Most of us will start working after we’ve finished our formal education, whether that’s after high school, undergraduate college or university, or graduate school. And most of us will also work well into our 60s, or perhaps even longer, depending on the type of work we do.

For some, though, having the ability – or the option – to retire early sounds very attractive. Some people would like to retire in their mid 50s, and some even earlier – in their mid 40s, for example. If you want to retire early, you’ll need a solid plan, a clear understanding of your expenses, and significant savings.

Let’s look in a bit more detail at four things to consider before you decide whether you can retire early.

Health Insurance

One of the biggest expenses you’ll have in retirement is health care costs. And for the past couple of decades, health care costs have been rising faster than the overall rate of inflation. So, making sure you have adequate, affordable health care coverage in retirement is essential.

Most retirees rely on Medicare for their health insurance. The Medicare program is comprised of three parts:

  • Medicare Part A, or hospital insurance, covers inpatient hospital stays, care in a skilled nursing facility, hospice care, and some home health care.
  • Medicare Part B, covers certain doctors’ services, outpatient care, medical supplies, and preventive services.
  • Medicare Part D, also called the Medicare prescription drug benefit, subsidizes the cost of prescription drugs and prescription drug insurance premiums for Medicare beneficiaries.

Medicare pays for much, but not all, of the cost for covered health care services and supplies. A Medicare Supplement Insurance (or Medigap) policy can help pay some of the remaining health care costs, like copayments, coinsurance, and deductibles.

The challenge for those who want to retire early is that Medicare is only available once you turn 65. What if you retire in your 40s, 50s or early 60s, before you’re eligible for Medicare?

One option is to see if your former employer provides health insurance. While it’s unlikely, there are some companies that will provide former employees with subsidized health insurance to age 65, or even for life (as a supplement to Medicare).

More than likely, though, you’ll need to buy private health insurance. The landscape for private health insurance has changed considerably since the Affordable Care Act was passed in 2010. At the time of this writing, individuals can visit the Healthcare.gov website to shop for private insurance, compare plans, and more. It’s important to note that the premiums you’ll pay for insurance coverage (and the subsidies you’ll receive) are based on your income level.

You should definitely shop for private insurance before you make the decision to retire early, so that you’re not unpleasantly surprised by the cost!

Social Security

Social Security forms the foundation of almost every American’s retirement income plan. Social Security is an incredible program. It provides retirees with a guaranteed stream of income that they can’t outlive, and that’s adjusted for inflation each year so they don’t lose purchasing power.

To be eligible for a Social Security benefit, you need to earn Social Security credits. You need to earn at least 40 credits to be eligible for a Social Security benefit. You earn credits when you work and pay Social Security taxes. These taxes are part of the FICA taxes withheld from your wages every pay period. FICA is comprised of 6.2% to fund Social Security and 1.45% to fund Medicare.

The amount of earnings it takes to earn a credit can change from year to year. For example, in 2021, you earn one Social Security credit for every $1,470 in covered earnings. So, you would need to earn $5,880 to get the maximum four credits for the year.

During your working career, you might earn more credits than the minimum number you need to be eligible for a Social Security benefit. These extra credits won’t increase your benefit amount. Instead, it’s the average of your earnings over your working years that determines how much your monthly benefit will be.

The starting point for determining your Social Security benefit is your “Full Retirement Age” – or FRA – which is based on the year in which you were born. If you were born between 1943 and 1954 your full retirement age is 66. If you were born between 1955 and 1959, your full retirement age is between 66 and 67. Finally, if you were born in 1960 or later, your full retirement age is 67.

You can claim a reduced Social Security benefit as early as age 62, or you can wait past your full retirement age to claim your benefit, and earn delayed retirement credits, up to age 70.

If you’re planning to retire early, you might think that claiming your benefit at 62 will make the most sense. But, if your FRA is 67, you should be aware that your early benefit at 62 will be 30% lower than your FRA benefit. And that’s a permanent benefit reduction.

Let’s look at an example. You were born in 1977, and started work right after college, at age 22, in 1999. You plan to retire at age 45, in 2022. Let’s also assume that in your first year of working, you earned $100,000 and that amount went up by $2,000 per year, so that in 2021, you’ll earn $144,000.

So, you worked for 23 years, and earned enough credits to be eligible for a full Social Security benefit. How much do you think that benefit will be?

According to the Social Security Administration’s website, your monthly benefit at Full Retirement Age will be $1,928, measured in today’s dollars. That’s $23,136 per year, or roughly 16% of the $144,000 you expect to earn in 2021. Now, imagine that you choose to take your benefit as early as possible, at age 62. Your benefit will be reduced by 30%, from $23,136 to $16,195 per year.

For most retirees, their Social Security benefit will only replace about 30-40% of their pre-retirement income. So, obviously, you can’t plan to live on just your Social Security benefit, unless you’re willing and able to dramatically lower your expenses once you’ve retired.

Savings and Your Retirement Income

If you’re like most Americans, you’ve been offered the opportunity to participate in an employer-sponsored retirement plan, like a 401(k) or 403(b) plan. And, hopefully, you’ve been doing so since you started your working career. Particularly if you want to retire early, because as we noted above, Social Security alone won’t be enough to live on.

Let’s build on our previous example. Let’s assume that when you started working at age 22 in 1999, you contributed 15% of your salary to your retirement account. In 1999, when you earned $100,000, that would have been $15,000. Let’s also assume that your employer is generous, and has provided a 6% employer match. So, in 1999, you would have received a $6,000 match into your account. Your total account contribution would have been $21,000.

Let’s also assume that your account would have earned a return of 9% per year. This is an optimistic and simplistic assumption, because the US stock market’s average annual return over the past 50+ years is only slightly above 9%, and we’re ignoring the variability of returns from year to year. But, for our example here, that’s not an issue. How much do you think you will have saved by 2022, when you’re 45 and want to retire?

The answer is a little over $2 million. That sounds like a lot of money, and to most people, it is. But is it enough to fund your early retirement?

A lot of research has been done over the past couple of decades into determining what a “safe” withdrawal rate is for a retirement portfolio. A safe withdrawal rate is one that you can start with in your first year of retirement, that will allow you to adjust your withdrawals each year to keep up with inflation, and that will last at least 30-40 years. For example, “If I’ve saved $1 million, can I retire at 65, and safely withdraw 4% in my first year of retirement, and not worry about running out of money?”

For someone who worked until 65, the example could probably safely provide them with $40,000 of income to supplement Social Security to age 95.

But what if you’re set on retiring at 45, like in our first example, rather than 65? Could you safely withdraw 4% of your $2,000,000 – or $80,000 – in your first year of retirement, and have the portfolio last 50 years, to age 95?

To answer this question, we’ll turn to some sophisticated financial planning software that uses a tool called “Monte Carlo simulation”, to simulate the randomness of investment returns in retirement.

It turns out that a $2 million portfolio almost certainly won’t support a 4% withdrawal rate. In other words, if you start out withdrawing $80,000 in your first year of retirement, and adjust that amount each year to keep up with inflation, you’ll deplete your $2 million nest egg well before life expectancy.

So, what is a “safe” withdrawal rate for a portfolio that needs to last 50 years, from age 45 to 95? The answer is a little over 1%. An initial withdrawal of $21,600, adjusted each year for inflation, has a fairly high probability of lasting 50 years.

What can we conclude from this?

Even with very attractive earnings from right out of college until age 45, and with diligent saving for retirement through a generous employer-sponsored plan, it will be difficult to replace more than a third of your pre-retirement income if you retire very early. At age 62, your combined (early) Social Security benefit and portfolio withdrawals will provide about $38,000 in today’s dollars – about 26% of your $144,000 final salary.

Filling Your Days

Perhaps more important than the financial aspects of an early retirement are the psychological ones. If you plan on living a long and robust life, you’ll want – and need – a plan to fill your days.

Most of your peers will be working well into their late 50s or 60s, so unless you want to be the youngest person on the tennis courts or golf course by several decades, you’ll want to have a range of interests to keep you happy, fulfilled and occupied. You might consider volunteering for a cause or organization that’s important to you, learning a new language or skill, or spending more time with family and close friends.

Looking for Guidance?

If you need help planning for retirement, consider working with a Certified Financial Planner™ (CFP®). Advisors who hold this designation have met rigorous educational, experience and ethics requirements.

If you’re looking for help with your retirement planning – including exploring early retirement – contact us today to see how our team at Springwater Wealth can help you.