Early retirement has become a popular financial topic in recent years, and it’s easy to see why. Who wouldn’t want to pack it in early and start enjoying the good life while you’re still young and healthy?
But as attractive as the idea seems, there are a few obstacles that don’t get a whole lot of coverage. A big one is how you’re going to survive until you are eligible to begin tapping your tax-advantaged retirement plans. The solution is to fund early retirement with taxable investments.
You can always bite the bullet and begin tapping your retirement plans early. But if you do this, you'll have to pay not only ordinary income taxes on withdrawals, but also the 10% early withdrawal penalty tax. That can be an expensive way to retire, and it will force you to draw down your retirement assets faster.
Related: Best Resources to Help You Retire Early
Why a Roth IRA Conversion Ladder May Not Be the Best Strategy
This particular strategy is all over the web—why not just go with that?
Here at Dough Roller, we have covered using a Roth IRA conversion ladder to fund early retirement, as well. It offers an opportunity to access your retirement funds before you turn 59, without paying taxes or penalties on the withdrawals. In that way, it definitely fits the bill as a source of income early on.
Read More: Why Your Roth IRA Should Be Used for Retirement (and Nothing Else)
But the Roth IRA conversion ladder isn’t without its limitations:
- You have to have a substantial amount of retirement assets available for the conversions.
- You must begin making the conversions at least five years before you plan to retire.
- You will pay substantial income tax on the converted balances, especially since the conversions will happen while you’re still working.
- A Roth IRA conversion isn’t really a tax-free withdrawal; you’re just paying the tax now in order to avoid it when you start withdrawing the funds later
- You will begin drawing down your retirement assets early in your retirement, which opens the possibility of depleting them in your later years.
Related: 2021/2022 Federal Income Tax Brackets and Standard Deductions
I’m not trying to trash the Roth IRA conversion ladder; it is a viable strategy. But it’s not for everyone, and it has to be done right. Otherwise, any or all of the limitations above could become costly issues.
In addition, as noted in the Roth IRA conversion ladder post, it will be better from a tax standpoint if you do the conversions once you retire. That way, you can minimize the tax bite. But during the five years you’re doing the conversions, you should live on withdrawals from ordinary, taxable accounts.
Let's take a look at why.
Save on Taxes During the Early Retirement Years
It’s true that saving money in taxable investments denies you the ability to get a tax deduction for the amount saved. You also lose the perk of accumulating investment earnings on a tax-deferred basis.
However, one thing that taxable investments can do is to provide you with a ready source of cash that will not create an immediate tax liability.
That makes taxable investments the perfect source of income during the early retirement years. While it’s true that the income you earn on those investments will continue to be taxable, withdrawals from the accounts will not be. That means you can withdraw as much as you want, and not have to wait until you reach 59 and ½.
Preserve Retirement Assets for the Traditional Retirement Years
One of the biggest reasons for tapping taxable investments for early retirement is to avoid touching your dedicated retirement accounts.
You can think of early retirement as requiring a two-tiered funding system. The first tier provides income for your early retirement years, while the second covers the traditional retirement years.
So, if you plan to retire at age 50, plan on living on taxable investments until you turn 65. Once you do hit that mark, you can shift over to your dedicated retirement savings.
Resource: Maxing Out Retirement Accounts: How Rich Could You Be?
In addition to the fact that this strategy will enable you to avoid touching your retirement savings, it will also provide valuable extra years for those savings to increase. After all, once you retire and you no longer have earned income, you will no longer be saving for retirement. The investment income you will earn between ages 50 and 65 could be substantial.
Example: Let’s say you have $500,000 in retirement savings at age 50, and you earn an average rate of return of 7%. The account will grow to $1,379,516 by age 65 simply as a result of your leaving the money alone and letting it grow.
Related: The Power of Compound Interest
Have a Strategy to Avoid Outliving Your Money
Outliving your savings is one of the biggest concerns for both people planning their retirement and those living in retirement.
The simple fact is that people are living longer than ever. According to the Social Security Administration, a 65-year-old man can expect to live to be 84.1, and a 65-year-old woman can expect to live to be 86.7.
That means that the average person, upon reaching 65, can expect to live roughly another 20 years. And we know that many people are living much longer than that. Turning 90-something is no longer exceptional.
So, if outliving your money is a concern when preparing for a typical retirement—one that will cover 20 or 30 years—how much more of a concern is it if you retire at 55, 50, or even 45?
If you retire that early, you will need to provide for yourself for anywhere from 30 to 50 years. That kind of planning requires a different kind of strategy, like drawing down on taxable investments in the early years of retirement.
Why a Big Chunk of Retirement Savings Should be in Taxable Investments
When planning for retirement, most people properly favor accumulating large amounts of money in tax-sheltered retirement plans. While that should be the basis of retirement savings, taxable investments should also be part of the mix. At a minimum, your taxable investments will serve as a large emergency fund when you retire.
Read More: How to Build an Emergency Fund
But taxable investments can open up retirement options, particularly for those who want to retire early. They can provide that valuable income bridge between the time that you retire and the time you reach age 65.
This makes a strong case for saving at least some of your retirement money in taxable investments.
To figure out how much you’ll need, first decide on the age at which you hope to retire. Then, subtract that age from 65. So, if you plan to retire at 55, you’ll need a 10-year income bridge. If you expect to need $40,000 per year, multiply that by 10, and you see that you need $400,000 in taxable investments.
This should actually be easier than normal retirement planning, since it will mostly be a matter of having enough money to provide income for a fixed term. Unlike traditional retirement savings, you won’t have to concern yourself with your taxable investments being able to provide you with an income for life. They may be needed for only 10 or 15 years. Then, you can begin drawing on your actual retirement savings.
Related: How Do You Know If You’re Ready to Retire Now
Have you thought about how you are going to fund the early years of your retirement?