What are the pitfalls of early retirement?

Retiring early is a dream for many, but it comes with challenges that go beyond financial security. With the rise of the FIRE (Financial Independence Retire Early) movement, there is more media and discussion around this topic than ever. While saving enough to sustain your lifestyle is crucial, there are several hidden pitfalls that can derail your early retirement plans. Let’s explore the non-financial risks, retirement account rules, and unexpected costs that early retirees often overlook.

Do you need to fully retire early to fulfill your goals?

Many alternative pathways to traditional early retirement have emerged because of the rise of remote work and the gig economy. Examples include Digital Nomadism and Slow Travel. This means that depending on your personal goals and situation, those considering early retirement may not need to fully retire to accomplish things that used to be relegated to full retirement, such as long travel stints or living abroad.

Non-Financial Pitfalls

Loss of Identity

For many, work is more than just a paycheck, it can be a source of purpose, structure, and social connection. Retiring early can lead to an unexpected loss of identity, making retirees feel disconnected or unsure of their place in the world. Without a clear plan for how to spend your time, you may struggle with a sense of direction after leaving the workforce.

Boredom

Boredom is another potential issue with early retirement. The idea of having unlimited free time sounds great, but for some, the excitement fades away after a few months. Many retirees experience boredom after the novelty of early retirement wears off. Before retiring at any stage (but especially early!), it is crucial to begin thinking about what will give your life meaning in your post-working years. Many people spend more time with their families, take up a hobby, or even a part-time job. Maintaining a sense of work, routine, and accomplishment is important, even outside of traditional 9-5 employment.

Spousal Dynamics

Spousal dynamics are another factor to consider when retiring early. If one spouse retires while the other continues working, it can create tension around household responsibilities and lifestyle expectations. If both retire simultaneously, spending more time together may require adjustments in personal space and routines, especially if one or both spouses spend significant time away from work.

Developing an understanding between spouses on the retirement plan is crucial. Both spouses need to have a clear understanding of shared retirement goals and how they will spend their years in retirement. If one spouse desires to continue working, ensure that this will fit both spouse’s goals in retirement, for instance, if one spouse plans to travel extensively.

Retirement Account Rules and Restrictions

One of the biggest hurdles for early retirees is accessing retirement funds without triggering early withdrawal penalties. Most retirement accounts have restrictions on withdrawals before age 59 ½, making it difficult to tap into these funds without careful planning.

Retirement Account Rules to Know

Age 59 ½ Rule for IRAs:

Withdrawals from Traditional and Roth IRAs before this age generally trigger a 10% penalty, unless an exception applies.

The Rule of 55 for 401(k)s:

If you leave your job at age 55 or later, you can withdraw from your 401(k) without the 10% penalty, but this does not apply to IRAs. This would have to be a 401(k) account, not an IRA, so if planning to retire early, it could be beneficial not to roll your assets to an IRA, to take advantage of this rule.

Substantially Equal Periodic Payments (SEPP or Rule 72(t)):

A structured withdrawal plan that allows penalty-free IRA withdrawals before age 59 ½, but once started, it must continue for a set period. This rule can work in specific circumstances, but it does lock in the payments for a minimum of 5 years or until reaching age 59 ½, whichever is longer.

Build A Taxable Brokerage Account

A key way to prepare for retirement, especially if planning to retire before eligible for penalty-free retirement account withdrawals, is by building a taxable brokerage account. Since retirement accounts have specific restrictions around the age for withdrawals, it’s wise to build a taxable brokerage account before retiring early. Unlike retirement accounts, brokerage accounts have no withdrawal penalties, making them an excellent source of liquidity in early retirement. Brokerage accounts are taxed using capital gains rules, which could mean that depending on withdrawal amounts, you even pay less taxes than a traditional pre-tax retirement account.

Avoid Unexpected Tax Burdens

Without careful planning, withdrawing from different types of retirement accounts (Roth IRA, Traditional IRA, taxable brokerage accounts) can lead to unexpected tax burdens and missed opportunities. For instance, taking a large sum from a pre-tax IRA for a one-time purchase could lead to a substantial unexpected increase in tax liability.

Implementing a tax-efficient withdrawal strategy that reduces unnecessary tax liabilities while strategically executing Roth conversions when beneficial allows you to maximize the value of your various account types. If the math makes sense, strategic Roth Conversions can cause a reduction in total tax paid for the dollars converted as well as reduce your future RMDs from the pre-tax retirement accounts. As an early retiree, you could especially benefit from this rule due to lower income brackets as opposed to your peak earning years in the workforce.

Unexpected or Underestimated Retirement Costs

Early retirees often assume their spending will decrease, but in reality, lifestyle creep can increase your expenses.  While it is true that some expenses, such as clothes for work or gas for your commute, will go down, increased leisure time can lead to more spending on travel, dining out, hobbies, and entertainment. For those planning to retire early, this can lead to a major miscalculation of retirement lifestyle expenses and severely impact their chances of success in retirement.

Healthcare costs are another area where costs are typically underestimated. If you retire before age 65, you won’t be eligible for Medicare, and private insurance can be costly. Not only do unexpected health issues lead to higher expenses, but healthcare costs historically have inflated at over 4% per year, which is higher than the inflation rate for other spending categories.

Some things to know are the specific costs of your healthcare options such as COBRA plans through your employer, ACA (Affordable Care Act) marketplace plans, or health-sharing programs, and how long you intend to use them. HSA (Health Savings Accounts) balances can be used to pay health insurance premiums like Medicare and COBRA, so this is a great account to maximize during working years if planning to retire early.

Is retiring early right for you?

Retiring early requires more than just a large retirement savings balance and the 4% withdrawal rule, it demands careful planning to avoid the pitfalls that can arise. By proactively addressing these challenges, you can ensure your early retirement is not only financially sustainable but also aligned with your goals, allowing you to enjoy the fulfilling lifestyle you have planned.

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