Early retirement has become a popular goal in the past few years. And why not? It offers an opportunity for a chance to enjoy leisure and pursue new opportunities much earlier in life.
But, like everything else in life that’s worth doing, early retirement comes at a price. You’ll need to amass a very large retirement portfolio, which will be the primary source of your income.
After all, there won’t be any Social Security benefit until you’re at least 62, and many companies with traditional pension plans don’t provide for payment of benefits in early retirement.
You’ll need to implement a series of strategies to retire early. But it is possible, and below are eight simple strategies to help you do just that.
1. Get Yourself Mentally Prepared
While this may seem like a soft step, it’s actually critical to your success in retiring early. That’s because early retirement will require nothing less than a complete change of mindset. This becomes even more true if you have not been a committed saver/investor up to this point.
You’ll need to be mentally prepared for the fact that you’ll have to start behaving differently from most of the culture. Driven largely by the media, most Americans unconsciously follow the eat, drink and be merry, for tomorrow we die approach to finances. This at least partially explains why 69% of Americans have less than $1,000 saved.
If you’ve already established a pattern as a regular saver, you’re halfway there. But if you haven’t, that’s where the change of mindset has to take place.
To retire early, you’re going to have to become completely committed to a better future. Translated, that means you’re going to have a less luxurious life now.
While friends, family members and coworkers are busy trading up to larger homes, more expensive cars, and going on exotic vacations, you’re going to have to make a conscious decision not to compete.
Each of those spending decisions soaks up capital that is needed for your early retirement preparations. You need to think like a saver, not like a consumer. If you can’t master that conversion from the start, early retirement will be little more than a pipe dream.
You’ll also need to set your time horizon. That’s important, because your planning will change dramatically if you plan to retire in 15 years, rather than 20. The more luxuries your pre-retirement life requires, the longer the planning phase will need to be. Make that decision now.
2. Know Your Early Retirement Target “Numbers”
This is where things start to get technical. You’ll need to crunch a bunch of numbers that will act as both targets and guideposts.
Let’s go through the steps, one at a time.
Calculate the income you’ll need in early retirement
There are plenty of shortcuts here, like using 80% of your preretirement income or basing it on your current net pay, among others. But shortcuts won’t work when it comes to early retirement. You’ll need hard numbers. After all, early retirement may mean planning for a 40- or 50-year retirement, rather than the standard 20 or 25.
The most accurate calculations will come from analyzing actual living expenses. You’ll need to assemble records from all spending accounts for at least the past 12 months. Go through those expenses, separating the ones you expect to continue in retirement, but eliminating those that will no longer apply.
For example, you know you’re going to have a housing payment, but if your plan includes getting out of debt, you won’t have a car payment. You should include the house payment, but exclude the car payment.
You’ll have to do some estimating, too. Some expenses, like income taxes and health insurance expenses, will be no better than ballpark estimates. But for our purposes, that will have to do. And don’t forget to make reasonable estimates for certain retirement luxuries, like travel.
For demonstration purposes, let’s assume you find your actual living costs come to $50,000 per year. That will be your income target number.
Determine the retirement portfolio needed to generate your target income
For this calculation, we’re going to use a shortcut—the safe withdrawal rate. The withdrawal strategy holds that if you withdraw 4% of your retirement assets each year, you’ll never fully deplete your portfolio.
Of course, this is based on an investment strategy using a combination of investments in stocks and bonds that will produce an average annual return greater than 4%.
For example, a portfolio with a 60/40 stock/bond mix can reasonably be expected to produce an average annual return of 6-7% per year. That would give you plenty of room for your 4% withdrawal, while retaining 2% to 3% for growth.
Using a 4% assumed withdrawal rate, you can multiply your income target number by 25 to determine the portfolio size needed.
Continuing the example from the previous section of a $50,000 target income number, you need a retirement portfolio of $1.25 million ($50,000 X 25, or $1.25 million X 4% = $50,000).
If $50,000 a year is your income target number, $1.25 million will become your retirement portfolio target number.
Taking inflation into consideration
Due to inflation, your retirement portfolio target number is likely to rise before you reach your desired retirement age.
There is no accurate way to predict what the cost of living will be in the future, but we can get some guidance by looking back at the recent past.
Let’s say your planned early retirement date is in 20 years. Using the Bureau of Labor Statistics CPI Inflation calculator, we see that it takes $1,495 in November 2020 to buy what $1,000 would have bought in November 2000. That translates into an inflation rate of about 2% per year.
If you’ve determined that $1.25 million is your retirement portfolio target number based on today’s price levels, you’ll need to increase it by about 50% to anticipate higher price levels in 20 years, consistent with the past 20 years.
That being the case, your inflation-adjusted retirement portfolio target number increases to $1.875 million.
3. Have a Strategy for Health Insurance
This is a contingency many early-retirement planners prefer to ignore completely. But given the high cost of health insurance, and the fact that you’ll be years away from Medicare eligibility, it’s one you’ll absolutely need to factor into the mix.
As an example, I ran health insurance scenarios through Healthcare.gov, where you can get estimates and preview plan options. You can go to the site and get an estimate based on your own personal profile, including your projected retirement age.
The plan below is for a married couple, each 45 years old, living in the Atlanta area. It’s a “silver” plan, with an out-of-pocket maximum of $8,550, and an estimated monthly premium of just over $400.
You’ll need to budget for both the monthly premium and a reasonable estimate of your out-of-pocket costs in your income target number. But much like inflation, future health insurance costs will be hard to predict. Still, an estimate needs to be factored into the mix.
4. Cut Your Expenses Now and for Retirement
This is a necessary strategy on two fronts:
- Cutting expenses now will create the extra room in your budget to save money at a higher level, and
- It will prepare your budget for reduced spending in retirement.
The twin benefit should provide you with all the motivation you need. Exactly how much you’ll need to cut will depend on how soon you plan to retire, what your retirement portfolio target is, and how much of that you already have saved and invested.
This is about much more than clipping coupons and cutting your TV cable. If you’re serious about retiring in just a few years, you may need to seriously consider cutting a big expense or two.
Two primary examples are housing and cars. If you plan to retire early, owning a McMansion will be counterproductive. And you may as well get comfortable driving a more modest car now to better prepare yourself for a future of living on less.
This may require trading down on both your house and your car.
Does that sound too extreme? It’s actually not, and it’s part of Strategy #1: getting yourself mentally prepared.
“Apart from being wildly wealthy, most need to think in terms of downsizing to meet their early retirement goal,” advises Tom Diem, CFP, of Diem Wealth Management. “Do the big house or big cars give you the kind of pleasures you will want? The fancy clothes for work or tools of the trade surely must go, and along with them the expense of keeping them up-to-date. Think about how much less stress you will put on your investment portfolio if you can get those expenses cut in half? This measure alone could eliminate the need for a part-time job.”
Early retirement is a major, long-term commitment, and you’ll need to be ready to make these kinds of sacrifices. The money you’ll save now by making these cuts will better enable you to save the kind of money you’ll need for early retirement, as well as to cover the cost of living during early retirement as well.
That’s a win-win in the early retirement game.
5. Debt is Now Your Mortal Enemy
A reality of early retirement planning is debt needs to go away, and the sooner the better. And as you eliminate old debt, it mustn’t be replaced with new debt.
Getting out of debt is part and parcel of being able to both save more money for retirement, and creating the ability to live on less when retirement finally arrives.
Relying on debt can be very convenient for making purchases large and small while you’re working and have a higher income. But once you retire, that will raise your cost of living. By paying it off, you’ll lower your income target number and your retirement portfolio target as a result.
Between now and retirement, getting out of debt will enable you to save more money for retirement. By paying off a $500 per month car loan, you’ll gain an extra $6,000 toward retirement savings each year.
Once you get all your debts paid off—with the possible exception of your mortgage—you’ll be able to move your retirement savings contributions into high gear.
You’ll need to make a decision on your housing situation for retirement. Will you stay in your current home? If you do, will you pay off the mortgage before retiring? If that’s not practical, do you plan to sell your current home and move to a less expensive one in a lower-cost area?
Since home ownership and debt are closely connected, you’ll have to decide for yourself which housing situation will work best for you and your prospects for early retirement.
6. Savings Must Become the Biggest Line Item in Your Budget
Unfortunately, the standard advice to save 10-15% of your income won’t cut it. If you want to retire early, you’ll need to think in much bigger terms. If you plan to retire in 15 or 20 years, you’ll need to target 30%, 40%, or even 50% of your income for savings.
Since this can be difficult to do on an annual basis, the best strategy here is to automate the process. Fortunately, this is done easily through payroll deductions into both retirement plans and taxable investment accounts.
“Most people do not have the willpower to save on their own,” warns Earl Rubinoff of The Rubinoff Group. “That is why putting in place automatic monthly savings plans, directly out of your checking account on a monthly basis, are a great solution. And since we are living longer, we need to start early and save as much as possible. It is amazing how this forced nest egg will grow over time with little to no impact on your current lifestyle. You’ll be glad you were disciplined in this area once you retire.”
The first and best way to automate your savings is through an employer-sponsored retirement plan, like a 401(k), 403(b), 457, or TSP. Each allows you to save up to $19,500 per year, or $26,000 if you are 50 or older.
If you’re self-employed, look into either a Solo 401(k), or a SEP IRA. Each will allow you to contribute up to 25% of your net business income, up to a maximum of $57,000 per year.
But don’t stop there. You can also set up a traditional IRA as a supplemental retirement plan for additional savings. Your contributions will be tax-deductible if your income doesn’t exceed certain IRS limits. But making contributions might make sense even if they’re not tax-deductible. After all, you’ll still be building up retirement savings that will accumulate investment income on a tax-deferred basis.
(I’m specifically not including the Roth IRA since it may not be beneficial for early retirement. Contributions are not tax-deductible, and though withdrawals can be taken tax-free, that feature doesn’t kick in until you reach age 59½.)
The magic of maximizing employer retirement contributions
Looking only at the 401(k) plan, let’s work an example using the following assumptions (using the Bankrate 401(k) Calculator):
- Percent to contribute: 20% (up to the $19,500 IRA maximum)
- Annual salary: $100,000
- Annual salary increase: 2%
- Current age: 30
- Age of retirement: 50
- Current 401(k) balance: $100,000
- Annual rate of return: 7%
- Employer match: 6%
- Employer match ends: 50%
Based on the numbers above, your plan will be worth nearly $1.2 million by age 50. That will get you nearly two-thirds of the way to a retirement portfolio target of $1.87 million.
You’ll need to add other savings vehicles, like a traditional IRA or taxable investment accounts, to make up the difference. But your contribution to your employer-sponsored retirement plan is an excellent foundation for early retirement. That, of course, assumes you make the maximum contribution to the plan each and every year.
7. Increase Your Income Before and During Early Retirement
Much like cutting your expenses, increasing your income provides a dual advantage:
- It enables you to save more money while you are preparing for retirement (assuming all the additional income goes into that savings), and
- It provides an opportunity to develop a supplemental income source when you do retire.
If you’re unable to reach your savings goals on your current income and by cutting expenses, the next step will be to create an additional income source dedicated to funding your future early retirement. This can have a secondary benefit if that additional income source is related to self-employment. You can set up a solo 401(k) or a SEP IRA for your side business, while also contributing to an employer-sponsored retirement plan.
But having a supplemental income once you’re in retirement is at least as important. As you can see from the strategies I’m recommending in this article, we rely heavily on estimates. It’s possible you won’t reach your retirement portfolio target in spite of your best efforts. Having a second career can be a Plan B.
For example, if inflation or health insurance costs turn out to be higher than you originally estimated, or if you have unexpected expenses after retirement, your backup income source could save the day.
Find something you like to do so it won’t feel like work
You may also find you’re not entirely happy with the idea of complete early retirement. That’s not unusual; many early retirees simply transition into a new career after exiting their lifelong occupation. It will help if that new income source is something you enjoy doing.
“Find something you’re passionate about now (while you are working) to get involved with and invest in,” recommends Taylor Kovar, CEO of Kovar Wealth Management and The Money Couple. “I know a lot of people who have retired early only to find out that they’re bored and end up going back to work. If you can figure out how to turn that hobby into an investment, you will not only enjoy early retirement even more, but it can be a great way to produce almost care-free income!”
An additional income source to fund your retirement portfolio and a backup income source in retirement is another example of an early retirement win-win.
8. Invest Aggressively – But Don’t Speculate
If you’re going to have any hope of reaching your early retirement goals, investing in safe vehicles, like certificates of deposit and bonds, is not going to get you there. The returns on those investments are simply too low to reach your retirement portfolio target.
You’ll need to invest more aggressively, and that will mean stocks, real estate, or a combination of both.
Stocks have provided an average annual rate of return of about 10% per year, going all the way back to 1928. That doesn’t mean you make 10% each and every year, but you can expect to earn that much on your stock portfolio over 20 years or more.
And though it requires a large upfront investment, rental real estate can be an excellent way to prepare for early retirement.
“I like rental properties for early retirement,” advises Jonathan Bednar, II, CFP at Paradigm Wealth Partners. “People need places to live and with rates as cheap as they are right now then a rental strategy might make sense. If you do not want the frustration that comes with being a landlord then you can outsource the property management part. The property managers usually take a cut of around 20%, but it’s still a great way to get passive income and they field the ‘broken water heater’ calls.”
Rental real estate has the advantage that your investment increases from two directions—the rising property value in combination with a declining mortgage balance.
If you buy a rental property now, it may provide a major piece of your retirement portfolio target in 20 years. If you pay off the mortgage, you’ll have the option to either sell the property for a major gain or get a much higher net rental income from the property. It’ll be your choice.
Investing aggressively does not mean speculating!
Investing aggressively should encompass putting your money in index-based investments, like the S&P 500 or the NASDAQ 100 indexes. It doesn’t mean gambling on penny stocks and other exotic investments.
The same is true of real estate. Your investments should be designed for the long term. Unless you are already actively—and profitably—engaged in property flipping and other forms of real estate investing, it’s not something you should take on with the hope of retiring early.
“Get educated and don’t be sold on any ‘for sure investments’,” warns Paul Miller, Managing Partner and CPA at Miller & Company, LLP. “For example, I have seen a lot of clients get sold on a whole life insurance policy or an annuity that will guarantee them a certain amount when they retire. I say, ‘that’s fine, could you give me one client in retirement who purchased one of those products at my age and is living off of it?’”
Preparing your life for early retirement will not be easy. But if you use the eight strategies above, you’ll make it. And once you do, you’ll enjoy a life of new choices, adventures, and opportunities—the kind you’re probably dreaming of right now.