Considering an Early Retirement? 5 Things to Think About

If you are considering early retirement, you may be grappling with questions about how to fill your newfound free time. Transitioning from a structured life to a more open-ended schedule at a younger age can be exciting and daunting. You might be considering whether to continue working in some capacity, perhaps through part-time or freelance opportunities, or engaging in volunteer activities that provide a sense of purpose and community involvement. These decisions are not just about staying busy; they also have significant implications for your financial stability in retirement. Balancing the desire for meaningful activities with the need to manage finances carefully is a crucial aspect of planning for this new phase of life.

Retirement isn’t just about reaching a certain age. It can be one of the most satisfying parts of your life’s journey if planned properly. Early retirement is a goal many aspire to, but it requires careful planning and informed decision-making. There’s much to consider, from understanding the intricacies of retirement distributions, delaying Social Security, and leveraging income tax gap years to navigating healthcare before Medicare eligibility. Let’s explore how these crucial areas can help pave the way to achieving early retirement.

A Holistic Approach to Early Retirement Planning

It’s essential to look at your financial retirement plan holistically. By factoring in all your available accounts, including 401(k)s, IRAs, and non-retirement savings, you can create a distribution plan that supports your financial needs while minimizing penalties and taxes. A fine-tuned approach to withdrawing from your retirement accounts includes considering how withdrawals will impact your modified adjusted gross income (MAGI). This might mean taking smaller or strategically timed distributions to maintain a lower income level. It’s important to remember that it’s not just retirement account withdrawals that count towards MAGI. Your MAGI calculation also includes any income generated from taxable investment accounts in the form of capital gains, dividends, and interest.

One of the most important factors to consider if you’re looking to access your retirement funds before age 59 ½ is understanding the rules for early retirement distributions. This will help you avoid unnecessary penalties and help you achieve financial stability. Generally, the amounts you withdraw from an IRA or retirement plan before age 59½ are called “early” or “premature” distributions. Most retirement plan distributions are subject to income tax. In addition, individuals must pay an additional 10% early withdrawal tax unless an exception applies.¹

Having a portion of your funds in non-retirement accounts allows you to manage your retirement income and investments. These accounts don’t have the same restrictions or penalties for early withdrawals as retirement accounts. They will enable you to access funds when needed without worrying about penalties. However, depending on the nature of the investment and the gains accrued, there may be varying tax implications for withdrawing funds from these accounts. Balancing withdrawals from these various accounts can help optimize your tax situation to make the most of your savings.

Understanding Income Gap Years

As an early retiree, you may choose to delay claiming Social Security benefits, which can result in significantly increased monthly payments later. However, suppose you choose to hold off on receiving Social Security benefits. How do you manage your finances during this interim period of ‘income gap years’? You may need to take larger distributions from your investment portfolio to cover your living expenses. This requires a balance of drawing enough to live comfortably without jeopardizing your long-term financial health. This approach requires careful investment planning to strategically utilize your investments in a way that bridges your income needs until you start receiving Social Security benefits.

Income gap years, when your income is temporarily lower before your Social Security benefits and required minimum distributions (RMDs) from retirement accounts begin, present a unique opportunity for early retirement tax planning. One strategy involves Roth IRA conversions. For example, let’s say you’re in an income gap year and the 12% tax bracket. Once required minimum distributions from your retirement plans and Social Security kick in, you anticipate moving into the 22% tax bracket.

In this scenario, converting a portion of your traditional IRA to a Roth IRA during your tax gap year can be advantageous. For instance, if you convert $50,000 from a traditional IRA to a Roth IRA during a gap year, you’ll pay taxes on those converted funds at your current 12% rate, which amounts to $6,000. If you waited until your tax rate rose to 22%, the tax on the same conversion would be $11,000—almost double. You’ll pay lower taxes now, reducing your lifetime tax liability. In addition, the converted amount in the Roth IRA grows tax-free, and qualified distributions in retirement are tax-free.

It’s important to remember that this strategy requires careful planning to ensure you’re not converting too much and inadvertently pushing yourself into a higher tax bracket. It’s also vital to have funds available to pay the tax on the conversion without dipping into your retirement accounts, as this could counter the benefits of the strategy.

Navigating Healthcare Before Medicare Eligibility

Planning for healthcare costs is a critical aspect of early retirement planning. If you retire before the age of 65, when Medicare becomes available, it’s important to understand the Premium Tax Credit (PTC). The PTC is a refundable tax credit designed to help eligible individuals and families with low or moderate income afford health insurance purchased through the Health Insurance Marketplace.² This can be a significant benefit for early retirees in income gaps who are looking to manage healthcare costs effectively.

The size of your Premium Tax Credit is based on a sliding income scale. Those with lower incomes get a larger credit to help cover the cost of their insurance. Strategically planning your retirement distributions to maintain an income level within certain thresholds becomes important when trying to maximize the benefit of PTC. The goal is to keep your MAGI (which we discussed above) within the range that allows you to qualify for the maximum PTC, thus reducing your health insurance premiums. This might mean taking smaller or strategically timed distributions to maintain a lower income level. Navigating this balance can be complex, as it involves understanding the specifics of the PTC and managing your retirement accounts and tax implications effectively.

Final Thoughts

Early retirement is an achievable goal with the proper planning and strategies. Diversification and proactive tax planning can give you more flexibility in managing your income during retirement. Each financial journey is unique, and it’s crucial to tailor these strategies to your situation. Ready to embark on your early retirement journey? Contact us to get started on the path to meet your financial goals and dreams.