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Dave Patterson and Erin Preston, a father-daughter team of Certified Financial Planner® licensees, provide thoughts and suggestions on a broad collection of personal finance topics.  Information provided in this BLOG is intended to be of a general nature and may not be appropriate for all situations.  Readers should consult with their own financial advisors before relying on any information contained herein.

Sunday, November 8, 2009

Early Retirees May Be Between a Rock and a Hard Place

It seems that more and more young people have dreams of retiring by age 50 or even sooner. Add to that, significant numbers of employees that are being let go in their early 50’s with 30 or more years of seniority. The result is substantially greater numbers of people considering early retirement. However, in more than a few cases, they will find themselves between “a rock and a hard place”.

The issue early retirees face, in many cases, is not that they don’t have enough money for retirement (though that is also often an issue); it’s having liquidity. Many have saved diligently but have all their cash tied up in retirement accounts or taxable assets with significant tax liabilities.

As a result, many employees suddenly faced with a forced early retirement may have limited options. If they have a pension, it likely has a reduced payout for those under age 65. If they can rollover the pension to an IRA they could take a stream of “substantially equal periodic payments (SEPP) from the rollover pension IRA under IRS rule 72(t), but due to their age (early fifties), those payments might not meet their needs if interest rates are low, like they are currently. In addition, once they start SEPP withdrawals, they can’t change the amount for five years or until age 59 and ½, whichever occurs later. (Note: they could take SEPP withdrawals from their other IRAs and 401(k)s as well).

They could take early retirement distributions from their 401(k)s and their IRAs but would have to pay a 10% tax penalty since they are under age 59 and ½. (Note: if they are over age 55 when terminated from their job they can take distributions from their 401(k) without having to pay the 10% penalty.)

In many cases, they will need to find another job to bridge the gap until they can begin collecting Social Security. They have heeded the guidance of financial advisors to maximize their 401(k) contributions, contribute to non-deductible IRAs and establish Roth IRAs. More often than you might imagine, they have not saved outside of their retirement accounts, and in many cases, don’t even have an emergency fund.

At a minimum, they need an emergency fund of cash to meet three to six months of living expenses. (Note: In today’s economy, six months to a year of living expenses seems more prudent.) Often, the only cash they have is in their checking and savings accounts and then only enough for day-to-day needs.

Assets to meet emergency situations need to be able to be converted to cash easily, without loss of principle. Therefore, they need to be invested in a checking account, savings account, money market account or the equivalent. They should not be kept in an investment asset that is subject to market-price fluctuations. Otherwise, they might have to be liquidated during a down market, thereby eliminating the opportunity to wait for a rebound.

Clearly, a six to twelve month emergency cash fund would make such a situation much more bearable. It would allow people to avoid onerous tax penalties, give them the option of taking the early retirement and buy time to obtain another job to bridge the gap between employment termination and when they could start collecting Social Security.

Sometimes we place too much emphasis on maximizing contributions to our retirement plans so that we can earn tax-free returns. We need to make sure that we have a basic safety net of emergency funds and insurance coverage in place first. Having lots of savings is great – just make sure you have enough in liquid assets for that always unforeseen emergency.


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