5 questions for early retirees

If you’re considering early retirement—say, in your late 50s or early 60s—it’s important to recognize the unique challenges you may face, as well as the potential opportunities. You’ll need to plan for a longer, more active (and likely more expensive) retirement than if you had opted to retire at a more advanced age, and it may be some time before you can count on backstops like Social Security or Medicare to supplement your needs.

With a little foresight, it may be possible to set yourself up for long-term success so you can enjoy your retirement in the here and now without having to worry too much about what the future holds. To get there, start by asking yourself these questions.

How am I going to spend my time?

Everyone knows what they’re retiring from—the grind of their 9-to-5 job, those long, arduous commutes, the feeling of not having control over how you spend your time and energy. But a surprising number of people have difficulty articulating exactly what it is they are retiring to; that is, how they intend to spend their time and keep themselves busy, entertained, and fulfilled.

When working with clients who are looking to retire early, Michelle Howell, a financial consultant at Fidelity Investments, encourages them to be specific about how they intend to spend their time. “Do you really see yourself as fully retired?” she asks. “Or are you going to take a break and maybe then start consulting or step into an ‘encore’ career? It’s important to understand what this next chapter is going to look like.”

Howell often suggests trying a “trial retirement,” either by taking a long vacation or allowing for a longer break between jobs. “It can be useful to take a meaningful period of time, maybe 2 weeks or 2 months (depending on your circumstances), to really decompress and get to know yourself outside of your job,” says Howell. “This can help you figure out how you want to spend your free time—whether it’s focusing on your hobbies, taking care of grandkids, or perhaps doing some sort of skills-based volunteering. Or some combination of all those things.”

With a better understanding of what your retirement will look like, you can better plan for the practical details, such as saving, spending, and investing, that will help you bring that vision to life.

How will I pay for everything?

As an early retiree, you could potentially need to plan to live off your retirement savings for as much as 30 or 40 years. That’s no easy feat, and to do so comfortably and confidently, you will need both a solid understanding of your needs and expenses, as well as a plan for how to pay for it all. While you could start taking Social Security as early as age 62, it’s important to know that doing so could result in a permanently reduced benefit. Waiting to take it until you reach your full retirement age (or longer) may help you maximize your monthly retirement income.

Generally speaking, you should plan to spend no more than 3% of your savings in your first year of retirement; for each subsequent year, take the prior year’s spending and increase it by the rate of inflation.

Howell notes that early retirees are not entirely out of luck when it comes to accessing funds in their retirement accounts. While IRAs generally require you to be 59 ½ years old to withdraw without a penalty, some employer-sponsored plans, such as 401(k)s or 403(b)s may be more flexible. “You may be able to take a withdrawal from an employer sponsored plan (401K or 403b) from the company you are leaving without incurring a penalty if you attained the age of 55 years or older prior to changing jobs or retiring,” says Howell. In some cases, however, there may be strings attached. Howell recommends consulting the summary plan documents for your plan and the IRS Special Tax Notice for retirement distributions to better understand your options.

Additionally, Section 72(t) of the Internal Revenue Code allows for withdrawals from IRAs before the age of 59 ½ under certain circumstances. It may be worth consulting a tax professional to see if this option is available to you or if you are considering pursuing it.

Can I sustain this over the long term?

Of particular importance to early retirees is the need for sustainable long-term growth potential in their retirement portfolios. Because an early retiree will be drawing on their savings sooner than someone who retires at a more traditional age, the risk of missing out on long-term, compounding growth potential by drawing down on their principal is heightened. But that growth potential is precisely what’s necessary to help ensure you will be able to maintain or achieve your desired lifestyle deep into your golden years.

“When you retire early,” says Howell, “you’re more exposed to the risk that inflation poses to your assets. Giving your principal a chance to potentially grow may help to alleviate some of that risk.”

So how can one balance the need to pay for expenses in the short-term with the need to stay invested to potentially benefit from long-term compounding? Howell suggests thinking about your needs in terms of three broad categories: Emergencies, protection, and growth. By identifying assets intended for short-term expenses, like day-to-day living or emergencies, and those dedicated to longer-term growth potential, you may be able to plan more effectively and, with a diversified portfolio tailored to your needs, weather the inevitable volatility that comes with investing.

“This type of strategy can help you maintain a healthy cash flow without getting too conservative with your investment portfolio,” says Howell.

How should I handle heath care coverage?

Health care can be expensive, and if you’re retiring early, you likely won’t be able to take advantage of Medicare right away—eligibility starts at age 65. That means you may need to buy private insurance, likely through the exchanges set up by the Affordable Care Act (ACA).

If you had health coverage through your employer, COBRA coverage can be a useful bridge in the period immediately after you retire, says Howell. “There are a lot of decisions to be made when you retire, and COBRA coverage may allow you to defer having to figure out your health care coverage situation for up to 18 months. That way, you can stay with your current health care providers and doctors while you sort everything out.” It’s important to note, however, that COBRA not only requires that you pay the portion of the premiums previously covered by your employer, it also adds a 2% fee on top of the total cost.

Still, the extra time it affords you may be advantageous in the long run. “If someone is anticipating extra income in the year they retire, such as payouts for vacation time or deferred compensation, it may be wise to wait until those have been addressed before seeking insurance on the ACA exchanges,” says Howell. Because ACA premiums may be discounted for those with lower incomes, waiting for a year in which you have a lower modified adjusted gross income to report could benefit you.

Am I paying too much in taxes?

Taxes can be a significant drag on the performance of your portfolio, something you’ll need to be especially mindful of when you retire early. Thankfully, there are strategies available that can potentially help you mitigate the impact of taxes so you can hang on to more of what you earn and keep it working for you.

Early retirees may want to consider a Roth conversion. Converting assets in an IRA to a Roth could provide you with tax-free growth and distributions¹ in the years to come—plus, Roth accounts can be excellent vehicles for passing on assets to the next generation. While you will have to pay tax on converted assets at the time of conversion, it may still be worthwhile, assuming you have the cash on hand to cover it. Generally, a Roth conversion may be worth considering if your tax rate in the current year is less than your expected tax rate in retirement when you plan to withdraw the money.

“Tax diversification can also be an asset for retirees” says Howell. “Having varying accounts with different tax treatments like Roth dollars, after-tax balances alongside pre-tax dollars provides some opportunity for tax efficiency in retirement.”

Still, it can be a balancing act, as the cash or assets used to pay the taxes may need to come from sources that you originally set aside for covering your day-to-day expenses or for providing long-term growth potential. “You need to think about this in practical terms: How much of your on-hand cash do you want to use or how much after-tax money do you want to take from your brokerage account to pay these taxes?” asks Howell.

Howell also notes something that many early retirees often overlook. “If you’ve retired but you or your spouse are still working, either part time or in a job that’s more aligned to your passions, you may also be able to just contribute to a Roth IRA directly,” says Howell, “assuming that your income is now lower than the Roth IRA contribution limits.”

Consult with a professional

Retirement is a major life event that requires careful consideration and planning, especially if you’re looking to do it early. Before you make any big decisions about when and how you want to retire, consider speaking with tax and financial professionals who can help you evaluate your situation, weigh your options, and come up with a strategy that may help you go into your retirement years feeling prepared.