The Bogleheads' Guide to Retirement Planning (34 page)

While you are contemplating early retirement, there are three H factors to consider in addition to how much you have in the bank. They are health care, household, and globe-hopping.

Health-care costs are a growing concern for many early retirees. In fact, health care is often the determining factor in their decision-making process. Most households cannot afford a financially catastrophic health-care event without sufficient insurance. Not only are they unable to afford the medical bills but also they often cannot return to work to bring in needed income. Because Medicare does not begin until 65, this becomes the de facto retirement age for many, superseding the importance of Social Security or pensions.

Other factors to consider are the magnitude and variability of your household expenses. How much money will your household spend in a year? What is the variability? Can you (and a possible significant other) live on a fixed budget? Do you have an emergency fund for unexpected costs, such as home repairs, auto accidents, or a child returning to your once-empty nest? The other side of your balance sheet is income and its possible variation. Do you have the appropriate asset allocation? Is part of your nest egg annuitized either through a pension or an investment vehicle like an annuity?

What do you expect to do in early retirement? Hobbies and traveling can be expensive. Deciding on an acceptable standard of living is crucial. Will you stay in your current home or downsize? Will you move to a cabin by the lake or travel the country by RV? Will a spur-of-the-moment cruise get booked?

George Foreman had it right: “The question isn’t at what age I want to retire, it’s at what income.” Early retirement comes down to the income you need to cover your cost of living. Is $25,000 a year enough? Is $100,000 enough? How much do you need to have saved to pay yourself that amount?

Most people love the sound of early retirement, but many are not emotionally prepared when it arrives. Realize that most of your peers will still be working full-time. You may not be ready for retirement cruises or the silver plate special at the diner. And while you may need to be a millionaire as you enter early retirement, you certainly cannot afford to live like one. In early retirement, it’s important that you live within your means and have a plan for daily activities to avoid boredom.

To answer the key question of this chapter, “Can you retire?” you will need to run the numbers. A good rule of thumb is the generally accepted 4 percent historically safe withdrawal rate (SWR) mentioned several times in earlier chapters. This means that when you retire, you can safely withdraw 4 percent of your nest egg for the first year. This 4 percent needs to include investment costs and taxes, as well as living expenses. Then, revise this initial 4 percent withdrawal rate upward by inflation for future years. So, if you retire with $1 million, you can withdraw 4 percent ($40,000) in your first year. In your second year of retirement, withdraw 4 percent plus inflation. Assuming an inflation rate of 3 percent, you can withdraw $41,200 ($1 million × 4 percent × the 1.03 inflation adjustment). In year three, you can withdraw $42,400, and so on.

The 4 percent SWR is assumed to be generally safe for someone 65 years old with 30 years in retirement to look forward to. But if you want to retire at 40, you will need to withdraw less than 4 percent a year because you are likely to have more than 30 years in retirement. As a general rule, although a somewhat conservative model, you should reduce your safe withdrawal rate if you retire younger. (See
Figure 13.1
.) Thus, if you want to retire at 55, you should plan to withdraw 3.3 percent or less of your nest egg per year. To retire at 45, you should plan to withdraw no more than 3 percent of your nest egg. What may be alarming to the prospective early retiree is that to retire at age 40, you should be able to live on only 3.0 percent of your nest egg.

These data may be depressing. What if you do not have $1 million or cannot live on 4 percent a year of your nest egg? What if your annual expenses are $60,000, but the SWR allows you to withdraw only $40,000 per year? The 4 percent SWR ignores other sources of income. This is where annuities, Social Security, pensions, rental income, and part-time jobs enter the picture to close that income gap.

Another withdrawal strategy to ensure your nest egg lasts as long as you do is to live off only dividends and interest, and leave the principal intact. This is a less precise strategy, because different stock sectors and company sizes offer different levels of dividends. For example, small high-tech company stocks historically offer little or no dividends, and large utility companies historically offer high dividends. Fixed-income investments have interest and dividend variability that will cause a retiree’s annual income to fluctuate each year. Also, this strategy does not provide an inflation hedge. Depending on its size, it may not be possible to leave the initial principal intact over the years, as inflation erodes the purchasing power of the dividends and interest.

There are some excellent, free Internet calculators to help you determine withdrawal strategies and chances of success. One of the best calculators is FIRECalc, available at
www.fireseeker.com
. FIRECalc uses very sophisticated (Monte Carlo) methodologies to predict your cash flow, based on user-supplied input.

Singles retiring early face unique issues. There is no income buffer provided by a significant other, and they cannot rely on a partner’s health-care plan. Also, being single and retired at 45 is no guarantee that you will still be single and able to stay retired at 55. A new partner could bring significant debt or have dependent children. On the other hand, singles are more mobile, need less living space, and have more flexibility to pursue their own interests, hobbies, and jobs without interference. In addition, singles often have larger annuity and/or pension payouts because they do not need to consider survivor benefits.

Half-retirement is when one partner has retired early and the other one continues to work full-time. This arrangement can create built-in conflicts. Vacation schedules, household duties, budgeting, resentment issues, and the sharing of free time must be worked through, preferably before early retirement begins. However, this is not a marriage counseling book (whew!), and this chapter will not delve into strategies for healthy relationships during half-retirement.

As with most issues, clear communication prior to the retirement party and during early retirement will make all the difference. The first year of early retirement is a lot like the first year of marriage or the first year with a newborn. You determine what works best through trial and error as your new normal takes root and lifestyles adjust. But do not be fooled. The first year of early retirement is not always one long, happy honeymoon.

Another family dynamic involves children and other dependents. College bills have delayed many early retirements. However, there is an old saying: pay yourself first. Nobody is going to finance your retirement, but you and your children can finance college. Dependents often incur other costs in addition to college. Weddings, home down payments, and children still living at home can put a strain on your early retirement plans.

At the other end of the dependent spectrum are elderly parents. Just as college bills have delayed many retirements, so has elder care. Unless managed correctly, a pending inheritance or your own retirement nest egg can shrink from significant medical costs, assisted living, nursing home care, and the day-to-day costs necessary to support aging parents. Deciding between early retirement and supporting your parents is usually an easy decision. The parents win.

So, how can you retire early? A key is to live below your means. Spend less money than you make. To do this, you must know how much money you bring in (this is the easy part), as well as how much goes out (it’s usually more than assumed). A good strategy is to track your spending for an extended period. Chapter 12 discussed developing a retirement budget. The same techniques apply to building an early retirement budget.

If you have children nearing college age, think about retiring before they start the application process. This may seem nonintuitive, but when applying for college aid via the Free Application for Federal Student Aid (FAFSA) form, parents are asked about their current income and assets. The lower your income and assets, the more your child may receive in financial aid. Therefore, you may want to retire four years earlier than conventional wisdom suggests.

Let’s get down to the nuts and bolts of early retirement. How can you make it happen? What successful early withdrawal strategies can be used? How can you most efficiently tap your retirement nest egg prior to the traditional retirement age? A key enabler of early retirement is to bridge yourself from when you stop working until the traditional sources of income start, such as Social Security, 401(k), and IRA withdrawals. As discussed elsewhere in this book, annuitizing a portion of your nonretirement assets is often a good idea. See Chapter 8 for details. Following are some additional strategies that can be used solo, or in concert, to help bridge your income gap.

The IRS has created a magnificent (but underutilized) loophole that allows anyone to tap their IRA without any penalties: the 72(t) exception (also known as SEPP, substantially equal periodic payments). At any age, you can begin taking withdrawals from your IRA by initiating a five-year or longer program of substantially equal periodic payments (SEPP) and continue these payments until you turn 59½. The beauty of this IRS rule is that you avoid the 10 percent early withdrawal penalty, and you pay income taxes only on the withdrawals. There are three withdrawal calculation methods (annuitization, life expectancy, and amortization) and it can be difficult to determine the optimal method for your situation. Visit
www.irs.gov
or meet with your tax professional to determine the logistics and best strategy to implement a SEPP program. Following is a simplified, hypothetical SEPP program withdrawal scenario.