Early retirement has become the American dream for many workers, especially those who are very successful at their jobs and have accumulated sufficient assets and tenure with their employers to do so. Other workers who stumble into early retirement come under rather less pleasant circumstances, such as those in their 50s who are laid off and unable to find other work. Those who have a choice and are contemplating this course of action should weigh the possible disadvantages carefully, as they can be substantial in many cases. Here are some of the drawbacks to early retirement.
IN PICTURES: 5 Tax(ing) Retirement Mistakes
Early Withdrawal Penalties
Those who withdraw funds from any tax-deferred account, such as a traditional or Roth IRA, employer-sponsored retirement plan or annuity contract before age 59.5, must generally pay through the nose to do so. Not only will they pay income tax on the amount withdrawn at ordinary income tax rates, they will also pay a 10% early withdrawal penalty on their distributions. Furthermore, they may be assessed additional early withdrawal penalties if they take funds out of a certificate of deposit or annuity contract, which generally has a declining sales charge surrender schedule.
For example, Clyde is 53 years old and is laid off from his job. He has no choice but to withdraw $20,000 from his traditional IRA to pay for living expenses. The IRA is invested in a fixed annuity contract and will charge a 4% penalty for any withdrawals made during the current year. Clyde will pay the 4% penalty, the 10% early withdrawal penalty plus income taxes on his withdrawal. If he is in the 25% tax bracket, then he will pay $5,000 in taxes on his withdrawal, plus a $2,000 early withdrawal penalty to the IRS and an additional $800 early withdrawal penalty to the annuity carrier. His total cost comes to $7,800 - nearly 40% of his withdrawal amount.
Of course, his tax bill may be reduced by various factors, depending upon his financial situation. He would also still pay tax at ordinary rates on his withdrawals, even if he were over 59.5. But the early withdrawal penalties are clearly substantial; in this case, they equal over one-eighth of the total amount of the distribution. (To learn more, see Early Out: A Realistic Plan For The Working Man.)
Loss of Control of Distributions
Those who wish to begin taking retirement plan distributions early can avoid early withdrawal penalties by taking a series of substantially equal periodic payments that meet the requirements of IRC section 72(t). This sets up a set annuity of payments from an IRA or qualified plan that will last from the time that they begin until the account is exhausted. However, this course of action is irrevocable, and payments must continue regardless of any future change in the circumstances of the recipient. This is the equivalent of choosing an annuity payout option, which also cannot be changed once it begins.
Less Money over a Longer Time Period
This is generally the greatest disadvantage of early retirement. Those who retire early must stretch their retirement funds out over a longer period of time. This also means that they have had less time to allow their funds to accumulate. The Rule of 72 dictates the amount of time that it takes for an amount of money to double at a given rate of growth; this can therefore mandate that those who retire 10 years early may only have about half as much in their retirement savings as those who retire at a later age. (To learn more, see Retiring Early: How Long Should You Wait?)
For example, two employees of the same age work for the same company and allocate the funds in their retirement plans in guaranteed accounts paying 8%. One retires at age 55 and the other retires at age 64. Since the rule of 72 shows that money growing at 8% interest doubles every nine years, the employee who retires at age 64 will have twice the amount of money in his or her plan as the other employee. Just as importantly, this employee will have nine fewer non-working years for which he or she has to provide for him or herself and/or spouse.
Reduced Social Security Payments
Those who begin drawing Social Security at age 62 can typically expect to receive about 75% of the benefit that they would be entitled to if they waited until full retirement age. So, an employee who would receive $1,400 per month at age 66 would only get $1,050 if he or she applies for early benefits. That equals $4,200 per year of benefits lost for the rest of his or her life. (Learn more in How Much Social Security Will You Get?)
Of course, financially savvy retirees may make up for the shortfall by investing the reduced amount prudently from the beginning and then applying for a Social Security "do over" at a later date, which involves repaying all previous benefits received and then receiving a new recalculated benefit based upon your current age.
The cost of private health insurance can be staggering, especially for retirees and senior citizens who need some form of long-term care. COBRA benefits are not free and expire after 18 months; those who retire early must carefully analyze their health care needs and the amount of premiums that they will have to pay in order to remain insured. Although long-term care insurance can help to defray these expenses, the cost of this coverage must be considered as well. Prospective early retirees with slim margins in their budgets should think twice before taking a chance that their money or health coverage will expire too soon if they incur substantial medical expenses. (Do you need more coverage? Find out in Long-Term Care Insurance: Who Needs It?)
The Bottom Line
Clearly, early retirement can substantially impact the quality of life that is lived during retirement, and can generally only be successfully accomplished by high-income employees and those who plan out their requirements with great care.
Catch up on your financial news; read Water Cooler Finance: Who Is The Next Buffett?
RetirementStay and pay the full fee? Cut and run to another provider? Five ways to cope when Medicare threatens to break up you and your medico.
RetirementUnderstand why more and more Americans are deciding to retire in developing countries. Learn about the top five reasons why Americans retire to Costa Rica.
RetirementLearn why Mexico's low cost of living, inexpensive health care, natural beauty and culture make it such a popular retirement destination for Americans.
RetirementUnderstand why the Florida communities of Miami Beach, Palm Beach and Key West serve as magnets for the ultra-rich retirees who descend on the state.
ProfessionalsSoon to be retirees are often told it's best to wait until age 70 to collect Social Security. Here's why this is not always the best advice.
ProfessionalsBetween delaying filing, claiming strategies and taking advantage of special marital benefits, there are several ways to maximize Social Security.
RetirementSure, you can tap your permanent life insurance policy to help fund your retirement. But in most cases, an IRA is the better choice. Here's why.
Investing BasicsLearn about how the data suggests that the buy-and-hold investment strategy still works, even after the huge declines of the Great Recession.
RetirementDiscover five of the most desirable retirement communities for seniors located in the Austin/Georgetown metropolitan area in Texas.
Options & FuturesProfessionals choose the options available to you in your plan, making your decisions easier.
You can borrow from your annuity to put a down payment on a house, but be prepared to pay an assortment of fees and penalties. ... Read Full Answer >>
There are two broad categories of annuity: fixed and variable. These categories refer to the manner in which the investment ... Read Full Answer >>
Though the appeal of having guaranteed income after retirement is undeniable, there are actually a number of risks to consider ... Read Full Answer >>
If you decide your current annuity is not for you, there is nothing stopping you from transferring your investment to a new ... Read Full Answer >>
Typically, qualified benefits offered through cafeteria plans are exempt from Social Security taxes. However, certain types ... Read Full Answer >>
Annuities can sound enticing when pitched by a salesperson who, not coincidentally, makes huge commissions selling them. ... Read Full Answer >>