4 Reasons Early Retirement Might Be Financially Risky

By Damian Davila on 24 August 2015 4 comments

"The money's no better in retirement — but the hours are!" So goes a popular saying.

Maybe that's why many dream of retiring early. A March 2015 study of Americans with investible assets of $1 million or more found that that most of them planned to retire by age 56, and a whopping 20% of them by age 40.

However, early retirement — even for those with a $1 million nest egg — might be financially risky. Here are four reasons why.

1. Reduced Social Security Benefits

Nine out of 10 Americans age 65 or older receive Social Security benefits. For those that receive Social Security, they count on those payments to cover about 38% of their income during retirement.

While you can start receiving your Social Security benefits as early as age 62, you should wait a couple more years. For those born in 1960 or later, you would receive only 70% of your full retirement benefit by retiring at age 62.

To receive your full retirement benefit, you need to retire by your full retirement age (age 67 for those born 1960 or later) as determined by the Social Security Administration. However, by waiting until age 70 to retire, depending on your year of birth, you can receive up to 132.5% of your full retirement benefits. (See also: 4 Exciting, Affordable American Cities to Retire In)

2. Early 401(k) Withdrawal Penalties

By socking away as much as possible and taking advantage of employer matches, you can build such a strong 401(k) plan, you'll be tempted to retire in your late 50s.

Hold that thought.

In 2014, 401(k) plans were 18% of the $24 trillion in U.S. retirement assets. From 2004 to 2010, penalized 401(k) withdrawals increased from $36 billion to about $60 billion. If this trend continues, then retirees may not receive the full share of their 401(k) plans.

Taking early distributions from your 401(k) before you reach age 59½ is a bad idea for several reasons:

  • On top of applicable income taxes, you're liable for a 10% additional tax on those early distributions.
     
  • To avoid that 10% tax penalty, you would have to take retirement payments under a substantially equal periodic payments program, which are not only very complicated to set up, but can also cause cash crunches.
     
  • All of your outstanding loans from your 401(k) plan become taxable income and are also subject to the additional 10% early distribution tax.
     
  • Outstanding 401(k) loan balances can't be rolled into any eligible retirement plan.

This is just one of the many dumb 401(k) mistakes smart people make.

3. Subpar Nest Egg

By deciding to retire early, you can say goodbye to a bigger nest egg.

Assuming you were contributing $400 every month to your 401(k) with a 5% rate of return compounded annually, here are some examples of how much you would forego by retiring early:

  • One year earlier: $4,929.03
  • Three years earlier: $15,538.77
  • Five years earlier: $27,236.01
  • Seven years earlier: $40,132.21
  • 10 years earlier: $61,996.82

The bigger your monthly contribution and the higher your plan's rate of return, the larger your nest egg… could have been! And let's not forget that these calculations don't include additional contributions:

  • Employer matches (average American foregoes $1,336 per year or extra 2.4% in retirement savings);
     
  • Potential windfalls (e.g. commissions, end-of-year bonuses); and
     
  • Catch-up contributions starting age 50 ($6,000 per year in 2015).

4. Higher Chance of Empty Retirement Fund

There's good news and bad news.

First, the good news: Americans are living longer. In 1990, the life expectancy for men and women were age 71.8 and 78.8, respectively. Nowadays, those number are age 84.3 and 86.6, respectively. Our life expectancy is so good that about 10% of current 65-year old Americans will live past age 95!

Now, the bad news: a longer life expectancy means that your nest egg may run out. For many years, $1 million used to be the goal for most retirement plans. If you make withdrawals from your nest egg using the suggested 4% annual rate, you will run out of retirement funds within 25 years. Under this scenario, by retiring early by age 55, you could run out of retirement monies by age 80!

Adapting to a very thrifty lifestyle ("What? No summer cruise to the Bahamas!") may not be possible for some early retirees. Especially those who worked really hard to build up those $1 million nest eggs.

The reality is that early retirement requires careful planning and persistent saving. To prevent such a retirement catastrophe, many registered investment advisors are recommending Millennials set a goal of at least $2 million for their retirement savings. (See also: 5 Facts Millennials Should Know About Retirement Planning)

Do you know any stories about people who successfully retired early? Please share them in the comments below.

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Guest's picture
Guest

The dire warning about running out of money in 25 years is a bit silly. It assumes zero growth in those 25 years.

Guest's picture
Guest

Agree!

Damian Davila's picture

Thank you for your comment, Guest. One of the main issues about early retirement is that the average individual isn't saving enough.

For example, according to a report from Boston College's Center for Retirement Research that analyzed recent Federal Reserve data, the typical 55- to 64-year-old household had just $111,000 saved in their 401(k)s and IRAs, which would translate into just $500 a month in retirement income. According to the same study, there are people who have saved much more than that, but there are also people who have saved much less than that.

Guest's picture
Doug @ The-Military-Guide.com

Thanks, Damian, we need more articles like this to jumpstart thinking and discussions about financial independence.

But I'd also like to offer you the opportunity to get together sometime over a cup of coffee to discuss how to hedge those four risks of early retirement.

I've worked with literally hundreds of early retirees, and nobody has regretted the first three concerns. There are two very simple ways to make penalty-free withdrawals from 401(k)s and traditional IRAs, and neither one involves 72(t) SEPPs. As for the fourth: a single-premium immediate annuity... and that "reduced" Social Security benefit might still be more than enough.

Damian Davila's picture

Are you on Oahu? If so, then please send me a message through the contact form (envelope icon under my picture above or via http://www.wisebread.com/users/damian-davila/contact).

Guest's picture
Gero1369

These might be true if someone were to retire on a whim. As noted in another comment, there are plenty of ways around SEPP and penalties. Most people that retire early put great amounts of thought, planning, and research into their decisions (especially those that 'retire' extremely early; >=50). Unless someone's idea of retirement is actually sitting on a beach the rest of your life or traveling the world as a tourist, most early retirees do bring in some money by doing some kind of 'work' or it's an option given hard times.
Given the 4% rule and a $1 million dollar suggested nest egg, one would end up with $40k of income (roughly $28k after taxes). I'd hope that if a planning retiree had any brains, they would have no mortgage, have no consumer debt, reduced or eliminated most commuting costs, maintain their health, not putting money into savings/investments, and a laundry list of other things to reduce or eliminate expenses. That $28k should be pretty much exclusively food and spending money (for each individual; double it for a couple).
Maybe people need to look at their spending and change their habits a bit if they fear running out of $1 million ;)

Damian Davila's picture

You have nailed my point, Gero1369. Early retirement increases your chances of an empty nest egg, however successful early retirement is possible. For sustainable early retirement to work, anybody needs careful planning. Your list of necessary steps provides a great overview of things to keep to keep in mind.