If you’re considering early retirement, you’re in good company. COVID-19 has been a catalyst for older Americans to leave the workforce voluntarily due to their high risk of infection. Quitting a job poses financial challenges for early retirees who suddenly have fewer years to accumulate assets and more years to live without a regular paycheck.
Determining whether you can afford early retirement can be complicated. Obviously, the future is uncertain, and projections involve many variables and assumptions. I believe in keeping things simple by focusing first on what’s certain…what you know right now—the current amount of your take-home pay. If the paycheck that’s deposited into your bank account covers your expenses and allows you to live comfortably, it can be a great starting point for estimating your retirement income needs.
Typically, retirement plan contributions, taxes, and health insurance are automatically taken out of your paycheck. Of these three expenses, only retirement plan contributions end with early retirement. You’ll continue paying federal, state, and local taxes, and unless you’re fortunate enough to have retiree health coverage, you’ll need to purchase individual health insurance until you’re eligible for Medicare at age 65.
Factor in the cost of individual health insurance
One of your health insurance options is to extend current employer-provided coverage through COBRA. Although your insurance coverage itself remains the same, your premiums may be significantly higher because your employer no longer contributes to the cost of coverage. If you have funds in a Health Savings Account (HSA), you can withdraw them without tax consequences to cover eligible expenses, including insurance premiums through COBRA and out-of-pocket medical expenses. Be sure to consult a list of eligible medical expenses before you make a withdrawal. Individuals under age 65 pay income taxes plus a 20% tax penalty on HSA withdrawals used for ineligible purchases.
As an alternative to COBRA, you can shop for plans through the Insurance Marketplace established by the Affordable Care Act. If your income is low enough, you may qualify for premium subsidies; otherwise, be prepared to pay relatively high rates due to your age.
Weigh the pros and cons of paying off your mortgage
A common dilemma for pre-retirees is whether or not to have a mortgage in retirement. The old rule of thumb calls for being debt-free in your golden years; however, it doesn’t always hold true in today’s world. If you have the cash on hand, paying off the principal is definitely something to consider, but be sure to run the numbers before you write the check. With today’s low interest rates and the federal income tax deduction for mortgage interest, you might come out ahead by holding onto that cash and investing it instead.
I’m not a fan of using qualified retirement savings from a 401(k) or Traditional IRA to pay off mortgage debt. Taking withdrawals has considerable income tax consequences and may trigger penalties if you’re under age 59 ½.
One way to avoid the mortgage pay-off question is to downsize—sell your current home and buy or rent a smaller, more affordable home or condominium. And if you live in a region with a high cost of living, think about relocating to a more affordable state.
Look at Social Security benefits from a different angle
Some early retirees apply for Social Security benefits as soon as they’re eligible and settle for a reduced benefit. Others prefer to maximize their monthly check by waiting until age 70 and using personal retirement savings in the interim. So, which choice is better?
The typical advice is to wait, the rationale being that the full Social Security benefit will increase by 8% annually until age 70. I like to look at it from another perspective: Which option offers more flexibility – Social Security or personal retirement savings? Would you prefer to spend an asset over which you have no control, that isn’t protected from creditors, and that you can’t pass on to your children? Or would you rather spend assets that you control and manage?
Protect your retirement assets
The high cost of an uninsured long-term care (LTC) event can shatter your retirement plans. If you need custodial care (assistance with the daily aspects of living), neither individual healthcare plans nor Medicare cover the cost. Your choice is to depend on relatives and friends as informal caregivers or pay out-of-pocket for a licensed care worker until you qualify for Medicaid. Either way, you’re likely to pay a high emotional or financial price.
Long-term care insurance protection can be a smart solution, especially if you apply for coverage in your 50s, before you develop the chronic health conditions that begin at older ages. Applying at mid-life increases your odds of getting insurance and paying lower rates, although it also means you may be paying premiums for a longer time which could increase your overall costs. But waiting also is risky because you could develop medical issues that make you uninsurable.
Think before you leap
Retiring early is usually an irreversible decision that can have major lifelong implications for your lifestyle and retirement assets. Take time to weigh all the pros and cons before you take action and consider talking to an experienced financial professional who can help you analyze and quantify the impact of leaving the workforce sooner rather than later.