Depending on who you ask, early retirement has different definitions. Generally, any time before your 62nd birthday when you are eligible to draw Social Security benefits. Recent years have seen the growth of the “Financial Independence, Retire Early” or FIRE movement, which encourages people to retire even in their 30s and 40s.
Many Americans do not know how much they will need to save for retirement, which poses a challenge. However, many people can achieve early retirement with dedication and planning. To find out if you can retire early, here’s an overview on how you can make that dream a reality.
What is Early Retirement?
Traditionally, early retirement was defined as retiring at age 60 as opposed to 65. Even though this is technically true, the notion of early retirement has evolved.
Taking early retirement doesn’t mean you’re completely done working. Instead, you work because you want to. In other words, you have the financial freedom to do whatever you please.
Early retirement is possible for people as early as their 30s or 40s. The majority of these people, however, also work in some way, often on their passion projects or some other activity.
To put that more succinctly, those who work this way work purely for their own sake, not as a necessity.
Remember that work can provide us with meaning, purpose, and fulfillment. Moreover, some studies suggest that people who retire early and do not work at all may die earlier than people who continue to work.
On the flipside, retiring early allows you to pursue hobbies or spend more time with friends and family. You can also launch your own business. Or, maybe you’re just fed up with the rat race.
It is therefore not the goal for many to stop working altogether. The goal is to be free to choose whatever you want to do.
How to Retire Early
If you want to retire early, there are a lot of factors to consider. But, here’s a blueprint you can refer to to get started.
Get the foundation in place.
Want to retire early? You first need to posses the right mindset. And, you’ll also need a financial plan in place — ideally as soon as you’re kicking off your career.
Take your savings strategy to the next level.
It’s crucial to change your attitude towards money if you’re serious about retiring early. And, to get started, a conscious tradeoff must be made whenever money is spent.
More specifically, a little belt-tightening won’t do the trick — despite popular opinion. Rather than swearing off your daily latte, the key is cutting back on high-cost expenditures. So, while making your coffee at home can help you stick to a budget, it’s also not going to make early retirement possible.
To put it simply, you should live well below your means. As result, you’ll be able to stash away a large part of your earnings.
How much should you be saving? Financial planners advise aiming for 30% of one’s earnings over a typical 40-year career instead of 10% to 15%.
That may sound like an unachievable goal. But, it’s possible if you automating your savings so that you don’t spend it. Also, whenever you come across a windfall of cash, think bonuses or tax refunds, contribute these funds to your nest egg.
Do not succumb to lifestyle creep.
If you get a huge raise or promotion, you know you should treat yourself. But as you earn more, there’s a natural tendency to spend more. Financial advisors call this “lifestyle creep.” Again, setting up an automatic deduction from your paycheck or a bank transfer can ensure that you save half of those additional dollars.
At the same time, it’s important to spend your dollars carefully without feeling restricted. For example, you can still travel after researching the best deals or finding ways to reduce your spending. Maybe you could visit a friend or family member and stay with them for a couple of days instead of booking a hotel room.
Again, just because you “retire” doesn’t mean that you’re no longer working. You could work part-time or maybe start a side hustle. This way you’ll have more free time while still having an income stream.
Spend less on housing.
Your greatest expense, and therefore greatest opportunity for saving, is probably your house. In fact, the average American’s housing budget consumes a third of their income, according to the Bureau of Labor Statistics.
But, what if want to buy a new home? Keep your home if it is large enough. If not, then don’t buy the biggest house you can buy.
To find out what you can realistically swing, use online calculators from Bankrate, NerdWallet, or Mortgage Loan. Based on your income and other financial information, these tools will let you figure out how much mortgage you can afford. Keep in mind, though, that you do not have to borrow the maximum amount. Keep your housing expenses to 30% of your income or lower if you would like to maximize your savings.
Make the most of tax savings.
Are you serious about retiring early? If so, you should put away as much money as possible in tax-favored accounts.
The most obvious place to start would be maxing out your 401(k). Employees can contribute up to $20,500 for 2022 to their 401(k). An additional $6,500 catch-up contribution is available to individuals over the age of 50 in 2022.
Another option is a Roth IRA.
Contributions to Roth IRAs are made after-tax. Remember that Roth IRAs require a certain level of income to qualify for contributions. You must have a Modified Adjusted Gross Income (MAGI) under $140,000 for the tax year 2021, or under $144,000 for the tax year 2022, if you file as a single person. If you’re married and file jointly, though, your MAGI must be under $208,000 for the tax year 2021, or under 214,000 for the tax year 2022 to contribute to a Roth IRA.
Combined, you can contribute the following amount to all of your IRAs;
- Under age 50, $6,000
- If you are 50 years old or older, you will receive $7,000
Furthermore, a SEP-IRA can be used to save a portion of the income from your side job, as well as your regular job.
If you’ve maxed out these retirement contributions and the funds in your budget, you may also want to buy an annuity. This is tax-deferred insurance product that guarantees a lifetime income. It’s a safe to prevent outliving your savings and can be a supplemental retirement income stream.
In addition, if you’ve got a high-deductible health plan, put as much into a health savings account as possible. When certain factors apply, an HSA can be a better investment than a 401(k). If the money is used for qualifying medical expenses today or in the future, HSA earnings aren’t taxed, and withdrawals are tax-free as well. As of 2022, for self-only coverage, you can contribute $3,650, and for family coverage, $7,300
Estimate your retirement savings.
Expenses and income estimates will be essential if you want to plan a successful early retirement lifestyle. Based on your Social Security income, your pension income, and any side jobs you may have, it is generally easy to estimate your retirement income.
As a retiree, most of your income is likely to come from Social Security and, to a lesser extent, pensions. These payments can usually be collected early, often as early as age 55 with a pension and at 62 for Social Security. You will, however, receive smaller monthly benefits if you take benefits early. Even if Social Security is simply the cherry on top of your retirement cake, that will affect your bottom line.
If you claim your benefits early, it will be projected on your Social Security website. It may be best to visit a Social Security office or meet with a financial professional if you’re part of a couple with two incomes to weigh options.
For example, if you die with a higher monthly benefit than your spouse, your spouse will receive your benefit. The early you claim your benefits, the less you receive, and the less your spouse could benefit if you die early.
You can estimate your monthly pension payments at different ages by asking your employer’s pension administrator. After you have these estimates, you’ll have a better idea of how much income you can expect for any specific period of time.
Calculating your expenses, on the other hand, can be difficult.
Create your post-work budget
Consider the lifestyle you want and how much it is likely to cost you when you are within five years of your desired early retirement. Identify where you will live as well as what activities you’ll pursue. Most people incorrectly believe that when they stop working, their expenses will decrease. The truth is that retired people spend about 20% more than they while working.
While you’ll have more time to pursue hobbies and take trips, this obviously costs more than working all day. And, if you leave the workforce young, you’ll likely have the energy and health the enjoy an active and most likely pricey retirement.
You should be aware that some items in your budget may increase faster than inflation as a whole. The cost of health care, for example, could increase by as much as 7% to 10% every year.
A retirement income calculator like T. Rowe Price’s Retirement Income Calculator can show you whether your portfolio is on track to make early retirement possible. Choosing between boosting your savings, reducing your lifestyle expectations, or delaying retirement will be a difficult choice.
In short, add up the pensions, Social Security, and savings you may be entitled to. Next, calculate your anticipated monthly expenditures (including income taxes) if you were to retire five years early and would be eligible for Social Security and pension benefits sooner. This should help you figure out your retirement budget.
The average American household budget.
If you look at the average American household budget, you can see how your budget compares. Using the Bureau of Labor Statistics’ Consumer Expenditure Survey, it is possible to determine how much is spent on everything from housing and transportation to clothing, entertainment and charitable contributions. Currently, data from 2020 is available.
According to the BLS survey, the average household earns $84,352 a year and spends $72,258 a year. Data shows that roughly $5,854 is spent on bills and other expenses a month. So, let’s break this down.
In 2020, households spent an average of $21,409 on housing, including rent, mortgage payments, utilities, furnishings, laundry and cleaning supplies, according to the BLS survey.
Taxes, interest, and maintenance accounted for about $7,473 of homeowners’ annual expenses;
- Mortgage interest: $2,962
- Property taxes: $2,353
- Maintenance, repairs, and insurance: $2,158
American households paid an average of $4,158 in 2020 for utilities, up from $3,737 in 2013, representing about 19 percent of all housing-related expenses. The calculation includes heating and cooling, internet service, and cellphone service.
- Natural gas: $414
- Electricity: $1,516
- Fuel oil and other fuels: $105
- Telephone services (including cellphone service): $1,441
- Water and other public services: $682
In the U.S., energy costs vary significantly by region, so Americans pay different prices to heat and cool their homes.
In 2020, stay-at-home orders and remote work brought down transportation costs by nearly 9 percent per household as a result of stay-at-home orders and remote work. On the other hand, household expenditures on vehicles increased slightly – just over 3 percent – in 2020 over 2019.
In 2020, the average household’s transportation expenses were:
- Vehicle purchases: $4,523
- Gasoline, other fuels and motor oil: $1,568
- Other vehicle expenses: $3,471
- Public and other transportation: $263
According to figures from the U.S. Census Bureau, American households earned an average of $84,352 in 2020 and paid an average of $9,402 in personal income taxes after accounting for $1,911 in stimulus payments from the government. Due to stimulus payments, taxpayers paid the lowest amount of taxes since 2015.
Federal taxes amounted to $8,812; state taxes amounted to $2,430; and other taxes amounted to $72.
- Food: $7,316
- Health care: $5,177
- Entertainment: $3,341
- Apparel and services: $1,434
- Personal care products and services: $646
Engage rather than beat the market.
Low-fee index funds are preferred over riskier, volatile investments like stocks or cryptocurrencies by those looking to retire early — specifically FIRE followers. If you’re unaware, the S&P 500 is an index fund that reflects the performance of the 500 largest companies in the U.S. based on market capitalization. Index funds are basically baskets of stocks that track the performance of a major stock index.
“The best advice I have is the conventional wisdom in the financial independence community is that it’s better to participate in the market than to try to beat it,” Ed Ditto of Early Retirement Dude told CNBC. “And one of the best ways to do that is to buy low-cost index funds. You’ll find that the Vanguard S&P 500 ETF is the darling of the FIRE set.”
If you invest in index funds, you get exposure to stocks from a wide variety of industries, explains Trina Paul for CNBC. Therefore, when you invest in an index fund that provides diversification, you take on less risk than if you bought individual stocks. You might see gains in another sector which will offset a decline in another.
FYI, from 1970 to 2020, the S&P 500 returned an average of 10.83% per year, according to Investopedia.
Getting started with investing.
TD Ameritrade, E*TRADE, or Vanguard are all solid options if you want to get started investing, suggests Paul. Unlike traditional brokers, these platforms don’t charge commissions for the trades they execute.
The money you invest in these funds, however, will be subject to expense fees known as expense ratios. An expense ratio is a fee charged to manage a fund. As an example, a fund charging 0.15% expense ratio would cost you $1.50 for every $1,000 you invest, clarifies Paul.
A robo-advisor, such as Wealthfront, Betterment, or Charles Schwab, is a great place to start if you don’t know where to begin assembling your investment portfolio. A robot advisor invests on your behalf after obtaining a picture of your current finances and future goals.
Typically, you’ll enter your age, risk tolerance, and investment horizon, she adds. After the portfolio is constructed, the robo-advisor will select stocks and bonds from a large selection. Upon reaching your financial goals, your portfolio will then be automatically adjusted over time by sales and purchases of funds.
Along with fund expense ratios, robo-advisors charge accounts fees. By reading the fine print, you will know how much money you will need to invest.
Following their success with index funds, some early retirees and FIRE followers move on to other asset classes requiring more expertise and knowledge.
“As time goes along, and as your portfolio starts to build, you owe it to yourself to take new risks,” Kiersten Saunders of rich & REGULAR. “I think what people find when they get online is they start to see all of the hype and the buzz around crypto, NFTs, real estate, these types of asset classes that are either very risky or have high barriers to entry.”
Know how far your money will go as inflation increases.
In order to plan for a comfortable retirement, you should consider inflation. “After all, if your retirement is 20 years away and you aim to save $1 million for it, that $1 million won’t have the same purchasing power in 20 years as it does today,” writes Selena Maranjian for the Motley Foul.
The inflation rate has averaged about 3% annually historically. Although, it has been different in different years. Over the course of 25 years, an interest rate of that kind will roughly halve your dollar’s purchasing power.
To illustrate how you can include inflation in your planning, imagine you’re still 20 years from retirement and anticipate living on the equivalent of a $50,000 income. “You could take the number 1.03 and raise it to the 20th degree — by punching buttons such as 1.03 ^ 20 on your calculator — getting 1.81,” states Maranjian. “Then multiply $50,000 by 1.81, getting $90,306. That’s the actual income in 2040 that would have a similar purchasing power as $50,000 in 2020.”
Dividend-paying stocks help combat inflation because they typically increase their dividends annually. As such, the stock price will rise over time as well.
“If you have, say, $100,000 invested in dividend payers with an overall average yield of 3%, you’ll receive $3,000 in dividend income this year,” she explains. “If those payouts grow by an annual average of 5%, in 10 years they will be generating close to $4,900 per year.”
The cost of annuities with inflation-adjusted features may also help combat inflation, as can investing in Treasury Inflation-Protected Securities (TIPS) bonds.
Consider your health (insurance).
In the years between early retirement and Medicare eligibility at age 65, no one wants to burn through their retirement savings by paying for unanticipated healthcare costs. Until you qualify for Medicare, you’ll need some health insurance coverage if you lose your employer-sponsored policy.
You can continue your employer-sponsored coverage through COBRA, join your spouse’s health insurance plan, or enroll in a health insurance plan through the Health Insurance Marketplace at HealthCare.gov. If you belong to an organization, such as AARP, you may be eligible for discounts on coverage.
Additionally, “long-term care insurance may be worth considering,” recommends Due Founder and CEO John Rampton. “In addition to the costs associated with long-term care, medical insurance for it can be expensive as well.” You might want to look into it while you’re still in your middle age to save money. Richer people may be able to pay for it themselves, while those with less wealth may not be able to afford it. This makes middle-income individuals the ideal candidates.
“By eating more nutritiously and exercising more, you may also be able to save a lot of money and years in retirement by taking care of your health,” John advises. And, if you have dependents, like a spouse or children, purchase a life insurance policy to protect their livelihood.
Work with a financial advisor.
You are faced with two major challenges if you wish to retire early;
- The retirement savings period is shorter.
- In retirement, you will have more time on your hands.
Working regularly with a financial advisor is a good idea unless you’re a season investing pro To make it easier for you to meet your retirement goals, an advisor can develop an investment strategy. A financial planner can also show you how much you need to invest each month to achieve your goals within a certain period of time.
You can work with your advisor to make sure that the money you receive lasts after you retire. Dividend income, required minimum distributions, Social Security, defined-benefit plans, and real estate investment income are examples of income streams.
Since you might end up working with that advisor for decades, it’s imperative to find someone you trust and are comfortable with. Also, the cost of a financial advisor should not be seen as merely their time, but as their expertise, too. After all, you will more than make up for the costs of that advisor if you work with one with the right expertise who can also steer you in the right direction.
Frequently Asked Questions About Early Retirement
How do I know when I should retire?
There are various factors you need to examine when you’re deciding when to retire. First and foremost, you need to how much you already have saved and will it help you maintain your lifestyle.
Additionally, you need to consider when you can start receiving different benefits. And, you need to determine when you can start taking advantage of your retirement plans.
What is the ideal age to become debt-free?
It’s often recommended that individuals are debt-free by the time they are 45 years old. Why at this age? By 45, you should have no debts except good debt like a mortgage. And, at this point, you should begin saving for retirement because this is where you should be in the second half of your career.
When can I start withdrawing from my 401(k) without penalties?
When you stop working, you can typically withdraw funds from your 401(k) without incurring penalties after age 59 1/2. As soon as you turn 72 (or 70 1/2 if you were born before July 1, 1949), you are required to take the required minimum distributions. If you retire later, you must take the required minimum distributions by April of that year.
How does early retirement impact Social Security?
“Workers planning for their retirement should be aware that retirement benefits depend on age at retirement,” notes the Social Security Administration. “If a worker begins receiving benefits before his/her normal (or full) retirement age, the worker will receive a reduced benefit. A worker can choose to retire as early as age 62, but doing so may result in a reduction of as much as 30 percent.”
“Starting to receive benefits after normal retirement age may result in larger benefits,” adds the SSA. “With delayed retirement credits, a person can receive his or her largest benefit by retiring at age 70.”
When you retire early, you lose 5/9 of one percent of your benefit for every month before the normal retirement age, up to 36 months. A benefit reduction of 5/12 of one percent per month occurs if the number of months over 36 is exceeded.
“For example, if the number of reduction months is 60 (the maximum number for retirement at 62 when normal retirement age is 67), then the benefit is reduced by 30 percent,” the SSA states. “This maximum reduction is calculated as 36 months times 5/9 of 1 percent plus 24 months times 5/12 of 1 percent.”
What is a good monthly retirement income?
Each individual will have a different definition of a good monthly retirement income. A good retirement income will depend on a variety of factors. At the minimum, this includes expected lifestyle in retirement, dependents, such as children or grandchildren, outstanding debts, and overall health.
However, a good retirement income is generally considered to be 70% to 80% of an individual’s last income before retirement.