Early retirement is a dream for many people. The hard part is actually funding an early retirement. The typical working-age household has only $3,000 in retirement account assets, according to the National Institute on Retirement Security. However, it is possible to save regularly over many years and accumulate a comfortable nest egg. Such diligent savers might want to retire before they are 59 1/2, and will need to take steps to avoid paying the 10 percent penalty for early retirement account withdrawals. Here are five ways to pay for an early retirement:
Passive income. Passive income is a great way to fund your early retirement, but it takes many years to build up. Many retirees receive income from rental properties, dividend stocks and other investments. The best way to build a passive income is to do it over many years so you will become an expert at that particular field. Rental properties usually generate more income as rents increase and mortgages are reduced. The right dividend stocks will also keep raising their dividend every year, and eventually can pay out a substantial amount every year.
Substantially equal periodic payments. If your retirement account is very large, then you may want to use IRS rule 72(t) to avoid the 10 percent early withdrawal penalty. Once you start the SEPP, you will have to continue these withdrawals for at least five years or until age 59 1/2, whichever is later. There are three methods to calculate how much you need to take out. You will need to talk to a qualified tax professional to make sure the withdrawal process is done correctly.
Retire after 55. You can access your 401(k) penalty free at age 55 if you retire at any time during or after that year. This exception only applies to 401(k) and other ERISA-qualified plans, including the federal Thrift Savings Plan, but not IRAs. Contact your 401(k) plan administrator to see if this option is available. You have to leave your retirement fund at your employer's plan if you intend to take advantage of this. If you roll over your 401(k) to an IRA this exception to the early withdrawal penalty no longer applies.
Roth IRA ladder. Another way to avoid the 10 percent early withdrawal penalty is to take advantage of the Roth IRA and build a ladder:
- Convert one year of living expense to a Roth IRA. You will have to pay tax when you do this.
- Wait five years. Roth IRA conversions can be withdrawn without penalty after five years.
- Withdraw one year of living expense from the Roth IRA.
- Repeat every year until 59 1/2.
The downside of this plan is the five-year waiting period before the first withdrawal. Advance planning is required to make this work.
Part-time work. Withdrawing from your retirement fund before you are 59 1/2 isn’t always a good idea. Most of us have a difficult time funding our retirement already. The earlier you withdraw from your retirement fund, the more difficult it will be to make your savings last. A better idea is to work part time until you are 59 1/2, and let your nest egg compound. Some early retirees work only a few months to accumulate some cash, and then take the rest of the year off.
Generally, early withdrawals are not a good idea because your retirement fund will be reduced. Your nest egg is meant to provide a comfortable lifestyle when you are older, meaning you are able to pay for basic necessities without much worry. At 50 or 55, most of us still have the ability to work, and staying in the workforce is often a better way to go. If you reduce your expenses and work only part time, then you can gradually make the transition into retirement. Continuing to bring in income on a part-time basis will lower your stress level and give you more time to figure out what to do in retirement.
Joe Udo blogs at Retire By 40 where he writes about passive income, frugal living, retirement investing and the challenges of early retirement. He recently left his corporate job to be a stay at home dad and blogger and is having the time of his life.