Want to retire early? Whether you have dreams of volunteering, lazing on a beach or enjoying your retirement overseas, getting there can seem tricky. With high costs for things like health care, housing, child care and transportation, it can even seem like an impossible dream.
Punching out early — permanently — doesn’t have to be a pipe dream, though. It’s not only possible, but doable. The catch: You’ll have to work (hard) at it.
Here’s what you need to start doing now if you want to achieve your dream of early retirement.
Just Start. Right Now.
Gretchen Hollstein, Partner and Senior Investment Advisor at San Francisco Bay Area-based Litman Gregory says not starting early is one of the biggest mistakes people make when it comes to saving for retirement.
Why does when you start matter? One of the greatest contributors to the size of your eventual retirement kitty is how long you spend building it up. To put it starkly, consider a very basic illustration. If you start saving $10,000 a year when you’re 25, you could have just over $1 million by the time you reach 55 (assuming an annual return on your investments of 7 percent).
But let’s say you waited until 35 to start saving. Even if you sock away $20,000 a year for the next 20 years, you’d still wind up with roughly $200,000 less in savings by the time you’re 55. Blame the disparity on the magic of compounding.
Jason Sherr, Senior Vice President and Investment Officer at Wells Fargo Advisors, sees people struggling most with getting organized.
“Most people do not have a plan,” he said. “Get something in place even if it is really basic. The plan helps to get you motivated and you know what you are working toward.”
Pay Yourself First
Hollstein offers two rules of thumb for retirement planning. First, save 10 percent of your income. Second (which Sherr also identified), pay yourself first.
Any income should first go towards your retirement savings, then to your emergency savings fund. After that, pay bills and discretionary expenses. Whatever vehicles you use to save for retirement, be sure to increase your contributions in line with your salary and compensation increases.
Plan Far Ahead
Both advisors agree you should plan for a long life.
With life expectancies rising (87 for women and 84 for men, according to Social Security Administration estimates), more people will be living well past the age they thought they needed to plan for. That also makes it important that people both plan ahead and “see themselves as the protector of their future self,” according to Hollstein.
Planning isn’t a one-and-done exercise. Sherr points out the need to stress test your plan.
“Go through different scenarios to see how your plan fares if things go well, poorly and everything in between,” Sherr said.
Run Your Numbers
Two key numbers you need to get a handle on are how many years you have before you retire and how many years you expect to be in retirement.
This requires a bit of future-gazing. In order to hit your retirement bogey, you need to have an idea of the income you expect to be bringing in from retirement savings, social security payments, pensions and any other income streams you can reasonably expect.
You also need to project how much you’ll be spending for housing, medical costs, vacations, transportation, insurance and leisure activities. Then you need to compare the two sets of numbers.
Warning: Although you’re eligible for social security beginning at age 62, the age for claiming full benefits is set to gradually rise to 67. On top of that, the earlier you tap into your social security benefits, the smaller the payments you’ll receive.
Run Your Numbers Again
Word to the wise: Many people underestimate their post-retirement living expenses because they assume once commuting, restaurant lunches and dry-cleaning costs are no longer factors, their expenses will drop drastically.
But not all costs fall. Some, like spending on travel and leisure, tend to increase.
Also, know that if you retire early, you’ll need to fund your own insurance costs until you’re eligible to tap Medicare. For most people, this won’t be until age 65.
Be Mindful of Inflation
The even nastier surprise for many is just how much inflation eats into savings. Projections of future costs have to take this into account. Keep two things in mind:
First, inflation has been below normal since the financial crisis period of 2007-08. But there’s no guarantee these low levels, around 2 percent, will last.
Second, cost increases for some big ticket items far outstrip inflation. These are things you have limited options for avoiding. We’re talking health care and college tuition costs.
You can find inflation calculators online that you can plug numbers into to get an idea of what costs will look like in the future.
Develop a Budget
Just as you don’t magically arrive at your vacation destination without first knowing how much you have and want to spend, you don’t get to early retirement by winging it. You need a road map.
If you’ve done some initial calculations of projected expenses, work backwards to figure out how much you need to spend today to have a shot at getting there. Compare that with how much you’re earning now, how much you are spending and what you’re consistently saving.
No idea where your money goes? Track your expenses. You can do this manually, or with an app such as Mint.
Once you know how much you’re spending, identify areas where you might need to cut back and come up with a plan for how to do it. Then, after you’ve got your budget together, stick to it.
Slow Your Roll
Your expense roll, that is.
The key is controlling your discretionary costs. That might mean moving to a cheaper city or living in a smaller house than you would prefer to save on living costs. It could also mean buying a used car versus a new one, or taking public transit.
Be realistic in your efforts. If you truly aren’t going to stop spending on daily take out lunches or vacations twice a year, find somewhere else to cut back. If doing those things isn’t possible or seems like too much of a sacrifice, then you need to find a way to boost your income.
Meet Your (Employer) Match
If you’re eligible for a 401(k), 403(b) or other retirement account through your employer, sign up as soon as you’re eligible. Contributions you make to a 401(k) are done on a pre-tax basis, so they have the dual effect of boosting your retirement savings and lowering your current tax bill.
On top of that many employers offer some form of match, say, 100 percent of your contributions up to the first 3 percent or a 50 percent match on the first 6 percent. While you do usually have to stick around long enough to vest, typically three to five years, not maxing out your 401(k) means you are missing out on free money.
If you’re self-employed, other tax-deferred retirement accounts are available, such as SEP IRAs.
Pre-tax retirement accounts also pay off in another way. Your contributions are not taxed until you start withdrawing them once you’re retired. By that time, you’re likely to be in a lower tax bracket than you are now.
Avoid (or Delay) Taxes
To be crystal clear, tax avoidance is perfectly legal. Tax evasion is not.
Just as timing and inflation do, taxes will also have a dramatic impact on your retirement stash. Yet not understanding how taxes impact their savings is one of the biggest mistakes people make. As Hollstein explains, $1 million in an IRA or 401(k) is not the same as $1 million in cash.
For instance, Roth IRAs are funded with after-tax income. Since you’ve already paid taxes on that income, once you hit retirement age or are ready to begin taking withdrawals, you can pull those funds out tax free (but not, with a few exceptions, if you’re younger than 59½). In a hypothetical portfolio of $1 million, with half held in a taxable account like a 401(k) and half held in a non-taxable account such as a Roth IRA, the tax bite can have a sizable impact.
As Hollstein notes, People need to “learn about how their assets will be taxed, so they understand how to create a helpful nest egg.”
Don’t Take Early Withdrawals
People who take money out of their retirement savings set themselves back in two ways. One, they are penalized. With few exceptions, the IRS levies a 10-percent penalty on early (before age 59½) withdrawals. You also have to pay taxes on the withdrawn funds. The other more insidious penalty — and this is true whether you take a distribution or a loan — is that you lose out on the benefit of compounding.
On top of that, if (as is likely to be the case) you’re unlucky with timing, you could wind up withdrawing funds just before a big run-up in the markets. So think really hard before taking funds out early from a 401(k) or an IRA.
Even if you really need the cash, try to tap other sources first.
Pay Off Your Debt
Maintaining outstanding debt balances, whether for loans or credit cards, makes your overall expense load higher. And if your debt is tied to the prime rate or some other floating rate, your interest rates could rise at the worst possible time, like just when you’re facing a large unexpected expense, loss of income or some other financial shock.
So pay off debt as quickly as you can. Then use the cash flow you free up to add to your retirement savings.
Choose Your Investments Wisely
Stashing all your retirement savings in bond funds because stocks seem too risky to you is a recipe for huge disappointment given that you need to make enough over time to beat inflation. Risking large chunks of your nest egg on the IPO du jour is also not a good strategy. Ditto for avoiding international stocks.
Successful investing requires time, commitment and most important, a diversified portfolio. People face the most struggles with selecting investments and then re-balancing (re-adjusting your portfolio to maintain your target mix of stocks, bonds and other investments) them as the market moves.
Hollstein says investing in target-date funds is a useful way to go “if selecting investments feels daunting. Because even though they have additional fees these funds offer a diversified investment allocation and a rebalancing strategy.”
Stay Focused
One final parting shot from Sherr: “Focus on the things you can control — how you are allocated, how you are diversified and, most importantly, how you behave and how much you are saving,” he said. “Everything else is noise.”