Morningstar Magazine, By Christine Benz| 10-31-13
Google the words “early retirement,” and you’ll find blogs, books, and chat boards dedicated to hanging it up early so you can spend time bumming around Europe or pursue a second career as a winemaker.
But for many older workers, early retirement isn’t about hopping on the Eurostar or tending to a hobby vineyard. Instead, they’ve had to stop working before they were actually ready to–because of downsizing, because of their own health problems or those of a family member, or because they took a buyout package.
For such individuals, early retirement isn’t exhilarating; it can be terrifying, especially from a financial standpoint. Tapping an investment portfolio prematurely can, of course, put undue strain on a nest egg–there’s a big difference in a portfolio’s longevity when you extend the withdrawal time horizon from 30 to 35 or 40 years or more. Health-care costs can also weigh heavily on the finances of individuals who aren’t covered by an employer plan and aren’t yet Medicare-eligible. Although the Affordable Care Act is a new safety net, enrolling in such a plan or COBRA is apt to result in extra out-of-pocket costs that weren’t there when an individual was working.
Even older workers who intend to find another job may have difficulty doing so. At the end of September 2013, the rate of joblessness among people age 55 and older was 5.3%, the lowest rate of any age group. Yet it takes displaced older workers a longer time to find a new job than it does their younger counterparts, according to Bureau of Labor Statistics research.
Workers over 55 should tackle many of the same tasks that any other unemployed workers should take: line up health insurance coverage, strip any nonessential expenditures from their household budgets, and, if they plan to continue working, network and polish their resumes. In addition, older workers should also take the following steps to ensure that premature unemployment doesn’t derail their financial plans.
Here are three guidelines I recommend for anyone in such a situation.
1) Be strategic about where to go for cash.
If you’re no longer earning a paycheck and forced to tap your assets or look elsewhere for living expenses, the name of the game is to first exhaust your most liquid assets. Only as a last resort should you tap assets where you’ll face taxes, rack up early-withdrawal penalties, or incur borrowing costs.
The proverbial “emergency fund”–cash held in a taxable account–is obviously your best source of cash. From there, longer-term taxable assets or Roth IRA contributions, the latter of which can be withdrawn without taxes or penalty at any age, are the next-most desirable.
Withdrawals from traditional IRAs and 401(k)s, would be next in the queue, though you’ll pay an early-withdrawal penalty unless you’re over the age thresholds, generally 59 1/2 and 55, respectively. (You can also avoid the early-withdrawal penalty by taking so-called 72(t) distributions, the details of which are outlined here.) Tapping traditional IRA and 401(k) accounts will trigger ordinary income tax on those distributions, so plan accordingly. But one silver lining of not earning a paycheck is that your tax rate likely will be lower than it was when you were employed. (More on this in my second point.)
Tapping home equity–via a home equity line of credit or a reverse mortgage–should be further down in the queue, especially as long as you have investment assets, because the interest payments to service your debt may well negate any investment earnings. Credit cards, needless to say, are a last resort.
2) Manage your taxable income to qualify for health-care subsidies.
Early retirees who aren’t yet eligible for Medicare and are shopping for health-care plans available under the Affordable Care Act have a new incentive to keep their taxable income down. The lower their income levels, the more likely they are to qualify for subsidies for their health-care plans; taxpayers whose income levels are 400% of the federal poverty level or lower can qualify for subsidies.
Mike Piper, author of several books about retirement planning and the founder of the website obliviousinvestor.com, notes “there are essentially huge marginal tax-rate spikes at the 150%, 200%, 250%, and 400% of federal poverty-level thresholds because at those points, one additional dollar of income can cause you to lose, in some cases, thousands of dollars worth of subsidies.”
Piper advises, “It’s super important to pay attention to those four thresholds and how your income compares with them. Many people will find that by making small changes (for example, spending more from taxable or Roth accounts and less from tax-deferred accounts), they can get their income just below one of those thresholds and thereby qualify for some very significant subsidies.”
But he also warns that a form of modified adjusted gross income affects one’s eligibility for the subsidies; increasing itemized deductions won’t affect this number. (You can see Piper’s full post on the topic here.)
3) Do your homework on Social Security strategies.
For individuals prematurely ejected from the workforce, turning on a stream of income by claiming Social Security benefits soon may look like the ideal stopgap–and a way to delay invading their portfolios prematurely. Not surprisingly, early claiming of Social Security increased during the financial crisis, reversing a trend from the previous decade. Of course, that uptick was very likely driven by necessity in many cases, and other retirees may have claimed benefits early to avoid tapping their nest eggs while at a low ebb.
But following a five-year rally in stocks, tapping a portfolio early–perhaps by rebalancing out of enlarged equity holdings–looks like a better bet than claiming Social Security benefits before full retirement age (66 for people born between 1938 and 1957 and 67 for people born after 1959). (This interview further details the advantages of delaying Social Security in favor of portfolio withdrawals.) Filing early carries the heavy cost of permanently reduced benefits–as much as a 30% reduction for those who file for benefits at age 62. By contrast, those who wait until age 70 to file will receive delayed credits that amount to an 8% annualized return in the period between their full retirement ages and age 70.
Mark Miller, a Morningstar contributor and the author of The Hard Times Guide to Retirement Security, says “Where else can you get an 8% return–risk free?” He advises that it’s particularly important for the higher-earning spouse in a household to delay filing. “That may well allow the lower earner to get a higher survivor benefit later than he would get if the higher-earner had filed early,” he said.
Delaying receipt of Social Security benefits until full retirement age can also allow couples to employ the so-called file-and-suspend strategy. Under this strategy, outlined here, Miller says “the result can be much higher combined lifetime benefits for the couple.”
To Your Successful Retirement!
Michael Ginsberg, JD, CFP®