Retiring Early

Forest fires are all over the news these days, but I’d like to address a different fire today. In the financial planning world, there’s a lot of buzz around the FIRE movement.

FIRE stands for “Financially Independent, Retire Early.” Although many people talk about it, few seem to understand the path to achieve it.

So let’s address what it takes to retire early. Early retirement can be done, but to do it right takes planning.

The Traditional Path

Let’s begin by talking about what retirement looks like for people who don’t plan on retiring early.

Most people that fully retire at age 65 rely on two income sources:

1. social security
2. retirement accounts such as 401(k)s and IRAs.

Some people will enjoy a pension, but those are becoming less and less common.

At 65, you are also eligible to enroll in Medicare. Medicare will help you cover health care expenses. Remember that after retirement, most people do not have access to an employer-provided health care plan. Getting health care coverage is a must.

If all goes well, 40+ years of working and saving will fund a retirement that lasts 20-30+ years.

The Alternative path

These days not everyone completely stops working at 65. Some people wind down their careers by simply spending less time working in their current position.

If that’s not an option, you may stay in your current industry but lighten your workload through part time consulting.

Other people keep working 40 hours a week but transition to a less stressful career in an entirely different industry.

Retirement is no longer an all-or-nothing proposition. You have the choice to define how you spend your golden years.

What You Need to Know about Early Retirement

There is a little more work for those who want to retire early. Here’s what you should know.

• Social Security: The earliest you can tap into this income source is 62. However, most financial planners agree that delaying Social Security makes more sense. You will receive higher monthly amounts if you wait a few years.

• IRA’s and 401(k)’s: Don’t plan on touching these until you are in your 60’s. The IRS penalizes withdrawals from IRA’s prior to age 59 1/2. Penalties come in the form of increased taxes. The one exception is Roth IRA contributions, which can be accessed penalty-free once your Roth IRA has been open for at least 5 years. Some 401(k) plans allow for penalty-free withdrawals if you retire from the company after age 55, but many do not, so research what type you have.

• Health Insurance: Medicare is not an option before 65 unless you are disabled. Early retirement will require you to search for health insurance independently. Finding health insurance is time-consuming. And once you’ve obtained insurance, be ready to pay. Older people pay more for health insurance than young people. If you’re interested in how much you’ll pay, find an online calculator like this one: https://communications.fidelity.com/wi/tools/retirement-health-care/.

• Longevity: Early retirement takes so much planning because you may end up funding a retirement that lasts longer than your career. Let’s assume you start working at age 22, retire at 55, and live until 92. That’s 33 years of working and 37 years of retirement. Sounds great! However… it means in those 33 years of working, you will need to save a substantial portion of your income.

How to Prepare

If you want an early retirement, it is crucial to figure out how much money you will need, how to save it, and where to save it.

Look at Your Budget

Budget work doesn’t necessarily equate to reducing spending. It’s more about gaining awareness of your spending habits.

Determine what your monthly expenses will be in retirement.

Note that some of your habits will change in retirement. You may not have a mortgage by the time you retire. Also, you’ll spend less money on work clothes, dry-cleaning, and gas for your commute. But some expenses may increase, such as travel and health care.

Save, Save, Save

Funding an early retirement means saving more money in less time than someone pursuing a traditional retirement.

Depending on your current investments, timeframe, and retirement income needs, you will most likely need to save 20-50% of your income to fund an early retirement. Look back at your expenses to determine how much you need to save.

Invest

Even if you plan on retiring in the near future, most of your portfolio still has long-term needs. If you retire at 55, think about the portion of your portfolio that you will use when you are in your 80’s.

You want to invest for growth to maintain your purchasing power, i.e., keeping pace with inflation.

Ideally, you’ll be living off the interest from your investments for many years before you need to start spending your principle. Figure out when you will hit that point. The later you tap into those funds, the better.

Location Matters

I am not talking about real estate. I am talking about the location of your savings. Where are you saving? To make it last long, you’ll need to use tax-efficient places to store it.

The federal government wants people to plan for their retirement. That’s why there are tax benefits to using 401(k)’s and IRA’s.

First and foremost, if you have an employer-sponsored plan (401k, 403b, SIMPLE IRA) available, save at least 10% of your income there. Often, employers will “match” some of your contributions. And who doesn’t love getting handed money?

Next, consider saving even more money in an IRA (Individual Retirement Account). There are two types of IRA’s: Roth and Traditional. Both offer tax advantages.

Roth IRA’s house after-tax money but and that money grows tax-free. Contributions are subject to income limitations, though. If your income is too high, you may be able to perform a backdoor Roth contribution.

Depending on your income, Traditional IRA contributions may be deducted from your income (helping your current-year taxes), but will be taxed when you withdraw the money in retirement.

401(k)’s, 403(b)’s, and IRA’s all have contribution limits, though. So how can you save more for retirement if you are maxing out those accounts?

Once you are maxing out your savings in your available retirement accounts, then you’ll want to save in a taxable account (i.e., a non-IRA). Although taxable brokerage accounts do not offer the tax advantages that retirement accounts do, they are more flexible and can be used prior to age 59 1/2 without any penalties.

But be careful about how you invest. You may owe taxes on dividends and capital gains incurred in this account. It may be worth consulting a financial planner to help you determine some tax-efficient investments for this account.

Retirement Is about Freedom

“Early Retirement” carries different meanings for different people. For some, that means retirement at 55. For others, it’s 62. The point of planning for early retirement is to provide yourself the freedom to decide when to retire.

As with anything, there are tradeoffs. But if you like the sound of early retirement, then start planning for it today.