How to Save for Early Retirement
For the average person, retiring early requires planning, saving, and investing—just at a faster pace and on a shortened timeline than those aiming for traditional retirement at age 60 or 65. Reaching financial independence—the more accurate and often preferred term for early retirement—means saving and investing more money earlier because you’ll need access to those funds sooner and for a longer time.
Define what financial independence means for you
Before you start thinking about strategies to reach financial independence, you should decide what that term means for you as this will help you pinpoint your saving and investing goals. For most people, “financial independence” means you, and not your employer (or a large amount of debt), get to decide how you spend your time.
This could mean you only work part-time or on a consultancy basis. Maybe you switch career tracks and pursue a passion that’s been on hold or work for a nonprofit. Perhaps you want to fill 40 hours a week with volunteer work or make extended travel a top priority. Regardless of your vision for financial independence, the steps to reach that dream will be very similar.
How much will you need?
Step one on your road to financial independence is setting a net-worth target. This includes calculating how much money you’ll need in passive income (i.e. income generated by investments and not hourly work) each year to achieve your unique dream of financial independence as well as regular contributions to traditional retirement accounts (401(k), 403(b), IRAs, mutual funds, etc.).
Calculate your anticipated cost of living every year. You can use your current budget and expenses as a guideline. However, many people imagine they will spend less in early retirement, when in fact studies show that those who become financially independent spend up to 20% more than before—which makes sense if you use your newly freed time for things like new hobbies and travel. Keep this in mind when estimating your needed yearly income.
Don’t overlook the cost of adequate medical insurance, either. You’ll need coverage until Medicare kicks in at age 65. The best option is continued coverage through your or your spouse’s job or former employer. If this isn’t an option, you’ll need to purchase individual insurance, and that can cause sticker shock, especially if you have any preexisting conditions. Research coverage offerings, possibly with the help of a health insurance broker.
Finally, consider how long you will need this income before you can make withdrawals from your traditional retirement savings without incurring a penalty. In other words, how many years between your desired financial independence and age 60? Now multiply the cost of living you already calculated by that number of years. There’s no doubt it’s a big number. Thankfully, you don’t have to save that exact and very large amount—you need to invest a smaller amount so that your net worth becomes that large number through compounding interest, returns, and dividends.
How you get to that target number—and stay there
The same principles for traditional retirement savings apply to an early retirement strategy: minimize taxes and allow your gains time to compound. The differences will be how much, how early, and how aggressively you save and invest (hint: it will be as much as you can, as soon as you can, and aggressively but prudently). The earlier you want to “retire,” the more compromises you’ll need to make between your current lifestyle and your future goals so you can save and invest more.
If having a hard number helps you envision how much you’ll need to start putting away in investments, financial planners will tell you that, at a minimum, you need to invest 30% of your income, but more likely closer to 50% to 60% if you want to speed up that retirement date. Again, this number will vary based on your unique situation, but it’s a number to start with.
But what to do with all of that money? Invest in tax-advantage investments without early withdrawal penalties. Here are a few to consider:
Defined benefit pension plans are rare these days, but there are a few employers that offer pensions that begin paying out immediately when you separate from the company or organization, regardless of age. If this is an option for you, take it. It could mostly or entirely fund your early retirement!
Bonds are loans you make with your money to a company or government and they pay you back plus regular interest payments. Most tax-exempt bonds are state and municipal bonds. Their yield—the interest you earn—is exempt from federal income tax. Municipal bonds from the state you live in allow you to avoid state and federal taxes.
U.S. Treasury bonds also offer tax advantages on the state level. Their yields may be lower, but they are considered one of the safest, surest, and most tax-efficient incomes for your investment portfolio.
Stocks are investments in for-profit companies. Currently, taxes on long-term capital gains and dividends are capped at 15%. Plus, you only have to pay this tax if you receive dividends or sell shares.
As a property owner or real estate investor, you’re allowed to write off large portions of rental income. Investment real estate can also produce sufficient income to fund an early retirement, especially if you invest and deal in a rental property market where demand is consistently high.