Should I Stop Contributing to Retirement Accounts if I Plan To Retire Early?
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Retirement is a transitional milestone that serves as a gateway to a different phase of life. The catalogue and itinerary are different but what remains the same is the need for green bills. However, retirement is not always synonymous with old age as many people these days are opting to retire early.
If you are looking forward to an early retirement, you need to proactively plan your finances. But the one question that confuses many advocates of early retirement is whether they need to contribute to their retirement funds like the 401(K) account. There does not exist a single answer to this question, and the solution can entirely depend on how you plan to live your post-retirement life and how flamboyantly you are spending right now.
Here are a few considerations to keep in mind while planning for an early retirement:
Wealth assessment is a crucial task in financial planning for an early retirement. It essentially takes into consideration all your assets, liabilities, loans, debts, and secondary income sources to give you a fair idea of your financial standing.
The second step is to take into consideration the taxes and penalties that will be levied on your investments when you make an early withdrawal. While the money that you contribute under Roth IRA can be withdrawn without tax liabilities and penalty fees, 401(k) savings, on the other hand, have rigid taxation rules with minimal scope for any adjustments.
Investing in a Roth IRA is preferred by some people as the earnings made on the contributions are treated in a different manner when it comes to taxation. The principal investment that you put under your Roth IRA account can be withdrawn without any tax liabilities and the interest earned on the principal investment is only taxable under certain conditions.
The next big thing to consider while planning an early retirement and sourcing of funds is to find ways to manage taxes, as efficiently as possible. Diligent planning and proper understanding of taxation rules for each of your retirement accounts can help you save a considerable amount of money on tax. The 10% penalty levied on the early withdrawal of 401(k) and IRAs before attaining the age of 55 years and 59.5 years can result into a heavy amount to be paid as tax. However, if you proactively plan these withdrawals as per the IRS Rule 72(t), you can reduce your tax obligations to a great extent. Here’s what you should know.
- The IRS Rule 72(t) works on the principal of mandatory periodic payments that need to be withdrawn upon attaining the age of 59.5 years. Following are some insights into this rule.
- Under the 72(t) Rule, you can manage and avoid the 10% penalty on the early withdrawal of your retirement funds. As per the stipulations of this rule, you are required to manage your distributions in two ways, either when you attain the age of 59.5 years or by distributing them over a span of five years or more, whichever comes later.
If the withdrawals or distributions are managed as per the rule, you will successfully be able to save a considerable amount. On the other hand, if you are unable to practice the disciplined approach and due to any reason are unable to follow the stipulations of the rule, you will be taxed retroactively right from the very first year of distribution. The IRS Rule 72(t), is a typical taxation rule that needs to be handled very carefully. It is always better to seek a financial advisor or tax expert’s help in such intricate matters.
Where should I invest to secure my early retirement?
Retirement planning can be managed broadly under three investment avenues that can be selected as per your convenience or the money you have at disposal. These are:
1. 401(k) Account
A 401(k) account can be confusing to people who plan an early retirement since they cannot access the money before the age of 59.5 years. However, there is an exception to this rule. Voluntary retirement before the age of 55 also does not result in a penalty on withdrawal. The age limit is further reduced to 50 years for public safety government employees.
However, for people retiring in their 40s, the only alternative is to manage taxes as per the IRS Rule 72(t) as mentioned above. You can either make withdrawals for five years or until you reach the age of 59.5 years, whichever comes later.
2. IRA (Individual Retirement Account)
IRA refers to an Individual Retirement Account that is a comparatively flexible option to consider while looking forward to an early retirement. The principal investment made under the IRA account can be withdrawn anytime. The earnings on the principal are however treated differently when it comes to taxation. Generally, the tax percentage on such withdrawals is the same as the tax bracket you fall under for your regular income tax payment. Hence, if you fall under the 12% income tax bracket, you will be taxed at a rate of 12% on your withdrawals from your IRA account as well.
You must know that there are also some exceptions made for special occasions when you are free to take out your principal investment without paying any fee or penalty. For example, medical expenses that are not covered by your health insurance and exceed 10% of your adjusted gross income can be covered with IRA funds without having to pay a penalty. The same goes for college education expenses. This will at least serve the need of the hour in case of an unplanned expense.
3. Taxable Account
A taxable account is a highly flexible option that allows you to withdraw any or all of your money at any time without any surcharge or fee. The noteworthy point, however, is that you might end up paying double taxes due to the different levels of taxation on gains and earnings.
For example, when you invest in a taxable account of any asset class like bonds, stocks, or mutual funds, etc, you will be eligible for an income tax on your salary or income. Secondly, when you invest in these avenues, the capital gain you earn will also be eligible for a capital gains tax. Hence, your tax liability doubles up on the same money.
However, the capital gains taxes can be managed by manipulating your investments under the lower tax brackets so that you are not charged heavily on your long-term capital gains. Also, if you are an active investor and can map the market movements, you can keep juggling and shuffling your investments from one asset class to another to avoid any long-term capital gain taxes.
To sum it up
Of all the available options, it is always good to go for at least two variants so that one serves as a backup when you overshoot the other. Contributing to retirement funds is always justifiable, whether it is for an early retirement or traditional one. Financial needs rarely go down and a well-appreciated wealth preserve is always good to have as a security reserve. However, be mindful of tax regulations as these are crucial matters that need to be handled with utmost intensity.
Are you planning to retire early? You can connect with financial advisors to seek direction in important decisions.