Early retirement may mean the freedom to pursue a passion project or a philanthropic endeavor. Early empty-nesters might be looking to travel or simply enjoy a longer retirement without the restrictions of the workplace. One thing that is clear is that the trend toward taking early retirement is rising. The COVID-19 pandemic gave some people a new perspective on work-life balance. Fat stock portfolios from a booming market and increasing home equity in a strong real estate market have made the goal realistic for more people.
Retiring early does require some solid financial planning, such as determining how to live in retirement, creating a retirement budget, and altering spending. Those who want to retire early need to start planning as early as possible.
“The key is really planning very early,” says Titan retirement expert Eddie Lopez. “I used to work with a great advisor, and he had a saying: Financial planning is just bringing the future to the present.”
Here are 5 things individuals should think about as they consider doing just that.
1. Determine how much income is needed in retirement
What does a fulfilling retirement look like? Will golf expenses markedly increase, or will more time be spent traveling? Aside from leisure goals, will individuals still have dependents or loved ones they might want to help financially?
To start figuring out how much income they’ll need in retirement, investors typically factor in health care and other living expenses to tally how much retirement will realistically cost. To make this exercise a little less onerous, they can take advantage of retirement planning tools, which prompt investors to plug in information like their current annual income, investment style, expectations for retirement and Social Security income, and spending estimates. Investors may also have (or may add) investments that generate passive income, such as real estate.
2. Calculate your target number
The Financial Independence/Retire Early (FIRE) philosophy has risen in popularity over the last two decades. Characterized by serious savings and investment plans geared towards early retirement, its basic formula asserts that one needs to save and invest 25 times their annual spending to become financially independent. The assumption is that a person can become financially independent when they need only to draw 4% of their portfolios each year.
FIRE is not a hard-and-fast formula. There are variations on the theme:
- Fat FIRE. The Fat FIRE adherent may be less willing to live in total frugality now to retire super early, so they may simply save and invest more than most workers but not deny themselves small pleasures in the meantime.
- Lean FIRE. This school of thought involves extreme savings and possibly serious restrictions to meet the goal.
- Barista FIRE. This type of early retiree has enough money to retire early but supplements their retirement through a side hustle or part-time job for health insurance and some income.
Investors might not fit perfectly into one of these boxes, but the FIRE formula can be useful for calculating one’s savings and investment profile to reach their target number.
3. Save first; spend second
A FIRE adherent or not, virtually anyone who wants to retire early will want to consider reducing current expenses and channeling that money toward retirement savings.
“The thing to do is save first,” says Lopez. “I think 95%, 97% of Americans spend first. When money comes in, they spend, and then they hope that they have money leftover by the end of the month to save. You need to be your own CFO. Save first, then everything else gets paid thereafter.”
Adjusting the ratio of spending to saving can be accomplished in multiple ways:
- Spending less. Cutting spending now and funneling it toward savings or investments can add years to a retirement plan. Even those who are not strict FIRE adherents might look toward FIRE strategies for cutting spending; everything from traveling differently to saving on fuel and groceries. It all adds up.
- Cutting debt. Those who plan to retire early examine all their debt, even mortgage debt, which is generally considered “good,” and pay it down in anticipation of retirement. A fully paid-off house means one less expense once there’s no longer a salary. “I always tell folks: You want to earn interest, not pay interest,” says Lopez.
- Lowering the retirement budget. A generally accepted rule for post-65 retirement is that a person’s retirement income should be about 80% of their final salary. FIRE and other early retirement planners often reduce that budget to a fraction of their final salary.
- Adding passive income. Real estate investments that generate income, including rentals, real estate funds, and crowdfunding are all ways of generating passive income streams.
- Adding active (but part-time) income. Like the Barista FIRE early retirees, some people choose a part-time job in early retirement that they don’t rely on for a salary, but that pays or supplements health insurance and other expenses.
A combination of these strategies can change a person’s retirement plan, but the mix is highly subjective. The key question when evaluating how to choose from the options is: How much feels comfortable to sacrifice now for relative ease later?
4. Contribute to retirement accounts
Diverting money to retirement accounts, such as 401(k)s, individual retirement accounts (IRAs), and Roth IRAs, is a key strategy for those trying to optimize their savings. These tax-advantaged accounts are part of a strategy that involves reducing individuals’ tax burden. Each comes with different advantages and restrictions:
- 401(k). Employers establish 401(k)s to provide benefits for their employees, and employers sometimes match their employees’ contributions up to a certain amount. In 2021, the maximum annual contribution by an employee is $19,500. If investors will turn 50 or older before the end of the tax year, they can add $6,500 to that amount. The employee won’t pay income tax on the money when they divert it to their 401(k); rather, they’ll pay income tax on those funds when they withdraw them in retirement.
- IRA. A traditional IRA functions similarly to a 401(k), but is not tied to a workplace. The annual contribution limit is $6,000 for those contributing through age 49 and $7,000 for those age 50 and up. Experts consider the main benefit to an IRA to be investors’ ability to reduce their taxable income by the amount they contributed for that tax year. They won’t be taxed until they take distributions from their account.
- Roth IRA. A Roth IRA is a retirement savings account that lets investors contribute after-tax money. So they’ll pay income tax on contributions when they’re made, but not when they withdraw them in retirement. The Roth IRA contribution limits for 2021 are the same as for a traditional IRA, but there are additional eligibility requirements for contributing to a Roth: Single taxpayers must make less than $125,000 annually and joint filers must make less than $198,000 to contribute.
5. Invest for growth
Investing for maximum growth is a key idea for those who plan to retire early, which is where the concept of compound interest comes into play. Investing in assets whose interest compounds, or multiplies, along with the principal, maximizes an investment. For instance, if an investor makes a principal investment of $100 that receives 10% interest each year, that earns $110. When that $110 receives 10%, it multiplies to $121, and so on.
For those who intend to retire earlier, a shorter time horizon makes investing for growth early on even more important. Dividend-paying stocks and mutual funds can compound profits when you select a dividend reinvestment plan. When these assets are held in a tax-advantaged account, such as an IRA, the compounding value of the investment is protected until the funds are withdrawn.
Whatever age investors decide to retire, they can begin planning now with their financial advisor to create a balanced portfolio that is geared toward long-term growth that will pay off once they’re no longer collecting a salary.
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