all want to know how much can we spend without running out of money. Maximizing your retirement income is the key to optimizing how much you can spend.

The two key components to maximizing your retirement income are how much you’ve saved for retirement and how much you need to withdraw from your nest egg every year. There are certainly a number of variables to maximizing your retirement income. But the three most important factors are determining your income needs, structuring your retirement income, and reducing taxes.

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