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Forbes Featured | Key Investment Concerns For Early Retirees

Minimizing taxes, obtaining affordable health insurance, and having ample penalty-free income at a young age are all critical variables for early retirement. At first glance, these different variables might seem independent of one another, but the decisions you make on one of the variables can heavily influence the others. Developing an investment strategy that will provide sufficient income for you as a young retiree requires a balancing act between liquidity, tax efficiency, and affordable health insurance.

Many people seeking early retirement invest in individual retirement accounts (IRAs) because of the immediate tax deductibility they can receive on their contributions coupled with the long-term, tax-deferred growth that can accumulate over time. Distributions from IRAs in retirement are typically fully subject to taxation. While the initial tax benefits of IRAs can be tempting, make sure you understand how they fit into your long-term investment strategy.

In addition to increasing taxable income in retirement, IRA distributions can also increase health insurance costs for young retirees who do not have health insurance provided by a previous employer. This occurs because many young retirees will choose to go on Affordable Care Act insurance or a state-run health insurance plan. The cost of these health insurance plans is frequently determined by one’s modified adjusted gross income. Typically, those with higher taxable incomes will also pay higher health insurance costs. Since distributions from IRAs can increase taxable income, they can also increase the cost of health insurance. This problem can persist until individuals begin Medicare at age 65.

In addition to increased taxes and increased health insurance costs, another disadvantage with IRAs includes liquidity. Distributions from IRAs before age 59.5 can cost a 10% early withdrawal penalty tax if you do not qualify for one of the IRS-approved exceptions. This penalty can be avoided by using 72(t) distributions. These distributions allow you to take income from your IRA according to a specific schedule before age 59.5. The amount you can withdraw is based on one of three IRS-approved calculation methods that you can select from. Once 72(t) distributions have started, they must be continued for five years or until age 59.5. If the income distributions are altered from the selected method, the 10% penalty can apply to all amounts withdrawn. This lack of flexibility based on income needs is one of the most significant drawbacks with 72(t) distributions.

Similar to IRA accounts, 401(k) and 403(b) plan contributions provide immediate tax relief and long-term tax-deferred growth. Distributions from these plans are also subject to taxation, increasing the cost of health insurance before Medicare. Fortunately, these plans do have one advantage over IRAs for young retirees. If you terminate employment during the year you turn 55 with an employer that provides a 401(k) or 403(b), you can be eligible for penalty-free distributions. It is worth noting that if you have a 401(k) or 403(b) plan that you left with a previous employer and then subsequently turn 55, these plans will not provide the same penalty-free distributions. In this situation, you would have to wait until the age of 59.5 for penalty-free distributions.

Another common investment option used by individuals hoping to retire at a young age includes Roth IRAs. Unlike IRAs, 401(k)s, and 403(b)s, Roth IRAs do not provide the same upfront tax relief. Fortunately, Roth IRAs do have an advantage over these other plans as they provide tax-free growth. In addition to tax-free growth, Roth IRAs can also provide future income that can be withdrawn tax-free. Further, qualified distributions do not count as income that will increase the cost of ACA or state-run health insurance.

In addition to the tax-free benefits, Roth IRAs have a liquidity advantage over IRAs, 401(k)s, and 403(b)s. The contributions to Roth IRAs can be withdrawn tax and penalty-free at any age. The growth associated with Roth IRAs must be handled carefully. The growth you have earned on your Roth IRA contributions will be taxed and assessed a 10% penalty unless you meet one of the IRS’ various exceptions. Once your Roth IRA exceeds five years from inception and you have turned 59.5, you will be eligible to take the growth from your Roth IRA tax and penalty-free. One way to avoid the 10% penalty tax on the growth within a Roth IRA includes waiting for the greater of five years from the inception of the account or until 59.5 to begin distributions.

One final investment option that can provide liquidity for young retirees includes investments that are not held inside a retirement account, such as an IRA, Roth IRA, or workplace retirement plan. These investments could include savings accounts, mutual funds, or a variety of other investment types. For this article, I will call these non-retirement investments. Generally, non-retirement investments do not receive any preferential tax treatment. What non-retirement investments lack in tax efficiency, they can make up for with liquidity. Many investments not held in a retirement account can allow unrestricted access to income distributions for young retirees. This liquidity can make non-retirement investments an ideal candidate for young retirees. In addition to liquidity, these investments can be managed to help minimize the tax bite while also minimizing the impact toward increasing health insurance costs.

Selecting the appropriate investment strategy is an essential component for individuals who want to retire young. Understanding the appropriate mix of IRAs, Roth IRAs, work retirement accounts and non-retirement accounts in advance of retirement can help you develop the appropriate contribution strategy to seek your desired results. By using these strategies, you can see the importance of balancing tax efficiency, liquidity, and affordable health insurance as it pertains to early retirement.

Originally posted in Forbes August 23, 2021

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