Retiring Early: 5 Steps to Prepare
You've got a sense of your ideal retirement age. And you've probably made certain plans based on that timeline. But what if you're forced to retire sooner than you expect?
There's no need to panic. Flexible and personalized financial planning that addresses how you'd cope if you had to retire early can help you make the best use of all your resources.
Here are five steps to follow. As an example, we'll consider someone determining whether they could retire five years early, but the steps remain the same regardless of your individual time frame or circumstances.
Step 1: Think strategically about pension and Social Security benefits
For most retirees, Social Security and (to a lesser degree) pensions are the two primary sources of regular income in retirement. You usually can collect these payments early—at age 62 for Social Security and sometimes as early as age 55 with a pension. However, taking benefits early will mean that you get smaller monthly benefits for the rest of your life. And that can matter for your bottom line, even if you expect Social Security to be merely the icing on your retirement cake.
On Social Security's website, you can find a projection of what your benefits would be if you were pushed to claim them five years early. But if you're part of a two-income couple, you may want to make an appointment at a Social Security office or with a financial professional to weigh your potential options.
For example, when you die, your spouse is eligible to receive your monthly benefit if it's higher than their own. But if you claim your benefits early—thus receiving a reduced amount—you're also limiting your spouse's potential survivor benefit.
If you have a pension, your employer's pension administrator can help estimate your monthly pension payments at various ages as well as different payout options that can include continuation to a spouse. Once you have these estimates, you'll have a good idea of how much monthly income you can count on at any given point in time.
Step 2: Pressure-test your 401(k) and IRA savings
In addition to weighing different strategies to maximize your non-portfolio income, evaluate how much you could potentially derive from your personal retirement savings—and there's a silver lining here if you're forced to retire early.
Rule of 55
Let's say you leave your job at any time during or after the calendar year you turn 55 (or age 50 if you're a public safety employee with a government defined-benefit plan). Under a little-known separation-of-service provision, often referred to as the "rule of 55," you may be able to take distributions (though some plans may allow only one lump-sum withdrawal) from your 401(k), 403(b), or other qualified retirement plan free of the usual 10% early-withdrawal penalties. However, be aware that you'll still owe ordinary income taxes on the amount distributed.
This exception applies only to the plan (including any consolidated accounts) that you were contributing to when you separated from service. It does not extend to IRAs.
The 4% rule
But what about those portfolio withdrawals? There's a simple retirement planning rule of thumb suggesting that if you spend 4% or less of your savings in your first year of retirement and then adjust your withdrawal for inflation each year following, your savings are likely to last for at least 30 years.
To determine how much you can safely withdraw from investments in the first year of a 30-year retirement, multiply your savings tally at retirement by 4%. For example, $1 million x .04 = $40,000. Divide that by 12 to get $3,333 per month of withdrawals in year one of retirement. (Again, you could increase that amount with inflation each year thereafter.)
If you are open to adjusting your spending during retirement and can monitor it on an ongoing basis with help, as needed, from a financial advisor, you may be able to increase your initial withdrawal amount above 4%. The 4% initial withdrawal rate is a conservative rule of thumb and represents only a starting point. With a flexible mindset and help from modern planning tools, you can craft a more personalized withdrawal rate based on your age, time horizon, investment mix, and future spending adjustments. Doing so can increase the likelihood of balancing two critical retirement needs: having your savings last over a long retirement and the ability for those funds to support a retirement that you can truly enjoy.
Step 3: Create a post-retirement budget and evaluate your spending
To help make sure your retirement savings will cover your expenses, start with your current spending. A surprising number of savers may not have a clear sense of their current spending habits.
Then, add up the monthly income you could get today—if you were to retire five years early—from pensions, Social Security (if you are eligible and choose to file for benefits), predictable dividends, and any income generated from savings. Now compare those two amounts to see where you stand.
At the end of this process, if you calculate that your monthly expenses will be lower than your income, you're in a good place. But if your budget suggests that your expenses would be higher than your early-retirement income, we suggest that you take one or more of the following measures:
Retire later (if possible).
Trim your budget now so there's less of a gap down the road.
Consider options for consulting or part-time work—and begin exploring some of those opportunities now.
In the years before retirement, many people are unaccustomed to thinking critically about their expenses because they simply spend what they make while working. But one of the most valuable decisions you can make as you pivot to retirement is reevaluating where your money is going now.
This serves two aims. First, it's a reality check on the spending plan you've envisioned for retirement, which may be idealized (e.g., "I'll do all the home maintenance and repairs myself!"). Second, it enables you to adjust your spending habits earlier in the process. This gives you more control and potentially more income to work with.
For example, if you're open to downsizing, moving to a less expensive home could reduce your monthly mortgage, property tax, and insurance payments while freeing up equity that could also be invested to provide additional monthly income.
Turning to the last suggestion—working part-time before you fully transition to retirement: finding a job later in life can be challenging, but it can also be a "second act" that enhances your life. Part-time work can have many non-financial benefits, such as maintaining relationships, purpose, and a level of activity, all of which can be just as important as your finances—and perhaps even more important. And if you can find work you like to cover a portion of your expenses, you might have the option of delaying tapping Social Security and/or your company pension to get higher payments later—and you can limit how much you dip into your retirement savings, giving those funds more time to stay invested with the potential to grow.
Step 4: Don't forget about health insurance
Many individuals who were forced into early retirement did so primarily because of health issues. And nobody wants to spend down a big chunk of their retirement savings on unanticipated healthcare costs in the years between early retirement and Medicare eligibility, which starts at age 65. If you lose your employer-sponsored health insurance, you'll want to find some coverage until you can apply for Medicare.
Your options may include continuing employer-sponsored coverage through COBRA, insurance enrollment through the Health Insurance Marketplace at HealthCare.gov, or joining your spouse's health insurance plan. You may also find discounted coverage through organizations you belong to—for example, the AARP.
Step 5: Protect your portfolio
When you retire early, you have to walk a fine line with your portfolio's asset allocation—investing aggressively enough that your money has the potential to grow over a long retirement, but also conservatively enough to help minimize the chance of big losses, particularly at the outset.
Managing risk is especially important during the first few years of retirement, regardless of when you retire, because it can be difficult to bounce back from a loss when you're drawing down income from your portfolio and reducing the total number of shares you own.
To strike a balance between growth and security, start by making sure you have enough money in cash or cash-equivalent investments, like money market accounts, to cover one year's worth of expenses. Then, set aside funds to cover the next two to three years of expenses in CDs or in a bond ladder made up of short-term Treasuries or high-quality investment-grade bonds. You should think of these investments as a part of your broader fixed-income portfolio. These less volatile investments, supplemented with Social Security and perhaps income from part-time work, may allow you to avoid having to sell assets in a down market to cover living expenses, which would undercut your remaining years of growth potential. Divide the rest of your portfolio among stocks, bonds, and other fixed-income investments, based on your risk tolerance, time horizon, and ideally a personalized financial plan. And don't hesitate to seek professional help to arrive at the right mix.
Bottom line
When you're saving for retirement, time is on your side. You lose that advantage, however, if you're forced to retire early. But having a thoughtful, pressure-tested plan that anticipates the possibility of an early retirement can make the unknowns you face a lot less daunting.