The first step to saving for retirement is to understand what retirement really means. It’s no longer just an age, it’s the time when you have enough income from other sources besides work to be able to support you and your family.
If you haven’t already, create a detailed budget to know what your monthly and annual expenses are. The main categories to budget for are: housing, health care, transportation, any schooling expenses, monthly recurring expenses, annual expenses, your monthly disposable expenses (food, shopping, etc), and any traveling expenses. Many people and investment sites then recommend that you reduce this amount a bit to account for less taxes and other expenses in retirement. A common multiplier used is 85%. I personally don’t reduce the amount as I’d rather aim high just in case.
Once you have your annual expense number that you need to replace, simply multiply it by 25 to get your magic retirement number. Why 25 you ask? Because that follows the 4% safe withdrawal rate rule of thumb. There was an extensive study (called the Trinity Study) that ran a ton of scenarios over the entire time of the stock market to determine the safest withdrawal rate. “Safe” is defined as the amount you can withdrawal every year and your money is virtually guaranteed to last 30 years. This includes retiring right before the Great Depression and other similar stock market shocks. It’s a hotly debated number in the investment community. One of the authors themselves recently came out and said he actually withdrawals confidently at 5% (so you could use a multiplier of 20). People aiming to retire early will definitely want their money to last longer than 30 years, so you may want to withdrawal at 3.5% for your money to last 50 years (28.57 multiplier), according to a recent analysis. I personally still use 4% as my target.
Now that you know your expenses and your target retirement total, let’s look more specifically at your different types of retirement income and their pros and cons.
- Tax-advantaged accounts are primarily your 401k and any IRA accounts that you have. You should try to max out your contributions for both of these if possible. The downside to be aware of is that you will get heavily penalized if you withdraw any money before age 59.5, so if you plan on retiring early, you should plan on supporting yourself using different income stream(s) until you reach this age. Also note that once you hit age 72, you are required to begin withdrawing money from these accounts, so keep that in mind to reduce your withdraws from other types of accounts.
- Brokerage accounts (or other types of private investments) are yours to do whatever you want with, so these will likely be your main source of income if you retire early. A big advantage to buying stocks with your brokerage account is that you can focus on ones that pay a dividend. Dividends are money that can go directly to you without having to sell any shares. You typically reinvest these into additional stocks while you’re still working, but you can change that once you retire.
- Real estate investments are a great source for passive income. Any net income you have after expenses can directly come off of what you need to withdraw from your other investment accounts. As the mortgages are paid off over time, you’ll get a jolt of new passive income without any additional work too.
- Social security is the biggest unknown to me. It should be something I can lean on to reduce other savings goals significantly, but it’s become such a political hot potato in recent years that I’m afraid to include it in my retirement planning. If it’s still around and paying well, the only downside to my planning is that I’ll have extra money, which seems safer than trying to rely on it. Note that you can’t get social security before age 62, so if you’re planning to retire early you can’t count on it at first, and also be aware that your payments will be lower since you’re contributing less than if you retired later. If you start collecting social security between ages 62 and 67, you’ll get a reduced payment because you haven’t reached “full retirement age”. Lastly, if you are able to delay collecting social security until age 70, you’ll get additional money in your monthly payments for life.
In summary, here’s what I did/do:
- Created a separate area of my budgeting spreadsheet to estimate what my family’s total annual expenses will be in retirement.
- Next to that, I list out the total annual net income from our investment properties and subtract this from the annual expenses.
- Then I look at other investment draw down in two ways:
- First, I take our total current investment balances (combining tax-advantaged with all others) and multiply by 4% to see how much potential income we could have if we retired today.
- Second, I project out each year’s total balances using our current savings rate and estimated market returns (~7%), and I do this for as many years as it takes to hit the magic retirement number.
- Then when I update my monthly budget, I’ll update the current balances, see if things are getting better or worse, and then play with all the numbers to daydream different early retirement scenarios.