Common Traps That Could Catch Early Retirees

Are you thinking of retiring early? There are some traps to be aware of when accessing funds from a retirement account before age 59 ½. The U.S. tax code generally deems age 59 ½ to be the earliest anyone should retire. Until you reach this age, attempting to access tax-deferred retirement accounts could trigger taxes and penalties.

The standard 10% premature-withdrawal penalty applies to IRA withdrawals before age 59 ½. However, the penalty is waived for withdrawals from employer-sponsored retirement plans after age 55. This is an important planning consid­er­ation for an early retiree. Anyone consid­ering early retirement should check with their employer to determine what options are available. To qualify for the penalty exception, an employee cannot separate from service until reaching age 55. The IRS recently deter­mined that a taxpayer still owed the 10% penalty on funds she withdrew from her company plan after age 55 because she stopped working at age 53. Company plans that use IRA accounts—such as Simplified Employee Pension (SEP) IRAs and Savings Incentive Match Plan for Employees (SIMPLE) IRAs—never qualify for the age 55 penalty exemption.

The surest way to access retirement funds from an IRA without penalty before age 59 ½ is by taking a series of substan­tially equal withdrawals, called 72(t) payments. There are three methods of calcu­lating the amount to withdraw: minimum distri­b­ution, fixed amorti­zation, and fixed annuiti­zation. A financial planner or accountant familiar with these formulas should be consulted to ensure the withdrawal plan is set up properly. Failure to set up the distri­b­u­tions correctly or adhere to the rules could result in all distri­b­u­tions becoming subject to the penalty retroactively.

Spend Sustainably

No matter what age you’re retiring at, a detailed spending plan is paramount. Many people do not realize how much money they spend until they put it in writing. Some people believe a spending plan can be too controlling. There is some truth to this. But the fact is, without a plan in place, spending can quickly get out of control.

Without a plan, money comes in and goes out unchecked, leaving room for unpleasant surprises. A spending plan projects the amount of money coming in and deter­mines in advance how much will be saved or spent. The retiree can choose how much is spent on fun or neces­sities in advance. This can be an important safeguard to ensure essential expenses are planned for and money is saved for long-term goals.

Carrying debt into retirement can be another trap. This probably doesn’t sound like it has anything to do with retirement, but there are two parts of the retirement equation—saving and spending. Simply making the commitment to get out of debt can subcon­sciously help reduce spending, ultimately leading to increased savings. Psycho­log­i­cally, many people are more comfortable in retirement when they are not respon­sible for making debt payments.

Plan for Inflation

Another big trap is under­es­ti­mating the impact inflation can have once you retire. According to Infla​tionData​.com, inflation has been relatively low over the past 25 years. It averaged slightly over 3% in the 1990s and 2.5% in the 2000s. Inflation has been under 2% in the current decade. Even relatively low inflation will more than triple the cost of goods and services during the average life expectancy of a healthy couple taking early retirement. Fixed income invest­ments are not likely to produce a high enough return to permit adequate withdrawals and keep pace with inflation.

An excellent way to prepare for inflation in retirement is to build substantial savings and keep a suffi­cient percentage of assets invested in equities. While equities have histor­i­cally shown more volatility (ups and downs) than fixed income, they also have histor­i­cally fared well relative to inflation.

Jeremy Siegel’s book Stocks for the Long Run examines the returns of different types of assets going back to 1802.¹ Dr. Siegel adjusts each type of asset’s return to factor out inflation and shows the net return. Siegel concluded that over the past 200-plus years, a broadly diver­sified stock portfolio averaged 6.6% per year over inflation. That would have resulted in doubling one’s purchasing power about every decade for the past two centuries.

Diversify for Stability

This doesn’t mean that all of your invest­ments should be in stocks. It’s important to establish an asset allocation strategy that provides an oppor­tunity to take advantage of the financial markets’ volatility without affecting retirement income. A proper asset allocation for many retirees should include equities, fixed income, and cash.

Diver­si­fying the equity portion of the allocation between growth and value stocks, domestic and foreign, and small and large companies can help to increase the proba­bility that at least part of your portfolio performs well. Using the asset allocation strategy to determine where to draw income from can help to maintain balance. In years when the stock market is going up, retirement income could come from stocks. When the market is doing poorly, fixed income assets could provide income. Remember that diver­si­fi­cation does not ensure a profit or protect against loss, and it is still possible to lose money.

The future is uncertain, and future retirees should be concerned about inflation. Planning helps prepare for uncer­tainty. Anyone planning to take early retirement should seek a competent retirement planner’s advice to review their plan before retiring.

Insights:

• The surest way to access retirement funds from an IRA without penalty before age 59 ½ is by taking a series of substan­tially equal withdrawals, called 72(t) payments.
• Even relatively low inflation will more than triple the cost of goods and services during the average life expectancy of a healthy couple taking early retirement.
• Diver­si­fi­cation does not ensure a profit or protect against investment losses, and it is still possible to lose money.

Origi­nally posted April 2012