Strategies to pay for an early retirement

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Last month I got to spend some time with a relation who recently left a high-powered tech job, and who asked for some advice about financing a more or less indefinite period of unemployment. I am strongly opposed to mixing money and family, but I eventually relented and offered some ideas in general terms about how I would advise someone who came to me in his situation. I thought it might be useful to write up those ideas in case they’re useful to anyone else in his situation.

Get your finances in order

Over the course of a 15 or 20 year career, workers accumulate an enormous quantity of financial junk. Multiple 401(k) and 403(b) plans, stock options and grants, individual stocks, term and whole life insurance policies, etc. Even if you tend each garden carefully, it can be hard to figure out what you really own: is a Fidelity target retirement date fund really equivalent to a Vanguard fund with the same target date? Is a Betterment “aggressive” portfolio the same as a FutureAdvisor “growth” portfolio?

An underrated advantage of an early retirement or break in your working life is that it’s an opportunity to get all that junk sorted out at minimal or no cost, for the simple reason that long-term capital gains are untaxed if your taxable income (after deductions) is below $39,375 for single filers and $78,750 for married joint filers. In low-income years you should be “harvesting” as many gains as possible in taxable accounts, and unlike with capital losses, there’s no wash sale rule with respect to gains. In low-income years, you can realize taxable gains, pay a 0% long-term capital gains rate on them, and then buy identical securities with a new, higher cost basis.

In addition to resetting your taxable basis, you should also consolidate your old retirement accounts in traditional and Roth IRA accounts with your preferred custodian. This is a good idea in general, but a break from the workforce is as good a time as any to finally get around to doing it.

How likely are you to return to work, and when?

This is the single most important question when contemplating early retirement, but unfortunately one of the most difficult to answer accurately. The two easiest answers are “I’m certain I will return to work in 1 year,” and “I’m certain I’ll never return to work,” but few people are able to give either. On the one hand, in one year unemployment could be 15% and no one will be hiring 40-year-olds with unexplainable gaps in their resume. On the other hand, 3 months into a supposedly “permanent” retirement you might have already landscaped the lawn, oiled all the hinges, replaced your floor, repainted your living room and be pulling your hair out from boredom.

Nonetheless, while it may only be an educated guess, guess you must, since whether or not you return to work is the main input into the most important question: how much risk can you expose your savings to? Unlike some people in the FIRE community, my attitude towards risk is simple: if you do not plan to return to work, you cannot risk any money you need for retirement, while if you are certain to return to work, then you can expose a relatively large amount of your assets to risky investments.

You may have noticed a semantic trick I played: I’m not interested in your total assets, I’m interested in the assets you need for retirement.

Take the case of a 40-year-old with $1 million in liquid, taxable assets, in a brokerage account for example, who never intends to return to work. They can spend $2,778 per month for the next 30 years, before claiming their maximum Social Security old age benefit at age 70, the very day they exhaust their brokerage account balance. But what if, upon studious reflection, they determine that they only need $1,500 per month to live? In that case, while keeping $540,000 in safe assets, they’re free to invest $460,000 in risky assets, knowing that even complete disaster will leave them enough money to meet their needs.

It doesn’t matter what they call that $460,000, whether it’s their “legacy” or “play” money or “gambling” money, what’s important is that you can’t risk money you need to survive.

Hopefully this makes clear the importance of the return-to-work question: if you’re certain to return to work in a year, then your “sabbatical” shouldn’t have a substantial impact your asset allocation at all: set aside 12 or 18 months worth of cash, CD’s, or Treasury bills, and leave the rest invested in an age- and risk-appropriate long-term portfolio. 5 years out of the workforce requires a higher allocation to safe assets, both for the longer timeframe and to take into account the likelihood of lower earning as your experience and skills age. To account for 10 years of early retirement you should count on a significantly lower income, if you do ultimately return to work.

Health insurance

While healthcare costs can pose a serious financial hardship for workers, in retirement the situation is much simpler: if you live in a Medicaid expansion state, you can enroll in Medicaid, which has no premiums or deductibles, and nominal co-payments for prescription drugs. There’s no open enrollment period, so you can enroll as soon as your employer-sponsored insurance coverage ends.

If you live in a non-expansion state, you’ll need to claim the maximum advance premium tax credit and cost-sharing reductions by entering an income into your state’s health insurance marketplace that’s right around 140% of the federal poverty line, and selecting an eligible Silver plan. You may end up paying a few dollars a month in premiums — in non-expansion Wisconsin my monthly premium was $0.83, so I just paid the $12 once a year in advance to make sure my policy wasn’t canceled in case I forgot. When you file your taxes you’ll be asked to calculate how much of your advance premium credit you have to repay, which will be $0 or close to it, as long as you’re sure to keep your income low enough.

And once you turn 65, of course, you’re eligible to enroll in Medicare. While Medicare is worse insurance than Medicaid (coming as it does with premiums, co-payments, and deductibles), it does give you access to a somewhat wider range of providers, which is increasingly valuable as you age, depending on your health status.

One quick note here: many people have heard of the “Medicaid asset test,” which requires people enrolled in Medicare to spend down certain assets before they become “dual eligible” and begin to receive much more generous Medicaid coverage. This asset test does not apply to non-Medicare enrollees living in Medicaid expansion states. Thanks, Obama.

The incredible advantage of working at least a little bit in pretirement

Finally, I want to point out an important advantage to bringing in at least a little bit of income in retirement, or “pretirement” as my relation calls it. Consider the same 40-year-old above, with $1 million in liquid assets and $1,500 in monthly expenses, who therefore needs $540,000 in safe assets and can invest $460,000 in risky assets — an overall asset allocation of 46/54.

Earning $500 per month (33 hours at $15 per hour, or roughly 8 hours per week), reduces the cash need over the next 30 years to just $360,000, leaving $640,000 to invest in risky assets — a much risker overall asset allocation of 64/36, with a consequently higher expected final value.

A few hours of work per week, whether it’s as a high-powered consultant, or a low-powered Walmart greeter, relieves an enormous amount of pressure on your assets.

A few notes on timing

I mentioned above the advantages of harvesting tax-free capital gains in low-income years, but I want to point out a few other opportunities that arise once you’ve stopped working.

Once you’ve rolled over your workplace-sponsored retirement balances to IRA’s, you’re able to convert your traditional IRA balances into Roth IRA balances. This is a taxable, but penalty-free, event, so you can convert up to the amount of your standard deduction every year (or your remaining standard deduction after accounting for earned income) tax-free (and substantially more than that at today’s favorable income tax rates). Those Roth balances can then be withdrawn tax-free any time after age 59 1/2, and aren’t subject to required minimum distributions.

Finally, it’s worth considering how and whether to make withdrawals from retirement accounts in general. An example of a “simple” strategy would be to draw down taxable assets before age 59 1/2, take distributions from qualified retirement accounts until age 70, then rely on your Social Security old age benefit and any remaining required minimum distributions from then on. More sophisticated strategies do exist, however: your assets may last longer, or accommodate higher spending (two ways of saying the same thing) if you’re able to meet your spending needs with your untaxed long-term capital gains in lieu of retirement assets prior to age 70, giving the latter more time to internally compound tax-free. Retirement assets are also granted much more protection in bankruptcy, a kind of built-in insurance policy against sudden financial misfortune.

These strategies can be quite complex, and I would not attempt to implement one without consulting a fee-only financial advisor, i.e. one who is not paid to sell you their firm’s flavor of the week.

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