It’s All About the Benjamins — Early Retirement Income
In my most recent blog, Are You On Fire Financially, I noted several factors early retirees need to consider. The first of which is how to generate income for the rest of their lifetime, which for some early retirees could be an additional 40-50 years. And yet, the first few years of retirement can be some of the trickiest to generate income because Congress has applied a 10 percent penalty for Americans that access their retirement funds before age 59.5. The purpose of the penalty was to encourage Americans to keep their monies invested for longer to benefit from compound interest. Consequently, it requires some deft planning to generate income during these first few years of early retirement. I’ve outlined some options below.
Income Sources in Early Retirement
Savings — I’ll start with the simplest, which is the money you have in the bank, that is in addition to what you have saved for your emergency fund (see my blog regarding emergency funds: In Case of Emergency). This extra money should be the first money you spend because if the money just sits in the bank, it will buy less in the future due to inflation (see my blog entitled The Silent Thief for why you don’t want to keep too much money in the bank).
I recommend that early retirees begin saving extra money in the bank in the few years just prior to their early retirement. This will be the money you spend first in your early retirement, as it isn’t subject to risk in the stock market where a downturn could reduce what you have to spend.
Non-Retirement Accounts — Remember in the late 90s when you opened an E-Trade account and purchased shares in an online book retailer called Amazon? The stock you bought then was around $20, and as of July 2021, it was around $3600/share. Okay, I admit that most of us were not that clairvoyant; however, even if you missed out on Amazon, non-retirement accounts are a great investment vehicle as you can access the money whenever you’d like. For those who want to retire early, non-retirement accounts are a great way to save more if you have already maxed out your retirement accounts. For example, if you invested an extra $150/month from ages 25-55 that earned an average of 8% per year, you’d have an additional $200,000 to bridge the years between ages 55 and 59.5.
Retirement Accounts — While there is a 10% penalty when you access retirement funds before age 59.5, Congress injected some work arounds. Here are a few:
• Roth IRA - Roth IRA contributions are made with after-tax money. Because you have already paid taxes on this money, the IRS allows you to withdraw the contributed amounts (not the gains) at any time without taxes or penalties. For example: Let’s say you contribute $5,000 to a Roth IRA in 2015, and it grows to $10,000 in 2020. You can take the $5,000 contribution out with no taxable consequences. However, the disadvantage is that less of your money will be compounding.
• Rule of 55 — The IRS recognized that some investors that leave or lose their job early, will need to access their money prior to age 59.5. The way the rule works is that if you turn age 55 during the calendar year that you lose or leave your job you can begin taking distributions from your 401k without paying the 10% penalty. However, you can only take distributions from the 401k plan for the employer you left your job at age 55 or older.
• 72(t) Distributions — What if you aren’t age 55, but have a lot of money in a tax-deferred 401k/IRA? Are you out of luck? Think again. You can access money in your retirement accounts prior to age 59.5 via a 72(t) distribution. The name comes from the section in the IRS tax code, which states that you can take distributions without penalty as long as you take at least five substantially equal periodic payments. The amount of the payment is based on your account balance, age, and on one of three different methods approved by the IRS. I won’t bore you with the calculations, but essentially this is how it works: If you want to take money out of your tax-deferred retirement account without incurring an 10% penalty, you can elect to take a 72(t) distribution. The catch is that you have to take the distribution for at least five years, no less, regardless of when you start the distribution. For example, if you were age 57 and started a 72(t) distribution you would still need to take distributions after age 59.5.
Other Income Options
Of course there are still other great options to generate income, such as rental properties, but the idea is that with enough foresight and planning you can generate income prior to age 59.5 (even from your retirement accounts without penalty).
Thanks for reading my blog. I hope you found it helpful. If you have questions regarding how to retire early, feel free to schedule a free introductory meeting by going to the Contact Us page.
