Early Retirement

Retirement Investing

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There are three things you need to do to retire early: 1) Manage your expenses and reduce or eliminate debt, 2) accumulate capital, and 3) save and invest wisely. It's easy, but requires patience and self-control.

It's every worker bee's dream to retire early: to lie in a hammock or on a beach, to swing a nine iron or hit the open road in the ol' Winnebago. Ah, to be free from the workday world while you're still young!

Maybe for you it's not just a dream. Let's assume for a moment that your insurance policies are in order and you've got enough money socked away to trade your power suit for some baggy Bermuda shorts. That's excellent.

Before you slam that file cabinet drawer and turn in your parking pass, though, let's go over the details one more time. After all, you may live 30 years or more in this state of retired bliss, and a mistake now — like failing to plan for emergency expenses or long-term care could make things a lot less blissful later.

The IRA and 401k

If you're retiring prior to age 59 1/2, and you need to tap your 401k money, it's easiest to roll it to an IRA and then implement rule 72t to make a penalty free IRA early withdrawal. Generally, there is no need to make a 401k early withdrawal because if you're retired, you just rollover the 401k money to your own IRA. There's a ton of great information on 72t distributions and how to avoid the pre-59 1/2 penalty for IRA early withdrawals at http://www.ira-distribution.com/technical.htm

"Annuity payments are steady, which is a positive, and they last a lifetime, but you don't know where you're going to be 15 years down the road," says Robert Doyle, a CPA with Spoor, Doyle & Associates in St. Petersburg, Fla. "You may have a catastrophic need and a $500-a-month annuity payment isn't going to help you if you have a $20,000 emergency medical bill. If you take a lump sum, you're in the driver's seat."

Make sure your pension plan deposits that windfall directly into an IRA, though, or you'll get hit with a 20% withholding tax. When you enjoy an early retirement, it's best to have the plan administrator send your 401k funds directly to your IRA custodian without your touching the funds.

A downside of taking a lump sum is that it may sever your relationship with the company's entire retirement plan, including any health insurance that may have been included.

As for monthly payments, there are nearly as many options as there are types of pension plans, so take the time to read the fine print and ask questions. You can take higher payments now and have payments end when you die, or take a slightly smaller amount now and have payments continue to your surviving spouse after your death. Those survivor benefits are usually only half of what you were getting, but they may be better than nothing.

Social Security

Don't retire too early. Your Social Security payment is based on the average of your best 35 years of work, adjusted for inflation, so if you retire too soon some of those 35 years will be computed as zeros. Let's say, for example, that you started work after college, at age 22. That means you won't have 35 years of earnings on the books until you're 57, and those zeros can put a big drag on your average income. So if you earned an annual average of $60,000 over your best 35 years, your benefit will be computed on that $60,000. If you only worked 30 years and then went to lie on a beach somewhere, your Social Security benefit will be computed as the average of those 30 years at $60,000 plus another five years at a whopping $0. That brings your best-35-years' average down to just over $51,000, which, depending on the age you retire, would cut significantly into your benefit.

Regardless of your retirement age, you can start collecting Social Security at age 62, although you get docked five-ninths of one percent for every month you are younger than 65. That means you'd get 20% less per month retiring at 62 than you would at 65.

(That's assuming you were born before 1938, making your full retirement age 65. Full retirement age goes up from there; those born in 1960 or later don't reach the required age until 67. That cuts into monthly benefits even more; you'll find the math on the Social Security website.)

Maximum Social Security benefits range from $1,422 per month for someone who retires early at age 62 to $2,111 for some who retires at age 70 — which might argue for retiring later rather than sooner.

Inflation

Figure on 3% a year, which means the $50,000 you think you have to live on will only be worth $48,500 next year, $36,871 in 10 years and $27,189 in 20. There's a big difference between living on $50,000 and on $27,189, and it's unlikely that your expenses will be cut in half in that time.

Lose the mortgage?
So should you pay off the mortgage, or keep making the payments? Like everything else, it depends. After all, the interest you pay on your mortgage is tax-deductible at your regular income tax bracket, so it's probably the best debt you can have. Therefore, go by the old tried-and-true: pay off more expensive debt first, like credit cards or auto loans.

If you still have enough to pay off your mortgage, it's time to compare the after-tax cost of the debt with how much you're making on your investments, Johnson says. If your portfolio is averaging 11%, as the stock market traditionally does, and your mortgage is at 8% before your tax deduction, then leave the money in the market and keep paying the mortgage. "If your investments are sitting in low-yielding money market accounts and your debt is at 10%, pay it off."

Remember, though, that if you're 25 years into a 30-year fixed-rate mortgage, you're paying almost nothing in deductible interest. By now, almost your entire payment is going to principal, which is not tax deductible. "Essentially, you're paying so little in mortgage interest, there's no reason to pre-pay it," Doyle says.

Some people, though, are just more comfortable knowing they own their home free and clear. If that's you and you choose to pay it off, it might be comforting to know that you can get money back out of your house by using a reverse mortgage, in which a lender pays you for a portion of the ownership of your home, or through a home equity line of credit. You also could sell it, of course. But as Doyle says, if you're counting on income from your house when contemplating early retirement, you probably ought to keep working for a while.

"When you retire, your house is your home," he says "Don't look at it as an investment. You can convert it if you need to, but if you're retiring because of the equity in your house, you better get back to work."

The little things
There are a lot of little things to consider when you're thinking about early retirement. Greens fees, for example, and gas for the Winnebago.

Bonnie Arnold of Columbia, Mo., took early retirement from her job as retirement consultant at the University of Missouri staff benefits office, but she promptly went back to work part-time, interspersed with long road trips in her Winnebago. "I hated to give up my association with my peers and I had had that job for a long time and loved it," she says. "Besides, what I earn keeps that motor home on the road. We have a little better lifestyle than we would have otherwise."

Arnold, who knows a bit about the subject from her years as a retirement adviser, says you also should analyze the condition of your home and cars. If your roof is about to cave in or your car is on the blink, figure out if you can afford repairs and replacements. It's much easier to deal with such things while you're still bringing in a paycheck.

Consider, too, your family's financial health. Arnold's 45-year-old son had a stroke in January, and she spent three weeks at his bedside. "You always need to make sure that not only can you meet your normal month-to-month expenses, but emergencies, too, because they don't stop happening just because you retire."

Granted, some of your living costs will go down, as you quit buying work clothes, fueling up with that double espresso on the way to work and paying $7 for a turkey sandwich for lunch. Your at-home food costs can go down, too, because you'll have more time to cook and less need to rip open a package of (expensive) ready-to-eat at the end of your commute. But travel costs may go up, simply because you have more time.

Then there's the question of where to live. If you have more than one home, you need to establish permanent residency somewhere for both tax and estate planning, says Reginald Tilley, a certified financial planner in Bellevue, WA. You may remember that there was a big to-do about the first George Bush establishing residency in Texas rather than in Maine, where he owned a substantial home, because Texas had no state income tax. Some states have no property taxes, some have no sales taxes and some have high taxes of every kind. North Carolina and Florida even have an intangibles tax, which hits the value of investments.

1) Managing Expenses.

Controlling your expenses and reducing or eliminating debt is the first step towards early retirement. Most families spend almost all of their income and save very little. It's not uncommon for families to spend 20-30% of their income on debt service. (Even the Federal government doesn't do that.) Credit card debt at 15-20% interest is the number one reason folks remain poor. If you don't pay your credit card bill in full each month, start making plans to do so today.

Just about everyone spends 20-50% more than they need to for their day to day expenses. Do you ever buy food at 7-Eleven? It's probably much cheaper at the supermarket. Do you buy your clothes at the fancy department stores in the mall? You can get the same items at Marshall's or SteinMart for half price. Think of what you could save if you bought generic rather than name brand. It really adds up.

2) Accumulating Capital.

Once you've got your spending and debt under control you should begin generating a surplus (i.e., your expenses are less than your after-tax income.) Retire Early's Generation-X Retirement Planner can show you how quickly this surplus can grow into some real money. Talking full advantage of tax protected vehicles like your employer's 401k plan or even an IRA will make your nest egg grow even faster.

It's really amazing how fast your accumulated capital can grow, especially if you're getting a good rate of return. Even a 7% return will double your money in 10 years. Prudent investors can do better than 7% over the long term.

3) Invest wisely with low fees and commissions.

If you've been wise and frugal enough to accumulate some capital, it would be a shame to lose a large piece of it to excessive fees and commissions. Unlike dentistry or brain surgery, investing is one of those activities that you really are better off doing yourself. More than 85% of investment professionals under perform the market averages after you adjust their stated returns for the fees and commissions you pay up front (see, "How much should I be paying in fees?"). Unfortunately, it's almost impossible to identify the 15% of investment advisors that outperform the market ahead of time. The investment world is a lot like baseball, last year's batting champion tends not to repeat.

Even if you've always been a do-it-yourselfer when it comes to investing and financial issues, because of the complexity that comes when you retire and especially when you retire early, it's prudent to consult a retirement planner even if just to get some hourly paid advice.

Related Web Sites for additional information.
Third Age - Reinventing Retirement - Weekly newsletter covering a variety of early retirement issues.

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