Here's what you need to know to quit work and begin a financially independent lifestyle.
Ready to quit work or begin a financially independent lifestyle? Laura covers five strategies to help you retire early and avoid paying early withdrawal penalties.
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Are you ready to quit work or begin a financially independent lifestyle? Here are five strategies to help you retire early and avoid paying early withdrawal penalties!
Hi, everyone! My name is Laura Adams, and I appreciate you downloading the show and spending time with me. I'm a personal finance author and have hosted the Money Girl podcast since 2008. I also partner with select brands for PR and marketing work as an on-camera spokesperson, voice-over talent, and multimedia creator.
Here on Money Girl, my mission is to help you get the knowledge and motivation to prioritize your finances, build wealth, and have more security and less stress. Every episode is a mini-money training designed to help you take your financial life to the next level. So, if that's what you're looking for, subscribe to the show.
And thank you if you're already a long-time listener! If you're enjoying the show or have a personal finance or small business question, you can leave a message 24/7 at 302-364-0308. You're also free to shoot me an email using my contact page at LauraDAdams.com.
Today's episode is number 736, called 5 Strategies for Retiring Early and Without Penalty.
I hope it will answer a recent question from Judy H., who says:
“I'm 31 years old and contribute 15% of my income to my Roth 401(k), and my employer contributes 6% in matching funds to my traditional 401(k). I've saved about $100,000 for retirement, own a home (with a mortgage), and have no other debt.
I was diagnosed with a chronic illness and have about a 50% chance of needing to retire early, like by age 50. I'm worried about not being able to access my money early before the official retirement age of 59.5. However, I did get long-term disability insurance before my diagnosis. What adjustments, if any, should I make in my retirement planning?”
Thanks for your question, Judy! I sincerely hope you won't have to retire early due to your health. But I'm sending you a virtual high-five for thinking so clearly and honestly about your future.
In this episode, I'll cover five strategies for retiring early and avoiding hefty penalties when tapping a retirement account early.
Whether a high-pressure job stresses you out, you dream of a different lifestyle, or you can no longer work due to physical or mental limitations, being ready for retirement sooner rather than later is a great and wise goal!
Maybe you want to "retire" and work part-time in a different or less lucrative career. You might choose self-employment or do volunteer work that keeps you engaged and involved in your community.
If you're fortunate, retirement may not have to be the end of income-producing work. It can be shifting from work you must do, to work that you genuinely want to do.
So I encourage everyone to aim for early retirement. Then, if you're healthy enough to continue working into your 60s, 70s, and beyond, you can build even more financial security.
So, let's dive into five strategies to make early retirement possible.
The first strategy is to calculate your savings target.
To know if and when you can retire early, figure out the amount of savings you'll need. An excellent place to start is adding up your living expenses, such as housing, food, insurance, medical bills, and transportation.
Remember that some expenses end or go down once you're retired, such as saving and commuting for work. But other costs may go up, such as travel and health care. While you can't know precisely what you'll spend in the future, you need an estimate to calculate an early retirement savings target.
How much savings you need to retire depends on a variety of factors, including:
Remember that the earliest you can begin collecting Social Security retirement benefits is age 62. So, until then, your savings must generate all your income.
In a recent show, episode 734, called How Much You Should Save for Retirement by Age (Even in a Recession), I reviewed more about how much money you need to retire by age. That's just one way to make sure you're on track. For instance, consider saving:
For example, if you live on $100,000 per year and receive Social Security retirement benefits, a good savings target is between $1 and $1.5 million for your mid-60s. So, if you want to retire in your 50s, you'll likely need to hit that goal years earlier.
Since the math can get complicated, working with a financial advisor is the best way to create an early retirement savings plan. You can also use a retirement planning calculator, like AARP's Retirement Nest Egg Calculator.
The second strategy is to invest consistently.
If you're thinking, Laura, I could never save that much money, the trick is investing early and consistently for as long as you can. If you haven't started, please don’t wait for the "right" time to invest because it doesn't exist.
No matter what's happening in the financial markets, your money can't grow if you sit on the sidelines. Every day of investment growth matters, especially when you want an extra-large nest egg to retire early.
My favorite way to invest is to put it on autopilot, so I don't have to think about it. With any investment account, you can set up automatic contributions on a schedule, such as daily or monthly.
Increase your savings rate until it hurts and then reach a little higher! For example, If you're investing 5% of your income, push it to 10% by the end of the year or increase it by 1% every month. Some investing platforms can even automate your savings increases so they happen on certain dates.
Judy mentioned that she's investing 15%, which is fantastic. Judy, I want to challenge you to save even more, such as 20%. Try cutting back on the most significant expenses in your budget first, such as housing, when possible. It's also wise to reduce unnecessary small costs, but slashing big expenses can make the difference in being able to invest more.
Also, invest more for retirement when you earn a raise, bonus, or receive a cash gift. And you might be able to earn extra income by starting a side business or getting a second job to boost your retirement account consistently.
Early retirement is an aggressive goal you'll need to attack with gusto to pull off. It won't be easy—but it's possible.
The third strategy is to minimize taxes.
As you know, taxes take a big bite out of your income. To keep more money and protect your future investment earnings, do everything legally possible to cut your tax liability. Tax-advantaged accounts, such as workplace retirement plans, IRAs, and health savings accounts, were designed to help you save and pay less tax at the same time.
With a traditional retirement account (such as a traditional 401(k) or a traditional IRA), contributions get made on a pre-tax basis, and then your withdrawals of contributions and earnings are taxed based on your ordinary income tax rate.
Judy mentioned that she's using a Roth 401(k), which is terrific! With a Roth account (such as a Roth 401(k) or a Roth IRA), contributions get taxed upfront, but your withdrawals of contributions and earnings are generally tax-free. Having tax-free accounts to withdraw from in early retirement leaves you with more money to spend.
The allowable contribution limits for tax-advantaged accounts increase with the cost of living index, so check each year for the maximum amount, and plan to hit it. If you max out these accounts first, you'll get the biggest bang for your buck.
Also, claim as many legitimate tax deductions and credits as possible each year. These might include deductions for:
Keep detailed records, so you know when to itemize deductions to save money instead of claiming the standard deduction.
Working with a qualified tax accountant to minimize your tax liability can really pay off. If you're unsure what expenses are tax-related, or you have a complex situation because you own a business or rental property, consult with a tax pro.
The fourth strategy is to know the retirement withdrawal rules.
That takes us back to Judy's question and her worry about tapping her retirement account early. After all, you've probably heard that taking money out of a retirement account before age 59.5 typically comes with a 10% early withdrawal penalty. The good news is that there are legit ways to avoid the penalty.
The first option is to use a Roth account, which Judy is doing. As I mentioned, a Roth requires you to pay tax upfront on your contributions. Therefore, you can withdraw them without paying the penalty or additional tax, making a Roth an excellent option for early retirees.
However, your investment gains in the account haven't been taxed. So, if you choose to withdraw earnings from a Roth before age 59.5, those amounts would be subject to tax, plus the 10% penalty.
The only hiccup is that high earners aren't eligible for a Roth IRA. But that rule doesn't apply to a Roth at work because you can contribute to a Roth 401(k) or a Roth 403(b), regardless of how much money you make.
Here are the Roth IRA eligibility rules for 2022:
Judy didn't mention her income or tax filing status. But if she earns less than the Roth IRA threshold, she can max out a retirement account at work and a Roth IRA in the same year.
But what if you earn too much to qualify for a Roth IRA or don't have an employer that offers a Roth retirement plan? You can still retire early using a traditional 401(k) or a traditional IRA and avoid the early withdrawal penalty utilizing a couple of workarounds.
The first exception applies if you have a workplace retirement plan and decide to retire at age 55 or later. If you are no longer employed, you can use the "rule of 55" to take penalty-free withdrawals from your 401(k) or 403(b).
For specific government workers, this exception can apply as early as age 50. But note that this rule doesn't apply to IRAs, only to workplace plans and solo 401(k)s.
The fifth strategy is to use a 72(t) payment plan.
There's also a little-known rule to avoid the early withdrawal penalty regardless of age. This exception goes by a few different names, including:
This regulation allows you to set up a plan to take equal monthly or annual distributions from your retirement account, such as a traditional IRA or a Roth IRA. You can also set up a 72(t) distribution for a workplace plan, such as a 401(k) or 403(b) if you no longer work for your employer. The name 72(t) comes from its numbered section of the IRS tax code.
The amount you can withdraw using a 72(t) plan gets calculated using one of three accounting methods approved by the IRS. They use factors such as your account balance, age, and life expectancy. The payment calculation can be based on the amount in a single retirement account or on the aggregate of all your retirement accounts.
The problem is that a 72(t) comes with restrictions and negative consequences if you don't use it correctly. It's important to understand that once you begin taking 72(t) distributions, you can't stop taking them for a certain period.
Once the plan begins, you must take the periodic payments for a minimum of five years or until you turn 59.5, whichever is longer. In other words, if you start a 72(t) at age 50, you'd have to continue payments for 9.5 years.
After you complete a series of five-year distributions or reach age 59.5, you can take retirement distributions any way you like. However, for most traditional accounts, once you reach age 72, you generally must take annual required minimum distributions, whether you used a 72(t) plan or not.
Another consideration is that you can't make new contributions to your retirement account or add rollovers while you take 72(t) payments. And, of course, all distributions that weren't previously taxed will be subject to ordinary income tax.
When properly executed, taking 72(t) payments can be a smart way to tap your retirement funds early without penalty. However, figuring out the allowable payment schedule is complex, so get help from a qualified tax professional.
Taking too little, too much, or missing a 72(t) distribution deadline can result in owing income tax and paying a 10% early withdrawal penalty plus interest calculated from the original date you made an error.
So, every early retiree should weigh their options carefully and never enter a 72(t) plan lightly. Make sure you can afford to take an immediate cash flow and still have a nest egg that will last throughout your retirement.
Thanks again, Judy!
Before we go, I want to invite you to connect with me on Twitter @lauraadams or Instagram @lauradadams. And LauraDAdams.com is my personal site where you can use my contact page and learn more about my work, books, and money courses.
That's all for now. I'll talk to you next week. Until then, here's to living a richer life.