Over the past few years, the United States has seen nearly three million more retirements than anticipated. While the contributing factors vary, one subset of the surge is early retirees who might be eligible for equity-sharing and employee stock ownership plans (ESOPs). In these scenarios, many retirement planning considerations are similar to those for individuals exiting the workforce early for reasons such as layoffs, liquidity events or illness, but there are differences that advisors should take into consideration.
Understanding ESOPs
An ESOP is a type of employee benefit plan that gives workers ownership interest in the company. ESOPs are designed to align worker and shareholder interests by granting employees shares in the company at no cost to them. The structure of an ESOP provides employees the opportunity to take penalty-free retirement distributions before age 59 ½ by using Rule 72(t). The financial benefits generated from the plan are directly tied to the company’s performance, allowing employees to share in their organization’s growth and success.
Breaking Down Rule 72(t)
Rule 72(t) is an IRS provision that allows penalty-free distributions from retirement accounts before age 59 1⁄2, provided the individual follows a specific distribution plan known as substantially equal periodic payments (SEPP). This rule was established to provide flexibility for individuals who need early access to their retirement funds due to extenuating circumstances, such as early retirement or financial hardship. The SEPP program requires strict adherence to a predefined schedule, with penalties applied if payments are modified before the designated period ends.
There are three IRS-approved methods to calculate these payments. Once an employee elects to take distributions under 72(t), they must continue for at least five years or until they turn 59 ½–whichever is greater–or face retroactive penalties. The options and details for each are as follows:
- Required Minimum Distribution (RMD):
This type of distribution follows the same calculation guidelines as IRS-required minimum distributions (RMDs) for traditional IRAs and retirement plans. The distribution amount is determined by dividing the account balance by a life expectancy factor from one of the IRS-provided tables (Uniform Lifetime Table, Single Life Expectancy Table or Joint Life and Last Survivor Expectancy Table). Once chosen, this method must be used for all subsequent distributions.
- Fixed Amortization
This method calculates the distribution based on an amortization schedule. The schedule spreads the account balance over life expectancy, using an interest rate that doesn’t exceed 120% of the federal mid-term rate published by the IRS. The interest rate used in the calculation is fixed and doesn’t change over time. This method provides a level annual payment amount, which may be higher than the amount calculated using the other methods.
- Fixed Annuitization
The option also follows a calculation from annual distribution, but it’s based on an annuity factor. This number is derived from mortality tables and an interest rate that doesn’t exceed 120% of the federal mid-term rate published by the IRS. Similar to the Fixed Amortization Method, once the annual amount is determined and paid, the same dollar amount must be distributed in future years. This method typically results in lower annual payments compared to the Fixed Amortization Method.
Each of these methods can produce a significantly different allocation, so when advising early retirees, it’s important to consider their unique needs.
Accounting for Common and Hidden Retirement Expenses
There are several common and hidden considerations that early retirees will need to keep in mind as they plan for the next 30-40 years, or more, of life:
- Basic living costs, including mortgage payments, groceries and monthly utility bills, are a good starting point for determining how much will be required to fuel a comfortable retirement.
- Health care coverage is important to consider, as most early retirees are too young for Medicare, and private health insurance premiums can be steep. Add deductibles, copays and unexpected medical emergencies, factoring in premium and fee adjustments over time, and healthcare could be one of the highest expenses depleting retirement income.
Preparing for Fluctuating Variables
- Inflation can erode purchasing power over time, presenting challenges for early retirees who will rely on savings for a longer term.
- Social Security can help cover expenses once early retirees meet the age requirements, but their eligibility and award amount will depend on the number of years worked and their age at distribution.
- Other retirement funds such as individual retirement accounts (IRAs), certificates of deposit (CDs) or market investments can supplement retirement income. However, each comes with its own unique considerations, such as taxation, penalties for early withdrawal and timing strategies to mitigate sequence-of-return risks.
Expecting the Unexpected
- Life changes such as getting married, divorced or having a child could impact expenses.
- Emergencies, from accidents to unanticipated home or automobile repair bills–or even needing to help a parent or a child in need–could quickly eat into retirement savings.
- Post-retirement purpose can help offset the feelings of a lost identity, particularly if one’s life has been centered around work. Hobbies, social outings and volunteer opportunities can help fill the void, but they can come at a price. From golf tee times to lunch dates, the tabs really add up.
- Long-term care and other insurance needs, such as life and pre-need burial insurance, are often overlooked by early retirees. While these might not be top of mind for a 45-year-old, age is one factor that affects premiums. What’s worse is that failure to account for the cost of long-term care could deplete assets quickly later in life, compromising financial security.
- Market ebbs and flows come with their own set of variables, posing questions about what, how and when to invest and plan for distributions.
Successfully Navigating Early Retirement: Working with the Right Advisor Can Replace Hurdles with Hammocks.
While the idea of early retirement can be appealing, it presents a myriad of considerations.Early retirees who tap into their ESOPs have unique financial and lifestyle needs. While these plans can provide the foundation for early retirement, attention to long-term risks and commonly overlooked considerations—combined with careful planning— is crucial for maintaining financial security and quality of life during retirement.
Given that early retirees are not a monolithic group and each face their own unique needs and challenges, financial advisors need to be ready to assist beyond offering traditional advice. Advisors who are versed in offering customized solutions for early retirees will likely be well-positioned to expand their practice, serving an emerging de novo client base with advice that transcends traditional wealth management strategies and tactics.
Additional Disclosure: This presentation contains general information that is not suitable for everyone and was prepared for informational purposes only. Nothing contained herein should not be construed as a solicitation to buy or sell any security or as an offer to provide investment, tax, or legal advice. Marshall Financial Group, Inc. (“Marshall”) is a registered investment adviser. For additional information about Marshall, including its services and fees, send for the firm’s disclosure brochure using the contact information contained herein or visit advisorinfo.sec.gov.
This communication contains certain forward-looking statements that indicate future possibilities. Due to known and unknown risks, other uncertainties and factors, actual results may differ materially. As such, there is no guarantee that any views and opinions expressed herein will come to pass.
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