Many people have a dream of retiring early so they can enjoy their time away from the grind. However, it is important to realize that there are some very real drawbacks to early retirement. The main issue is that you can’t begin taking distributions from your tax advantaged retirement account, penalty free, until you are 59 1/2. That means that early retirement can really puts your saving ability to the test. There are some strategies you can employ, though, to help you as you get ready for early retirement. Here are a few for those thinking about taking the leap one day.
Creating an Early Retirement Portfolio
While you want to make sure that you are taking full advantage of the tax advantaged retirement accounts available to you, you should also create another retirement portfolio that can build value (also known as a taxable account). Though you won’t get the full benefit of avoid taxes on gains, here are two options for your early retirement portfolio that will help in that regard:
- Bonds: The interest earnings from some bonds are taxed. However, there are some bonds that are exempt from taxes. Many municipal and state bond earnings are free from federal income tax. On top of that, some states offer exemptions on bonds to residents of the state.
- Dividend Paying Stocks: You can also look into dividend paying stocks. Right now, the top rate on dividend earnings is 15%. Plus, if you sell the stocks, you will be capped at 15% as well (for now) on long term capital gains. Even if the tax rate on long term capital gains goes up, it is unlikely to come close to approaching the top tax rate. Dividend stocks — especially dividend aristocrats — are known as great value investments, and earnings are likely to go up.
It’s true that neither of these choices are going to offer huge gains; bonds and dividend stocks aren’t exactly “get rich quick” choices. However, they do provide relatively stable returns that can be counted on during an early retirement. The key is to build up the portfolio now, over time. That way, when you are ready for your early retirement, you might even have a solid income stream.
Remember that your early retirement investment portfolio doesn’t have to last you your entire life; it’s main purpose is to provide you with a way to bridge the gap between the time you retire early, and the time that you can access your “regular” retirement accounts without incurring the penalty. (Plus, with more time to grow, your more traditional retirement accounts will grow larger.) Indeed, with the right planning, you can put together a tiered plan that also allows you to put off taking Social Security until you are older, making your benefits that much larger.
Even if you plan to retire early, it’s important to consider your options, and put together a plan to keep your taxes as low as possible. The use of certain bonds, as well as dividend paying stocks can help you achieve the best possible tax efficiency, while still providing you with the money you need to enjoy retirement before 59 1/2.
Editor's Note: I've begun tracking my assets through Personal Capital. I'm only using the free service so far and I no longer have to log into all the different accounts just to pull the numbers. And with a single screen showing all my assets, it's much easier to figure out when I need to rebalance or where I stand on the path to financial independence. They developed this pretty nifty 401K Fee Analyzer that will show you whether you are paying too much in fees, as well as an Investment Checkup tool to help determine whether your asset allocation fits your risk profile. The platform literally takes a few minutes to sign up and it's free to use by following this link here. For those trying to build wealth, Personal Capital is worth a look.