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Retirement

If you plan to retire early, you may be wondering whether it makes sense to invest in traditional retirement accounts, such as employer-sponsored 401(k)s/403(b)s and IRAs/Roth IRAs. The speculation comes into play because there’s an early withdrawal penalty when you take money out of these accounts before age 59 ½.

I argue that it’s still a good idea to invest in traditional retirement accounts if you plan to retire early. This is because there are tax benefits that come with these retirement plans. Money contributed to employer sponsored 401(k)s/403(b)s are pre-tax and reduce your taxable income for the year. Money contributed to Roth IRAs isn’t pre-tax but the money grows tax-free.

The best scenario is to have enough money outside of these retirement accounts so that you can live off other investments before age 59 ½ and then tap into your retirement accounts after turning 59 ½. Here are a few tips to aid you in your early retirement planning.

Avoid Early Withdrawal Penalties

Generally, the money withdrawn from a retirement plan before the age of 59 ½ is considered “early” or “premature.” When this happens, you must pay an additional 10% early withdrawal tax. For most, that 10% penalty is a big deal. It will likely result in enough money lost that you’ll want to avoid making early withdrawals.

One thing you can do to avoid early withdrawal penalties from retirement plans is to have other investments. We’ll get to that in a moment.

Another way to avoid early withdrawal penalties is via the IRS rule 72(t). This rule permits penalty-free withdrawals from an individual retirement account (IRA), provided that you take “substantially equal periodic payments (SEPPs)” for at least five years or until you reach 59 ½, whichever period of time is longer. The payment amount will depend on your life expectancy as calculated by IRS-approved methods.

The withdrawals will still be taxed at your normal income tax rate. You can roll over a portion of your 401(k) into an IRA to take advantage of this rule as well. A good guide for IRA conversion can be found here on Dough Roller.

The IRS rule 72(t) is a bit complicated. You may want to work with a financial advisor to make sure you are complying by the rule’s stipulations. If you stop payments too early, you’ll have to pay the early withdrawal penalty on the previously withdrawn amounts.

It’s good to know there’s a way to access your retirement plan funds without the early withdrawal penalty. But, that doesn’t have to be the only option if you plan to retire early. Another option is to have other investments that you can liquidate before you turn 59 ½.

Plan on Other Investments

The best thing you can do is not touch your retirement plan funds until you reach age 59 ½. It’s best to have other investments that you can use as income until you reach IRS retirement age. This means you’ll have to do even more saving during your early years. But it’s worth it for the sake of early retirement.

Here are some options for where to save the rest of your money:

  • Savings accounts and certificates of deposit (CDs) – These accounts offer lower interest rates but guaranteed returns. Your money is also FDIC insured up to at least $250,000.
  • Peer to peer lending – Companies like LendingClub and Prosper let you build an investment portfolio of personal loans. This gives you monthly cash flow.
  • Rental properties – This investment takes some time and skill. But it also offers monthly cash flow as long as you have tenants.
  • Dividend stocks – You’ll gain money in two ways. First, you’ll earn as the value of the stocks appreciate. Second, you’ll gain money from distributions paid out to shareholders by the dividend-paying companies.

You can use these investments to fund your lifestyle until you reach IRS retirement age. Depending on the age you plan to retire, you may not even need that much to sustain you until you reach 59 ½. It’s all about planning ahead of time.

Consider Phased Retirement

Most people work a long career and then jump right into retirement and stop working altogether. If you plan to retire early, though, that doesn’t necessarily have to be the path for you. Consider phased retirement as an alternative, in order to make early retirement work for you.

For example, if you work an office job now and want to retire at age 40, you can leave that day job and then start another career. You could start an online business that doesn’t require you to go into an office. Use the time between when you leave your first career and when you reach age 59 ½ to explore another one of your interests. Have you always wanted to write books? Do you have a passion for working with animals? The possibilities are endless.

Finding a new career to embark on during the first few years of early retirement will not only give you extra money to live on, but it’ll also keep you mobile and energized. Make sure it’s something you enjoy so you can still consider yourself “retired.”

Final Thoughts

Yes, you should invest in traditional retirement accounts if you plan to retire early. They have many tax benefits that make them good investments. What you want to avoid is early withdrawal penalties. You can avoid this by taking advantage of the IRS rule 72(t) as explained above. Or, you could have other investments that fund your lifestyle until you reach age 59 ½ and can withdraw money from your retirement plans penalty-free.

Another consideration to keep in mind is phased retirement. Although you retire from your day job at an early age, that doesn’t mean you don’t have to work at all. Consider starting a new career based on another one of your interests or passions. This way, you’ll keep some money coming in until you reach age 59 ½ — and can withdraw from the traditional accounts — but you’ll still enjoy your early retirement.

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Retirement is a huge financial undertaking, as we all know. It requires plenty of planning to ensure that all of your needs will be met once your career, and working income, ends. It needs to be able to cover your costs of living, some fun money to actually enjoy your years, and expenses such as healthcare. Of course, the latter become becomes even more important as we age, but many seem to overlook the magnitude of this expense in their planning.

The average person between the ages of 55 and 74 with retirement savings has only $104,000 to $148,000 tucked away in a defined benefit account. What’s even more concerning is that this statistic only reflects 48% of American households. The rest of them have no retirement savings at all.

Those with retirement savings tend to also have other resources to depend on, such as non-retirement investment accounts. On the other hand, those without retirement savings tend to have less of those resource, too.

What does this mean for costs associated with retirement? It means that many Americans will struggle to afford to retire at the standard age of 65. And those who do will have trouble meeting their monthly expenses, including health care.

In fact, 74% of married partners said they worry about unexpected medical costs in retirement. With the cost of health care in retirement being such a big concern, it’s important to consider the actual numbers and plan accordingly.

How Much Does Health Care Cost In Retirement?

According to a 2015 study conducted by Fidelity, a couple, both aged 65, can expect to spend about $245,000 on health care during their retirement. That’s over $12,000 a year — or $1,000 a month — based on average life expectancy!

Why is this so expensive? When you factor in copays, out-of-pocket costs, and dental and vision care, you’ll easily see how the numbers add up quickly. That’s exclusive of any insurance premiums, too.

Speaking of health insurance, here’s a breakdown of how insurance provided by the government works:

Medicare Part A

Hospital Insurance

As long as you or your spouse paid Medicare taxes while working, you won’t have to pay a premium for this coverage.
It mainly covers hospital inpatient care, skilled nursing facility care, hospice care, and home health care.
Medicare Part B

Medical Insurance

Most people will pay $104.90 per month.
It mainly covers services from doctors, outpatient care, durable medical equipment, and some preventive services.
Medicare Part C

Medicare Advantage Plus

Monthly premium varies greatly, but can be up to $200 per month.
It mainly covers everything in Parts A and B and is run by Medicare-approved private insurance companies.
Medicare Part D

Prescription Drug Coverage

Monthly premium varies greatly, but can be up to $100 per month.
It mainly helps cover the cost of prescription drugs.

As you can see, if you opt for all parts of government-provided medical insurance, you can pay up to $400 in monthly premiums per person. This is exclusive of the other costs associated with health care as mentioned above: copays, out-of-pocket expenses, and auxiliary care.

There are ways plan for these expenses, however. The main thing you can do is start saving early.

How To Plan For Health Care Costs In Retirement

Your first plan of attack should be your employer’s retirement account, if one is offered. According to the American Benefits Council, nearly 80% of full-time workers have access to an employer-sponsored defined benefit account, such as a 401(k)/403(b). So if you’re one of many offered this benefit, make sure you take advantage.

Saving even just a small percentage of your salary will make a big difference if you start early. You can begin by saving a mere 3% of your salary, then gradually increase your contributions until you reach 10%. This is generally considered the target amount to save.

This is just a recommendation though. If you can contribute even more, by all means do so.

If you max out your 401(k)/403(b) by contributing $18,000 in 2016 ($24,000, if over the age of 50), investing in an individual retirement account (IRA) is a great next step. Although the annual contribution limit for IRA’s and Roth IRA’s is much lower than that of 401(k)s/403(b)s, the extra savings will help you cover cost of your future health care.

Lastly, saving money in a Health Savings Account (HSA) is a great way to plan for covering medical expenses in retirement. If you are currently enrolled in a high-deductible health insurance plan, you are eligible to contribute to an HSA.

HSAs offer a triple tax benefit. First, HSA contributions are tax deductible. Second, the interest earned on money in an HSA is tax-free. Third, you can withdraw money from your HSA for qualified medical expenses tax-free, as well.

HSAs can be considered retirement funds because there is no carry-over limit, unlike Flexible Spending Accounts. So, the money you contribute today can be used for health care costs in retirement years later.

How To Offset Health Care Costs Once In Retirement

In today’s economic environment, retirement doesn’t necessarily meaning relaxing on sandy beaches. The unfortunate reality is that many people must continue to work in order to supplement Social Security and their minimal retirement savings.

Working a part-time job during the early years of retirement can greatly offset the cost of health care. In fact, you could even save some of your earnings from your part-time job and put it into a retirement savings account to use in future years.

Here are a few ideas of part-time jobs you can take up that won’t be taxing on your health:

  • Consultant: Transfer all the skills you accumulated from your day job over the years and use those expertise to help other companies accomplish their goals.
  • Freelancer: Use your talents to do one-off assignments for businesses. This could include graphic design, writing, proofreading, and much more.
  • Blogging: It can take a while to make money from a blog. But once you get the ball rolling, this gig can bring in a lot of income.

Other Things To Consider

Aside from Medicare, Social Security, and your retirement savings, there may be other ways to cover the cost of health care in retirement.

One thing to consider is COBRA. Under the Consolidated Omnibus Budget Reconciliation Act, federal law requires that companies with more than 20 employees give them the option to continue receiving coverage under the employer’s health plan for at least 18 months.

With COBRA, however, you’ll be responsible for the entire cost of the health plan. While working, your employer likely paid for a large percentage of the premium. This expense will be wholly your responsibility with COBRA.

You may want to consider continuing your employer’s health plan before enrolling in Medicare. Your employer’s health plan will likely cover more medical expenses.

On that note, if you want a more comprehensive health insurance plan after your COBRA benefits end, you can consider enrolling in a Marketplace health insurance plan. If you don’t enroll in Medicare, you may qualify for lower out-of-pocket costs and premium tax credits. You could also use the two in combination; but you won’t receive the same tax credits for the Marketplace health insurance plan.

Wrapping Up

There is a lot to consider on the topic of health care costs in retirement. If you’re young, the lesson here is to start saving early, because the cost of health insurance and medical care is only increasing. If you’re approaching retirement age, you may want to consider working part-time during your early retirement years, in order to offset the costs of health care. And if you’re already retired, it wouldn’t hurt to tuck away any extra money each month, in case unexpected health concerns pop up.

How are you planning to cover your health care expenses in retirement? Is it a big concern to you yet?

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If you’re unhappy with your 401(k), rest easy… you’re not alone. In fact, on August 19, over 60,000 employees joined up and filed a class action lawsuit against their employer, Morgan Stanley. Their reason: questionably managed and poorly performing 401(k) plans.

It’s one thing to ask workers to stay late or forget to restock the break room. Messing with their retirement plans, though? That’s a whole different animal.

The filed suit alleges that Morgan Stanley, a company with over $8 billion in 401(k) assets, chose to invest employees’ money in its own funds in order to maximize profits and benefit itself. Using only in-house investment funds would have been a questionable practice on its own. The unfortunate and compounding fact, though, is that these funds have also been grossly underperforming.

In fact, its Morgan Stanley Institutional Small Cap Growth Fund IS Class was 99% less profitable than other small cap growth funds in 2014. It didn’t get much better in 2015, where the fund performed worse than 95% of the others.

So, why would the company continue to toss 401(k) funds into obviously poor choices such as these? Self-promotion and siphoning profits for themselves are two potential reasons. The class action suit last week alleges that these were indeed the motivating factors, but it gets better.

The lawsuit also claims that on top of these 401(k) plans earning less than they could have with 99% of the other options out there, the costs were also exorbitant in comparison. It accuses Morgan Stanley of charging its own employees higher mutual fund fees than it charged outside investors.

These fees are also higher than those that other funds on the market currently carry. For instance, Morgan Stanley was apparently charging a fee of .98%, whereas a similar fund from Vanguard charged a mere .07%. The effects of this percent difference on a retirement account could be astronomical!

Of course, this would not only be shady business practice, but is potentially illegal. The federal Employee Retirement Income Security Act (ERISA) of 1974 places a fiduciary obligation on companies to act in the best interests of the plan participants. Managing funds in a way that primarily benefits the company, instead, is a potential violation.

Seeing how 401(k) plans play such a large role in the retirement savings of today’s working class, this sort of practice would have detrimental effects on the future financial security of each of their employees. Most of us pay into retirement plans and give blind faith that our employers are managing our money with our best interests in mind. Morgan Stanley, it would seem, has let a lot of people down.

It will be interesting to see how this suit plays out in court. It has the potential to be a harsh reminder of companies’ ethical and legal obligations to their workers. The class action suit is seeking damages of $150 million on behalf of its approximate 60,000 proposed participants. Morgan Stanley has not yet responded to requests for comments on the suit.

Have you worked for Morgan Stanley? Leave a comment to let us know your thoughts on their 401(k) plan and the class action lawsuit.

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