Early retirement? Yes please.
This week, I answer questions from the audience around early retirement planning, health savings and debt pay-off.
Question #1: How can I avoid early-withdrawal penalties?
Our first caller is Christianna, who asks two questions:
- I’m interested in early retirement. How can I avoid early withdrawal penalties?
- How does early retirement impact the 4 Percent Rule?
Let’s tackle the first question regarding accounts. TL;DR: focus on your Roth IRA and HSA.
Roth IRAs for Early Retirement
The more detailed answer is that a Roth IRA allows you to contribute up to $5,500 of earned income per year (or $6,500 if you’re 50 or over). You can withdraw your principal contributions penalty-free whenever you want, while keeping the gains invested.
The great thing about Roth IRAs is that they’re simple. The downside is that $5,500 isn’t much money, and if you’re a high-income-earner, you may not qualify to contribute to a Roth. Still, this is a great place to start. What next?
HSAs for Early Retirement
Enter: the HSA. We’ll get into a crazy amount of detail about the HSA in the next question, but it’s worth mentioning that it’s an epic early retirement account with triple tax benefits.
The upside to the HSA is that it’s easy to set up and you reap massive tax benefits. Again, the downside is that you can’t invest much money here. The IRS announced that the contribution limit for 2018 is only $3,450 for self-only coverage, or $6,900 for family coverage.
Between both the Roth IRA and the HSA, assuming you qualify for both, assuming you’re under 50, and assuming your HSA is for a family health plan (whew, that’s a lot of assumptions), you can contribute a maximum of $12,400 per year … which is not enough. Fantastic start, but not enough.
So what else can you do?
Roth Conversion Ladders for Early Retirement
Thankfully, there’s a fancy thing called a Roth Conversion Ladder that can help. Here are the steps:
Step 1: When you quit your job, roll your Traditional 401k money into a Traditional IRA. These have similar tax treatments, so this conversion has no penalties and no tax consequences. Woohoo!
Step 2: During Year 1 of your retirement, you’ll be in a lower tax bracket, so make a conversion from your Trad IRA to a Roth IRA. Convert as much money as you’d like to withdraw for one years’ expenses. You will pay taxes on this conversion.
Step 3: Wait for 5 years. During these 5 years, you’ll need another source of income, so you can live on your principal contributions to an (unconverted) Roth IRA, or you can withdraw receipt-backed deferred HSA reimbursements.
Step 4: After 5 years, you can withdraw the money that’s in your Roth account without paying penalties or additional taxes.
In other words…
- At the beginning of Year 1 – you’ll convert money from a Trad IRA to a Roth IRA that you’ll withdraw and spend at the start of Year 6.
- At the beginning of Year 2 – you’ll convert money that you’ll tap at the start of Year 7.
- At the beginning of Year 3 – you’ll convert money that you’ll tap at the start of Year 8.
- At the beginning of Year 4 – you’ll convert money that you’ll tap at the start of Year 9.
The only ‘gap’ you’ll need to plug are years 1-5 of your retirement – which, again, is where your Roth IRA and HSA comes in.
Also, don’t forget – you’ll only need to do this for a couple of decades. If you retire at age 39 and a half, you’ll need to follow this strategy for 20 years. Then, at age 59 and a half, you can withdraw 401k funds in the conventional way.
Another option is the SEPP 72(t), and you can read the MadFientist graph for more details on how it works.
Does the 4 Percent Rule Apply to an Early Retirement?
Onto Christianna’s second question: how does early retirement impact the 4 Percent Rule?
First, for the sake of listeners who aren’t familiar with this rule-of-thumb:
Assume you have a balanced portfolio of stocks and bonds. The 4 Percent Rule states that if you withdraw 4 percent of your portfolio in the first year of retirement, and 4 percent adjusted for inflation every subsequent year, you’ll have a reasonable likelihood of not outliving your money. Score!
How does early retirement affect this?
- If you use the SEPP 72(t) method, it totally throws the 4% rule out the window, since you’ll determine your withdrawal rate based on IRS regulations.
- If, however, you use the Roth Conversion Ladder, then you can convert 4% every year and withdraw that money 5 years later. The 4% rule holds here, as there are no IRS rules telling you how much to withdraw.
It’s worth noting that the 4 Percent Rule assumes a 30-year retirement. But when you project this into the future for a longer retirement, it can still work – especially if you stay flexible.
How? In times of market declines, withdraw a little less. If theres a big recession, withdraw 2-3% and start earning some side income.
The major risk here is a one-size-fits-all, flat-line approach. You can reduce your risk by withdrawing less from your investments – in other words, by holding – when the market is down.
Question #2: Should I Get an HRA or HSA?
Our second question comes from Kate, who is wondering if she should open an H.S.A. with her employer (to which her company will contribute $750 annually), or keep the H.R.A. she currently has (to which her company will contribute an unknown amount).
First, let’s take a look at Kate’s situation:
- She has mortgage and credit card debt
- Her mortgage is higher than she’d like
- Her CC debt is an undisclosed amount; she’s transferring the balance to a CC with a 0 percent interest rate; hopefully she’ll pay that off in full before the teaser rate expires!
- She’s redirecting some retirement money towards her debt payoff
- Kate contributes 4%
- Her company contributes a total of 6%
- 10% of Kate’s salary goes into her 401k
- Company contributes 4 %
- Overall, 14% of Kate’s salary is getting saved into retirement accounts (awesome!)
- 10% in 401k
- 4% in pension
- AND she’s getting the maximum possible company match
Okay, now that we have that background, I’m going to answer Kate’s question in 3 parts:
- First, I’m going to define HRA and HSA.
- Then I’m going to compare them.
- Finally, I’m going to talk about the answer in the context of Kate’s broader retirement goals.
What’s an HRA?
An HRA is a Health Reimbursement Account. It’s an account that’s owned and funded by the employer, and the money inside of it can be used by the employee for health-related expenses.
Here’s how it works:
- The employer sets up an HRA for every participant.
- The employer puts money into the HRA account.
- The participants – that’s you – can use the money that’s inside the HRA to pay for qualified medical expenses.
- This money is NOT income. It’s money that belongs to your employer that you’re allowed to use to pay for your qualified medical expenses.
What’s an HSA?
An HSA is a Health Savings Account. It’s an account that’s owned and funded by the employee, or by the individual.
Individuals make tax-deductible contributions into an HSA. Money inside an HSA can, for example, be invested into a broad market index fund, and all of that growth is tax-deferred, just as it would be in a Traditional 401k.
If the individual spends that money on qualified health expenses, then the individual does not get taxed on the withdrawal.
Essentially, an HSA allows you to pay for health care expenses with tax-free dollars.
Now here’s where it gets even better…
There’s this practice that’s common among the financial independence / early retiree crowd. It’s called HSA hacking – and we call it that because we are using the HSA for purposes beyond its original design.
We are HSA enthusiasts who have figured out how to hack it to its maximum benefit.
(Yes, I just described myself as an HSA enthusiast, which probably tells you a lot about me. #nerd #hsasandbeerpong)
Here’s the hack.
If instead of using HSA money to pay for qualified health expenses, you instead choose to pay out-of-pocket, after-tax dollars for your health expenses, then the money inside your HSA will continue to grow tax-deferred.
Assuming that the money is invested in equities or bonds, that tax-deferred growth, over the long term, could be substantial.
Heres’s a breakdown of how it works:
- You pay for health expenses out-of-pocket
- You save the receipt so you can reimburse yourself for making that payment.
- You can reimburse yourself immediately, or, if you choose, you can reimburse yourself 1 year, 5 years, 10 years, or 20 years from now.
- If you’re willing to wait, the money will continue to grow tax-deferred.
- When you withdraw it, that withdrawal – because it’s backed by a receipt – is tax-exempt.
Here’s the triple tax benefit:
- The contribution is tax-deductible
- The growth is tax-deferred
- The withdrawal is tax-exempt if it’s backed by a receipt for a qualified medical expense – and again, that receipt could be from 30 years ago, and in the meantime, you’ve let the tax-free growth accumulate.
That’s the best tagline for an HSA – it’s the account with the triple tax benefit.
If there’s money within the account that you don’t withdraw to support a qualified medical expense — in other words, if there’s more money in the account than you have receipts for — then when you reach retirement age, you can withdraw that money in the same way that you’d withdraw money from a Traditional 401k. You still get all the benefits of decades of tax-deferred growth.
TL;DR – If you have health expenses, the HSA gives you the benefits of a Traditional IRA and the benefits of a Roth IRA combined. If you don’t have health expenses, then the HSA basically acts like an additional or supplemental Traditional 401k.
HRA vs. HSA
Let’s go to the kernel of Kate’s question, which is to compare an HRA vs. an HSA.
Main difference: The employer owns the HRA and the employee owns the HSA.
The money within your HSA is YOURS – it’s an asset on your personal balance sheet. The money within your HRA can be used by you, but the HRA is not an asset that is owned by you.
More broadly speaking:
- The money in an HRA is intended to be spent, NOW, on qualified medical expenses.
- The money in an HSA is intended to be a long-term savings account, which can be used for medical expenses or for retirement.
Note: HRA funds can be used for insurance premiums, while HSA funds cannot be used for insurance premiums.
What Should Kate Do?
Since Kate has credit card debt, she needs to prioritize debt payoff — especially before her 0% teaser APR expires. I’d recommend that she should stick with the HRA.
Why? Kate can use the funds in the HRA to offset some of the cost of her insurance premiums, which, in the short term, allows her to save more money that she can put towards her debt.
Assume she pays $100 per month out-of-pocket for her insurance premiums, and assume her company contributes $750 annually to her HRA, which is $62.50 per month.
Every month, Kate could file for a $62.50 reimbursement from her HRA for her insurance premium. She should then pay an extra $62.50 toward her credit card debt. (And if Kate wants to be extra badass, she could round the amount she pays up to $70. She won’t miss the extra $8!)
What Should Others Do?
For anyone else who is trying to choose between an HRA vs. HSA, here are a few questions to consider:
#1: Do you need to switch health plans to have an HSA?
To contribute to an HSA, your insurance plan needs to be an HSA-qualified, high-deducitlble health plan.
If your current insurance plan is already HSA-compatible, awesome; you can be in the same health plan regardless of whether you’re in an HRA or HSA.
But if your current health plan is not HSA-compatible, then you want to look at the compatible options that your employer provides, because you’d have to swtich plans to get into an HSA.
#2: How long will you stay at your job?
Money inside your HRA is not portable. If you quit your job or you get laid off, you lose the money inside your HRA (because it was never yours).
If you don’t think you’ll be at your job for much longer, then it makes more sense to opt for the HSA because you can carry that money with you as you move from job to job, or as you transition into self-employement or early retirement.
- IRS document about the SEPP 72(t) Rule
- Sweet graphics explaining the Roth Conversion Ladder and the SEPP 72(t) Rule, courtesy of my good friend The MadFientist
- How to open a Roth IRA at Vanguard
- How to start a blog in 5 minutes
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