If you have ever thought about retiring early but your not sure how this is for you. When alot of people think of early retirement they might think it means just taking social security at age 62 instead of 65. I don’t know about you but that doesn’t seem early at all to me. I’m still forty years from being 62! No what I’m talking about is retiring much sooner than that- in your 50’s, 40’s, 30’s, or maybe even your 20’s.
The way to go about doing this is fairly simple- Live below your means, reduce your expenses, save money, invest wisely. I’ll cover everything in more detail below. I’m going include links to articles and books so that you can have a better understanding of everything I cover.
How Much Money Will You Need?
Calculating how much money you will need for retirement is fairly simple. Just multiply the amount you spend for one year by 25. So for example if on average you spend $25,000 a year you will need $625,000. Now you may be wondering where I got 25 from. There was a study done that says you can safely withdraw 4% per year from your portfolio without running out of money provided your portfolio consists of at least 50% stocks. 25 is the inverse of 4%.
I’m a little wary of the 4% rate so a 3% withdrawal rate may be a better choice. If you want to be a little more conservative and use 3% rather than 4% just multiply your yearly expenses by 30 instead of 25. If you still choose to go with 4% you will most likely be fine. I think it’s good to be flexible with your spending. If it’s a bad year for stocks and your portfolio loses value you can just lower the amount you withdraw until the market has time to recover.
Tracking Your Spending
To find how much money it takes for you to live off of for one year you should start tracking your expenses. It’s important to account for everything you spend no matter how large or small. For more information on tracking your expenses check out this article. Keep in mind that some expenses may actually increase in retirement such as health insurance so plan accordingly.
How Much Should I be Saving Each Year?
How much you need to save depends on how soon you want to retire. A longer timeline means you have to save less per year and it also gives your investments more time to grow. The sooner you want to retire the more you will need to save each year. I think a good goal would be to save between 60% and 85% of your income each year. To reach that level of savings you will probably have to reduce some of your expenses and live a more frugal life.
Setting up an Emergency Fund
It’s very important to have money set aside for unexpected events or the loss of your job.You never know when you might have unexpected car repairs or medical bills so you want to be prepared. An emergency fund gives you a financial cushion to fall back on. I keep my emergency fund in a savings account at a different bank from my regular checking account. This way the money is readily available but I wont be tempted to spend it.
Start out with a minimum of 3 to 6 months of expenses and from there it would be good to build it up to one year or more of expenses, put away enough money to give you peace of mind. Before retiring I think you should have at least two years of living expenses in your emergency fund.
How To Invest
To help us accumulate enough money for retirement and to provide income once we reach retirement we must invest. The investments that we will use are stocks and bonds. Owning stock means you own part of a company and are entitled to your fair share of profits through dividends and share price appreciation. When you own a bond you lend money to a company or other entity that is obligated to make regular interest payments plus pay back the original loan on time.
Rather than stocks and bonds of individual companies we are going to buy index funds. An index fund is a passively managed mutual fund that seeks to own all the stocks or bonds in the same proportions as the index it tracks. Some popular stock indices include the S&P 500, The Dow Jones Industrial Average, and the Wilshire 5,000. There are indices that track United States stocks, foreign stocks, small or large company stocks, bonds, and many more.
Owning an index fund rather than the stock of an individual company protects us from the risk of losing all our money should that company go out of business. An index fund may own hundreds or thousands of stocks or bonds so one company will have little effect on us.
You can great a great and simple portfolio with just three index funds: a total US stock market index fund, a total international stock market index fund, and a total bond market index fund. To learn more about this three fund portfolio click here. The amount you put in the total bond fund will depend on your risk tolerance. Bonds are less volatile than stocks and reduce the risk of a portfolio. The remaining portion could be split 50/50 between The total US and total international stock index funds.
If you would like to see a list of recommended books on investing click here.
How much will my investments earn for me?
Historically stocks have averaged about 10%. Going forward I think it would be very unwise to count on that number. Most experts seem to think that we will experience lower returns in the future. If your plans require you to earn a 10% return from your investments you either need to start saving more or further reduce your expenses going into retirement. It would be more prudent to figure in a 6% or even lower rate of return.
Types of Investment Accounts
There are three types of accounts most investors will use: a Roth IRA, a 401(k), and a brokerage account. In a Roth IRA you contribute after tax money but your money grows completely tax free and when you reach age 59 1/2 you can make tax free withdrawals. They are my favorite account however the contribution limit as of 2017 is 5,500 per year.
A 401(k) is an employer sponsored account that allows your money to grow tax free however you will have to pay taxes on your withdrawals. The contribution limits are much higher for 401(k) plans and some employers will even match part of the money you put in. The biggest downfall to these is most plans have limited choices to what investments you can buy and the mutual funds available to you might have high expenses. Like the Roth IRA you must be 59 1/2 before you can make withdrawals or you will pay penalties.
A brokerage account is just a normal account that you would open with an investment company such as Vanguard. While you do not get any kind of tax advantages you are free to withdraw your money at any time without penalties and you have a wide range of investment options to choose from.
A Word of Warning
The stock market is one of the greatest tools for accumulating wealth but it is also very volatile. Over the long run stocks have always gone up but some years you may see big losses in your portfolio. It’s not necessarily bad when the market has its downturns- in a way it can be good because you can buy stocks at a “discount”- however, losing money is a very uncomfortable feeling. Never panic and sell during a down market. If you just hold on to your stock the markets will come back up and you can see some very impressive returns. If you sell though you can guarantee that you will lose money. This is why I believe it is very important to educate yourself about investing, not just how to invest but also the history of investing and the stock market. Please check out the reading list for a good start to your education
You should also be aware that some companies charge much higher fees than others. When buying a mutual fund make sure the expense ratio is as low as possible. Some funds such as the Vanguard 500 index fund which tracks the S&P 500 index have expense ratios as low as .14% or even lower. Certainly try to avoid funds with expense ratios of 1% or more. Some companies will also charge you a front end load which is basically just a fee they charge before you can buy into a fund. Avoid these if at all possible. They do nothing to increase your return and simply go to line the pockets of the investment company