How Does Early Retirement Work?

Planning for Retirement

People do not always realize just how much planning goes into retirement. It's about more than saving money and investing it for the future. There are a number of critical factors to consider. While individuals often choose to take early retirement for a variety of reasons, sound financial advice and a good retirement plan are required before you decide to opt for early retirement. You should have a clear idea beforehand about how much money you will need to manage your expenses. Also, you need to be realistic in your calculations, as it will take sufficient assets to see you through the retirement years.

Loss of Health Insurance Coverage

Health insurance coverage often is the primary obstacle preventing people from retiring early. Medicare benefits do not begin until age 65; therefore, if you retire before that time, you may be responsible for paying all health care costs out-of-pocket. Exceptions may include if your spouse remains employed, or you receive continued health care coverage as a retirement benefit paid for by your employer. If neither of these situations apply to you, other options for health care coverage may include purchasing a private health insurance policy, or choosing COBRA coverage, which would be available to you for up to 18 months after you retire from your job. In that case, you would be responsible for paying the premiums.

Effects on Social Security Benefits

Retiring early will reduce Social Security benefits as well. Monthly retirement benefits are calculated on the average of a person's salary throughout his or her highest earning 35 years of employment. By retiring before working a total of 35 years, the nonworking years are calculated as having zero earnings. The Social Security Administration also considers full retirement age to be age 65 for those individuals born in 1937 or before. Under current guidelines, individuals born in 1960 and after will not qualify for full retirement benefits until age 67. For those born in the years between 1938 and 1959, there is a gradual age increase until the full retirement age reaches 67. Although an individual still can begin collecting retirement benefits from Social Security at age 62, he will receive only partial benefits. In that case, over the length of retirement, a person could receive up to 30 percent less in Social Security benefits, if he retires sometime after age 62, but before age 67.

Other Risks Involved

Keep in mind that retiring early comes with a number of risks, along with the obvious rewards. If you decide to retire early, you will be paying some steep tax penalties for early withdrawal from IRAs or 401(k) plans. A 10 percent penalty will be imposed if you withdraw money before you reach age 59.5, except in special circumstances, which may include disability or withdrawals to pay medical expenses, which exceed more than 7.5 percent of your adjusted gross income. In addition, most pension plans offered by employers are set up so that you cannot begin drawing benefits until you reach a certain age. The longer you wait after that, the more your monthly distribution will be. A good rule of thumb to follow when considering early retirement is whether your financial situation after retirement will provide at least 80 percent of your pre-retirement income. If the answer is no, consider whether you can survive financially on less than that, or if you are willing to make changes in your lifestyle in order to cut costs.