How to Pay for Early Retirement

by Linda Stern

The longer you work, the better, retirement experts will tell you. Plow on until you're 70 and you'll make more, have fewer years of retirement to fund, and collect a fatter Social Security check. But that's not always desirable, or possible.

People often retire in their early 60s because they can't get a job, they aren't healthy enough to work, or they're just sick of the 9-to-5 grind and want to begin the next part of their lives.

The question for them is how to pay for it. Early retirees can start collecting Social Security early, or defer their Social Security by using money from their 401(k) account or by buying an annuity.

The question is complex, and the wrong answer could really constrict your 80s and 90s. But it also seems like a question that should have a mathematical answer: Given enough data, shouldn't you be able to optimize your spending in your 60s to protect the cash flow you'll need for the decades you'll probably spend in retirement.

I asked David Hultstrom, a spreadsheet-loving financial adviser with Financial Architects in Woodstock, Georgia, to help me find the answer. Then I ran the question by a few other experts. Here's the latest, best advice on how to fund your 60s without impoverishing your 80s. There are, of course, some exceptions.

Spend your savings first. Your regular savings and investments, sitting in taxable accounts, are the most efficient place for a 60-something to find spending money, even though it might be difficult psychologically to take those withdrawals. You'll allow your tax-deferred savings as well as Social Security benefits to grow. And you'll be able to minimize your taxes by selling losing securities (and taking capital losses) to get spending money.

Then hit your tax-deferred accounts. This would include a traditional individual retirement account, rollover IRA and 401(k) plan. Every dollar you withdraw will be subject to income tax. So, if you are in a high tax bracket, you may want to switch this category with the next and pull enough money out of your Roth IRA to keep your overall taxes down. (Roth IRA withdrawals are not taxed in retirement.)

At 70, start your Social Security benefits. You may not be able to hold out until then, but deferring Social Security as long as possible does make sense — for a variety of reasons. Your benefit increases almost 8 percent a year for every year you defer it, and in this market it's hard to make that kind of return in any other instrument. Furthermore, Social Security is the rare retirement benefit that will be adjusted for inflation.

Finally, if you defer Social Security benefits until full retirement age — currently 66 — you'll be able to work around the edges and earn income without it reducing your benefits. The Government Accountability Office has determined that deferring Social Security benefits is a cheaper and more efficient way of getting a guaranteed source of income than buying an annuity.

Now for the exceptions: You may want to turn on that Social Security tap earlier if you have health problems and are fairly confident they will shorten your life expectancy. The break-even point for deferring Social Security until you are 66 is age 78, says Hultstrom. You may also opt to take benefits earlier if you're married and have a higher-earning spouse who is deferring benefits.

Buy an annuity. This is at the bottom of the list because giving up a large sum of money now to pay for a steady and increasing income stream is expensive. When Hultstrom compared a moderately priced inflation-adjusted immediate annuity to deferring Social Security, he found that the annuity buyer wouldn't break even until age 83 or 84. Even if the recipient lived to age 99, the annuity would still be more expensive than deferring Social Security. (The annuity he studied provided $1,400 in monthly income, indexed every year for inflation, for a 66-year-old man at a cost of $289,000 (available through the Vanguard Annuity Access platform).

The exceptions? Annuities work if you need more money every month than Social Security can provide and you aren't well-heeled enough to pay for that stream out of your investments. And some new annuity products aim to lower fees or add features that can make them more useful to investors. New York Life offers a new feature, called the "changing needs option" which would allow an annuity holder to take a larger monthly benefit in the first few years of the annuity, allowing the recipient to delay Social Security benefits. Then, when the Social Security benefits kicked in, the monthly annuity amount could be reduced. That may not be worth buying just to defer Social Security benefits but may make sense for a retiree who expects to supplement their Social Security with an annuity.

Use tools and advice. These are general rules of thumb, but every individual and couple faces a unique set of numbers and considerations. Some online tools, like the new Fidelity Income Strategy Evaluator, can bring you close to figuring out your own retirement income stream. But a good numbers-savvy, fee-only adviser (not someone who makes money selling insurance products) can help you figure out how to optimize your own 60s and, all those other retirement decades that may lie ahead.
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