How Early Retirement Affects a Retirement Portfolio
It doesn't matter if retirement occurs at 55 or 65; a retiree still needs to make sure that there's enough income each month to cover anticipated expenses like a mortgage payment, electricity, and food. There also needs to be enough in savings to cover unexpected expenses like car repairs and out-of-pocket healthcare costs. Further, the amount of income received each month needs to increase over time in order to offset the effects of inflation. The challenge of retiring early is to make sure that at least in the early years, the income is coming from investment or residual income and not from principal. Otherwise, early retirement will drain the assets needed to generate income later on.
The first step to determining how early retirement will affect your retirement needs is to calculate (as accurately as possible) all current monthly expenses. Some expenses, like utilities, are easy to figure out on a monthly basis because that's how they're paid. Other expenses, like property taxes and insurance premiums, are often paid annually and should be factored accordingly.
The Extra Fees Associated with Early Retirement
Unless you're using the money in a way that will not incur the 10% early withdrawal penalty, it's never a good idea to take funds out of a retirement savings account before age 59 ½. For early retirees, this means leveraging other sources of income. Distributions from an employer-sponsored 401(k) or from a traditional or Roth IRA should always be left alone so they can continue to grow tax-deferred. For example, if you plan to retire at 57 and withdraw $50,000 from a retirement account that year, $5,000 will be taken right off the top to pay the 10% penalty. And that doesn't factor in taxes.
Key Steps to Reaching Early Retirement
The best way to approach early retirement is to have money available in non-tax qualified accounts. Traditional savings accounts, brokerage accounts, and real estate holdings should be able to sustain the retiree until he or she can take distributions from the retirements accounts penalty-free.
Becoming 100% Debt Free
Before taking early retirement, it's imperative to pay off all high-interest non-deductible loans. Car loans and credit cards especially should be paid in full because even the best investments in the market won't beat the 20% interest you waste paying down a credit card Monthly payments on high-interest loans are a drain assets and prevent wealth-building. Even loans that are fully or partially tax-deductible, like student and home equity loans, should be paid off prior to retirement.
Whether a mortgage should be paid off in full will depend on the interest rate of and balance on the loan, the deductions it provides at both the federal and state income tax level, and the length of time the retiree expects to live in the home after retirement. In some cases, it may make more sense to keep the mortgage.
Developing Sources of Residual Income
Most people who retire early have established solid sources of residual income. They may have built an after-tax investment portfolio that includes stocks that pay dividends and bonds that pay interest. (The interest on some bonds is even paid free of local, state and federal income tax.) They may have invested in a business – anything from a restaurant, car wash, or dry cleaner. Or they may sell their recipes online or sell their crafts at tradeshows.
Residual income is income that keeps coming in regardless of your participation in the business. Even if the business is cyclical and you're not guaranteed the same amount of income each month, you have an additional source of money. A residual income provides "moving room" in your budget, even if you decide to go back to work after retirement.
Working Part-Time or Having a Hobby that Provides Income
Working part-time after retiring from a full-time job is a great way to make the transition from the working world to full retirement. But making money on a hobby is usually not easy. While hobbies may be rewarding in other ways, there are always expenses involved in turning a hobby into a business. Those who work from home need to make sure that local zoning laws permit a business to be run out of a home. They also need to look into liability insurance, sales tax, and how to market the goods they produce. These expenses, along with phone lines, websites, and travel add up quickly.
Budgeting is probably the most crucial step for early retirement. Most people who retire early are in their late fifties or early sixties. They're still active and healthy and may want to do everything they didn't have the time or money to do when they were younger. Traveling around the country in a recreational vehicle, sailing to Hawaii, or traveling around the world is expensive. All this is only possible with proper planning, consistent saving, and moderated expenses. Necessities like healthcare, college tuition for children, life insurance, health insurance, owning your own home, and rainy-day savings should take priority over the urge to retire early. Early retirement is the treat for having planned and management your affairs prudently.
Tips for Those Who Retire Early
The first step to creating a successful early retirement is to accurately estimate expenses. Food, shelter, energy, healthcare, and taxes are the big five. The second step is to understand how inflation will affect future expenses. While the future rate of inflation can't be known, most financial planners suggest assuming a rate of 3 – 4% per year. That means an item costing $1.00 today will cost $1.03 next year, $1.06 the year after that, and almost $1.18 in 20 years. $0.18 over 20 years may not seem like much, but on items that cost hundreds of dollars, the amount is significant.
The third step is to reduce expenses wherever possible. For example, joining an organization like AARP, AAA, or a college alumni association that offers discounts on car insurance, hotel stays, or theatre tickets will help retirement funds go further. Combining your cable service with your phone and Internet service will help to reduce vital communication costs. Growing vegetables and herbs in a backyard garden or in containers on the patio saves money and energy.
Finally, keep investing in growth companies. As money gets withdrawn from a retirement account, less of it gets compounded and grown. For example, if an account with $100,000 earns 5% interest, it will be worth $105,000 at the end of the year. But if $20,000 is taken out for living expenses, there will be $85,000 on which the 5% is paid. At the end of year two, the account will be worth $89,250. As a rule of thumb, you want to earn enough "passive" income to offset living expenses. This way, you never dip into principle and the account can keep paying out indefinitely. Growth stocks or residual income sources do just this and are the two keys to a successful early retirement.
While we've covered the basics of retirement planning here, there is much more to securing a great retirement. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
More Retirement Planning Guidance
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- Building a Solid Retirement — A practial guide to implementing your retirement plan.
- Inflation — Understanding how inflation affects retirement planning.
- Assest Allocation & Diversification — Learn how to manage investment risk.
- Retirement Pitfalls — Common retirement planning mistakes you'll want to avoid.
- Tax Considerations — How to minimize tax burden while saving for retirement.
- Retirement Planning FAQ — Frequently asked questions about retirement planning.