Retirement saving options for early retirement

by Guest Blogger on February 26, 2010

in Retirement Planning

You did your math.  You know how much you need to save for retirement.  Now what?  Do you just keep all your savings in a box under your mattress?  What about in the freezer?  A savings account at the bank?  None of these let your money work for you while you save it.  Let’s go over a few popular retirement saving options.  After we do, we’ll talk about how early withdrawal affects your savings.  Tax deferred savings options include:

  • 401(s)s at work
  • Annuities
  • IRAs

401(k)s are employer provided retirement savings plans.

  • The employee decides how much to contribute a month.
  • The employee gets to choose what to invest in from a list of mutual funds.
  • Contributions are put into the account before they are taxed.  Building interest is not taxed.  All withdrawals are taxed.  If the person lowers their tax bracket at retirement, the savings here can be great.
  • Company matching provides financial benefits to employees.  The maximum amount a company can pay is six percent the employee’s annual salary.
  • The maximum amount a person can contribute to their 401(k) is $16,500.  If an employee is over 50 ½, they can contribute an additional $5,500 annually.

Annuities are insurance contracts people buy from insurance companies.  By agreeing to pay a set amount of money up front, the owner receives money back after a set time.

  • Annuities are not normally good retirement investments unless a person has maxed out other options and wants to save more money tax deferred.
  • Annuities have many more up front fees than 401(k)s.  To take your money out before a minimum period (usually from three to five years), you must forfeit a surrender fee.  This fee is typically between 5% and 7%.  In addition, you must pay the 10% early withdrawal penalty to the IRS.
  • Payments are taxed first.  Contributions are not made pre-tax.  Earnings are tax deferred but are taxed as ordinary income when distributed.  This is a higher rate than the capital gains rate used for 401(k)s.

IRAs are self-directed retirement savings accounts.  There are eleven types.  Some are done through work.  The two most common ones are the traditional IRA and the Roth IRA.

  • With the traditional IRA, the amount contributed is tax exempt but everything is taxed when distributed.
  • With the Roth IRA, money is contributed after a person has paid his or her taxes on it.  Then, when the money is distributed, it is tax-free.  This makes sense if you think you will be in a higher tax bracket when you retire than the bracket you’re in now.  Oh, we can all hope, can’t we?
  • As long as you are younger than 70 ½ and you are earning money, you can start an IRA.
  • You can contribute $5,000 a year to your IRA.  If you are over 50 years old, you can contribute another $1,000 a year.  You can have both types of IRAs open (traditional and Roth).  Your total contribution in one year is still $5,000 or $6,000 (for those over 50).

If you are deciding to retire early, you might worry about what the IRS thinks.  After all, they don’t think you should retire before you turn 59 ½.  If you do, you would have to pay an early distribution penalty.  This is a 10% fee paid to the IRS on withdrawn money.  The penalty is supposed to help people keep their retirement money in their retirement savings accounts until they need them.

Here is the lowdown on that early distribution fee.

  • Not all early withdrawals face an early distribution penalty.  A person can convince the IRS they need to make a hardship withdrawal.  In this case, he or she will not pay the 10% early withdrawal fee.  The IRS usually accepts the following reasons for approved early withdrawal of retirement savings:  medical and funeral expenses, college tuition, to purchase, repair, or keep from losing his or her main home.
  • Tax law under 72(t)(2)(A)(IV) lets people start early withdrawal of their retirement savings without being penalized with that 10% fee.  This is the golden key for anybody contemplating early retirement.
  • As long you take out equal periodic withdrawals made during the rest of your life, you do not pay the early withdrawal fee.
  • Figuring out the right amount to take out is complicated.  The IRS accepts three ways to figure out how much you should start taking out.  These methods are the life expectancy method, the amortization method, and the annuity method.

A lot of paperwork is involved as well.  You have to use the same method to withdraw the money for five years or until you reach 59 ½, (whichever one happens last).

{ 1 comment… read it below or add one }

carmencrespo09 July 2, 2010 at 3:44 AM

Thank for giving such good information about early retirement plan which will be useful for the people who do not well known about retirement plan.

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