For frugal savers and extreme planners, early retirement is a possibility. When it comes to retirement planning and timing, extreme savers who expect to be financially independent by the age of 40 defy the norm. Only 14 percent of retirees quit working when they were under the age of 55, according to the 2020 EBRI/Greenwald Retirement Confidence Survey, compared to 19 percent at age 55 to 59; 11 percent at 60 or 61; 26 percent at 62 to 64; 13 percent at 65; 11 percent at 66 to 69; and 6 percent who either retired at 70 or said they would never retire.
Important Points to Remember
- According to one general guideline, most retirees should aim to replace around 80% of their pre-retirement income.
- Remember that retirement income sources like Social Security won't be available until you're at least 62 years old.
- If you plan to retire in your 40s, a debt-to-income ratio of 20% or less is a good rule of thumb.
- To calculate your early retirement goal, multiply your projected annual retirement expenses by 25.
What Are the Difficulties of Retiring at 40?
While most people think of early retirement as a pipe dream, it is possible if you are willing to tackle some major financial planning challenges. The first step is to determine how much money you'll need to save in order to reach financial independence on day one.What Is an Appropriate Savings Amount?
According to a rule of thumb, most retirees should aim to replace around 80% of their pre-retirement income. This is the amount you should aim for in order to live comfortably after you stop working. Traditional retirement-saving benchmarks, such as this, may be appropriate for people planning to retire in their mid- to late-sixties. They are, however, less effective if you intend to retire early. And if you're a frugal saver who wants to retire at 40, you're probably used to cover your living expenses with a small portion of your income.Considering Social Security as a Source of Extra Income
Another issue is that one source of retirement income, Social Security, will not be available until at least the age of 62. In addition, because of their shorter work history, when early retirees become eligible for Social Security, their actual benefits are likely to be reduced. Benefits from Social Security are calculated using average indexed monthly earnings over the 35 years when you earned the most taxable income. Your expected monthly benefit will be reduced if you retire early and have no or limited earnings. Note that the age at which you are eligible for full Social Security benefits is determined by the year you were born. If you were born in 1960 or later, your full retirement age is 67. The majority of people who want to retire early see Social Security as a bonus. If you start saving early enough for retirement in your 40s, you won't have to rely on Social Security for income. The ability to leave the workforce on your terms—or at the very least have the freedom to retire when you're ready—usually necessitates a higher-than-average savings-to-income ratio, frugal living, and debt repayment.Taxable Investments, 401(k) Plans, and IRAs
If you want to work toward early retirement, there are a few things you should do right away. Save as much as you can in tax-deferred 401(k) plans, IRAs, and non-deferred investments. Socking away as much money as possible is the key to achieving early retirement. The location of your assets is almost as important as how much you save. Investing as much as possible in 401(k) plans, Roth and traditional IRAs, and large sums in brokerage accounts helps to diversify taxes. Early withdrawals from retirement accounts such as 401(k)s and IRAs are generally subject to a 10% penalty if taken before reaching the age of 591/2. Internal Revenue Code 72(t) and other special tax rules can help you avoid these penalties. You must make equal periodic payments that have a value based on the IRS' life-expectancy calculation under that IRS rule. The rule is most commonly applied in cases of illness or disability. Whether there is a penalty for early withdrawal or not, the early retiree must eventually consider the tax implications of their retirement income. You can withdraw the value of your Roth IRA contributions at any age without incurring a tax penalty. If you are under the age of 591/2, however, you cannot withdraw earnings from those contributions without paying the penalty.Developing a Passive Income System
Look for ways to receive streams of passive income or money that come to you without having to work for it if you want to retire early. Stocks of companies with a long history of paying dividends are a common source of passive income. You can choose to receive dividends in cash rather than reinvesting them in more shares of these companies after you have amassed a large number of shares in these companies. You don't have to invest directly in dividend-paying stocks; you can buy shares of a mutual fund or exchange-traded fund that focuses on companies with a strong dividend track record. Passive income can also come from a non-operating business or rental properties that you pay someone else to manage. It could also come from a song you wrote or another creation for which you are compensated with royalties.Costs of Living
Your ability to save is also heavily influenced by where you live and what you do for a living. During your working years, your cost of living must be a good match for the retirement lifestyle you desire. Minimalism and frugal living are gaining popularity among a growing number of people who value meaningful life experiences over material possessions. If you can achieve big life goals while working while spending a smaller portion of your income, you'll be able to maintain a similar enjoyable lifestyle in retirement. Living in small spaces and purchasing used clothing, furniture, and cars are just a few of the economical options available.Most Debt Can Be Avoided
If you want to retire early, you'll need to pay off high-interest consumer debt and keep your debt-to-income ratio low. In retirement, lower debt obligations help free up income for basic needs and lifestyle expenses. The majority of early retirees have the same goal of becoming debt-free before they retire. Debt obligations for real assets, such as a primary residence or rental properties, are an exception if the monthly debt payments are low. If you plan to retire in your 40s, a debt-to-income ratio of 20% or less is a good goal to aim for.Medical Points to Consider
- You can't consider early retirement without considering how you'll cover medical costs. For starters, Medicare eligibility does not begin until the age of 65. Because most people do not qualify for Medicare, you will need to look into other options for obtaining affordable health insurance.
- People under the age of 65 who have disabilities or end-stage renal disease can apply for Medicare early.
- Even with good coverage, out-of-pocket medical expenses can quickly add up. You'll also need to consider the costs of dental, vision, and hearing care, as Medicare only covers a small portion of these costs.
Early-Retirement Calculation Made Easy
Whether you're in your 30s or your 70s, there's no magic number for how much you should save for retirement. However, there is a widely accepted method for estimating that figure: Calculate how much money you'll spend in a given year during retirement and multiply it by 25. As you prepare for life after work, the resultant estimate will provide you with a number to aim for. This method assumes that you can withdraw 4% of your annual income without risking running out of money. Warning: If you plan to retire early, adhering to this rule may not leave you with enough money to live on until you die. It would be best if you talked to a financial advisor about any retirement plans you have. Here's a quick example of how the 4% rule works in practice. Assume your retirement goal is to have generated $40,000 in income per year. To achieve that goal, you'd need to have saved around $1 million by the time you want to retire. Let's take the example of a 25-year-old who saves half of his or her $50,000 annual income for 15 years. A $25,000 investment would increase to just over $628,000 per year, or nearly two-thirds of the initial investment, assuming an average annual return of 7 percent. It's important to remember that the 4% annual withdrawal rate is more of a recommendation than a guarantee. The 4 percent rule has several flaws, including the requirement to keep a large portion of your savings in stocks as you approach retirement age. In addition, it has been demonstrated that lower than 4% withdrawal rates increase the likelihood that your retirement savings will last as long as you need them to. The reality is that the future is always uncertain, especially for early retirees with a long withdrawal period, so keeping some flexibility in your retirement income plan is a good idea.