Monday, March 31, 2014

Early Retirement Calculations

Figuring out whether you have enough to retire is one thing, figuring out when is another.

One problem in deciding when to retire is figuring out what your income streams will be, when they will kick in, and how long they will last.

For many people, this question never comes up.  Their career lurches along until one day they are tossed out of the company and they never work again.  Retirement is thrust upon them and they live on what they have saved up, plus whatever they can get from Social Security and a pension plan, if any.

But suppose you actually want to plan your retirement and maybe want to retire early?

The problem is, there are a number of benchmark ages you and your spouse will hit, that define when streams of income will become available, and also expire.   For example:

1.  Age 59-1/2:  The age you can tap your 401(k) or IRA without tax penalty.

2.  Age 62:  The age you can start collecting Social Security.

3.  Age 65:  The age you qualify for medicare (cuts expenses dramatically)

4.  Age 67:  The present age for "full" Social Security.

5.  Age 70:  The present age for "enhanced" Social Security.

6.  Age 89:  The age your 401(k)/IRA will tap out, if spent using the 5% Rule & Draw at age 59
As you can see, this means your retirement income stream can bump up at one of several points in time - and drop off.   Now throw in your spouse's retirement.   Unless you are both of the same age, this means your income will have several steps of increasing and decreasing income, over time.  Instead of six steps, you may have twelve, each about 2-3 years apart, depending on your age spread.

So when you hit 59, you may be able to retire early and withdraw money from your IRA.  Three years later, you hit 62, and qualify for Social security.   Two years after that, your spouse hits 59, and she can tap her IRA.   Three years after that, she qualifies for Social Security - and you for Medicare.  And so on, and so on.  These "break points" in retirement can be many!

Of course, how much you choose to take out of your 401(k) and IRA is up to you - at least until age 70, when you are forced to take out a certain amount.   But even then, you can choose to spend only part of it and thus preserve your income for a longer period of time.

People routinely live to ages longer than 89 today, so running out of money in retirement is a real possibility, if you start drawing at age 59-1/2.   Thirty years later is age 89-1/2, and you may be still kicking.

This creates an income stream that ramps up over time, peaks at about age 70, and then declines to mere Social Security, by the time the youngest spouse reaches age 89.   If you want to take these disparate sources of income and reduce them to an even yearly income stream, you'd have to solve some second-order equations that take into account inflation, rate of return, future value of money, and the like.   It is not as simple as it appears.

And compounding (and confounding) the problem is that we don't know how long we will live which makes calculating your annual income even harder.   Suppose by the time you reach 89, they have new drugs and methods that make living to 100 a commonplace thing?

Sounds crazy, but already within my lifetime, the average life expectancy has risen by nearly ten years.  In Japan, for every baby born, another person turns 100.   The world is getting older and older.

Needless to say, this adds another level of complexity to the retirement calculations for the 401(k) generation.   Our parents got Social Security and a Pension - so they knew exactly how much to expect every month (with cost of living increases) for the rest of their lives.   There was no need to "wait" for these breakpoints to occur, and then decide how much to cash in, versus how much to spend.

One additional wrench in the works is that if you want to retire early before age 62, this may affect your Social Security payout.  The Social Security Administration has an excellent website (and brochure) that illustrates how this works.   In their lexicon, the "retirement" age is the age you collect Social Security (minimum age, 62) while the "Stop Work" age is when you, well, stop working.

As they illustrate:

"If you stop work before you have 35 years of earnings, we use a zero for each year without earnings when we do our calculations to determine the amount of retirement benefits you are due.

Even if you have 35 years of earnings, some of those years may be low earnings years. Those low earnings years will be averaged in, creating a lower benefit than if you had continued to work."

So, if you are counting on that amount of money that your Social Security Statement projects, and you decide to retire, say at age 59 (when you can tap that IRA or 401(k)) you may be in for a surprise at age 62, when your retirement benefits are less than you expected.  How does this play out?

For example, at age 54, I have exactly 37 years of work logged by the Social Security Administration, starting at age 17 with the $590 of reported income from the Olde Tyme Gaslight Restaurant and going on until today.  Sadly, my peak income was in 1999, which reflects the declining fortunes of the Patent business, as well as the fact I have moved more to a part-time basis.

For me, with declining income in my declining years, going to "Stop Work" may affect my Social Security calculation less dramatically than others.   For many people, their last few years of work are their highest earning years, and thus cutting off those years from the Social Security average could dramatically affect their benefits.

Bear in mind, however, that your earnings are "capped" at the cutoff amount (about $108,000 or so, at the time of this writing) so you don't get an extra benefit for those years you earned more than that.

So, how early retirement will affect your Social Security is yet another factor to consider in an already complex equation with multiple variables, and several unknowns.

My gut conclusion, after doing some initial calculations, is that I should work to about age 60 at least, in order to have a comfortable retirement.   If I quit work now, I would have to burn through a lot of after-tax savings to make it to 59-1/2.   Once there, I would have to burn through my IRA money pretty quickly, until Social Security kicks in three years later, and Mark's IRA kicks in, two years after that.   In the meantime, health care costs, even under Obamacare, will continue to rise, until I reach 65, and Medicare kicks in (and even then, there are costs associated with that).   Health Care costs - yet another variable.

You know, this 401(k)/IRA thing sounded so simple back in 1978 when it was created.  It turns out to be a lot more complicated, once you scratch the surface.