It's no secret that Americans are drastically underprepared when it comes to retirement. According to the National Institute on Retirement Security, 45% of households in the U.S. have zero retirement assets. The median retirement account balance for all working-age households is just $3,000.
Those numbers aren't exactly inspiring, but they don't necessarily paint the whole picture. While some workers are struggling to fund their 401(k) or IRA, others are getting prepped to leave their 9-to-5 gig behind well before their 65th birthday rolls around.
Charting a course for early retirement isn't easy, but with the right planning, it's possible to say sayonara to the workforce ahead of schedule. Below are the steps you need to take to make it happen.
- If you want to retire early, it's important to have a savings goal and a target date.
- If you have access to a 401(k), first max out that account if you can, or at least contribute enough to max out any company matching.
- If eligible, after you have funded your 401(k) open a Roth or a traditional IRA and make a plan to max that out too.
- If you are under age 50, you can put $6,000 a year into an IRA in 2020 and 2021.
Know Your Target
Retirement is really a numbers game and before embarking on a plan to retire early, it's important to have an end goal in mind. That starts with knowing how much money you'll need to cover your expenses once you're no longer working. Planning to live on 70% to 80% of your pre-retirement income once you retire is a good baseline to start with. If you're making $100,000 a year, for example, you'd need to generate $70,000 to $80,000 in retirement income between social security, pension income (if any), and investment income for each year you're retired.
Safe Withdrawal Rate
So how do you figure out how much you need to save? The best way to look at it is in terms of your safe withdrawal rate. This is the pace at which you can take money out of your retirement accounts each year without depleting your assets too quickly.
Historically, 4% has been the recommended rate for taking retirement withdrawals. You can compare this rate to the amount of income you expect to need in retirement to figure out how big your total portfolio needs to be.
For example, let's assume your goal is $70,000 a year in retirement income. The 4% rule dictates saving the equivalent of 25 times one year's income. In that scenario, you'd need $1.75 million to cover your costs in retirement, assuming that was your only source of income
If you're planning to retire early, you'll likely be looking at a longer horizon for spending down your assets. Using a rate of 3% instead can give you a more accurate number to work with. If that's the case, you'd need to save 33 times your target income amount, which would bump up the size of your projected nest egg to $2.3 million.
Retiring early means you may likely have a longer time frame for spending down your assets. Financial preparation is the key to having enough to live on after you retire.
Map out a Time Frame
Once you have a grip on the total you need to save, the next step is breaking it down into digestible bites. Knowing that you need to save $1 million or more to retire early can be daunting, but it's less intimidating to think of it in terms of what you need to save on a yearly or monthly basis. Calculating this number can also tell you if your goal is realistic.
If you're 35 and you want to retire by age 50 with $1.75 million in the bank, for example, you have 15 years to funnel away enough money to do it. If you're making $100,000 a year, you'd need to be saving at least 50% of your income annually to reach your goal, assuming, roughly, a 5% average annual rate of return on your investments. If you're not able to save as much as you need to based on your current salary, you need to either cut your spending, increase your income, or both, to make your timeline work.
Just knowing how much you need to be saving isn't enough; you also need to know where to put it. The first stop for your retirement savings is your employer's retirement plan if you have one. If you have access to a 401(k), for example, you'd want to max that account out first then move on to a traditional or Roth IRA. A solo 401(k) or SEP IRA are two options for self-employed savers. If you are under age 50, you can put $6,000 a year into an IRA account in 2020 and 2021.
If you have a high deductible health insurance plan with a Health Savings Account (HSA), you should also be contributing the full amount to your HSA. While these accounts are designed to be used for medical expenses, they can be a valuable savings tool for younger workers who are planning an early exit. Once you turn 65, you can take money out of an HSA for any purpose without incurring a penalty, although you will have to pay regular income tax on any distributions. That makes it a great backup when you've maxed out your other tax-advantaged accounts.
The Bottom Line
Retiring early isn't something you can do without a clear roadmap for where you want to go. The number one rule is to save, save, and save some more, but there's more to it than that. Being realistic about how much time you have to save, how much you can realistically afford to save—and what your expenses will be once you retire—can help to guide you towards your final destination.