How Much Do You Need to Save to Retire By 40?
Early Retirement Is a Possibility for Frugal Savers and Extreme Planners
While early retirement may seem like a farfetched idea for most of us, it is a real possibility if you are willing to put your journey to financial independence on high speed rails.
In general, retirement confidence remains low with nearly half of all U.S. households being at risk of not having enough money in retirement. For extreme savers with ambitious goals of achieving financial independence by age 40, the general lack of retirement preparedness in this country does not affect their desire to challenge conventional wisdom.
Early retirement is a dream many people would like to achieve. But the reality is that transitioning to an early retirement creates some financial planning challenges. The first challenge is trying to figure out how much money you will really need to have saved once you reach Day 1 of Financial Independence. The answer: It depends on how you define retirement.
A general guideline for most retirement savers is to strive to replace around 80 percent of pre-retirement income. This income replacement goal is a target amount set to maintain your same comfortable lifestyle during retirement. Retirement benchmarks like this may work for the majority of workers planning on a more traditional retirement start date in their 60’s. However, traditional retirement saving benchmarks are less effective if you are planning on an early retirement. This is because early retirees are likely already used to requiring much less than 100 percent of income to cover living expenses.
Other challenges include the realization that retirement income sources such as Social Security will not be available until 62 at the earliest. When early retirees are eligible for Social Security the actual benefits will likely be reduced due to a shortened work history. That is because Social Security benefits are based on an average of indexed monthly earnings during the 35 years in which you earned the most taxable income. Any early retirement years with zero or limited earnings will lower your anticipated monthly benefit.
Most prospective early retirees view Social Security as an added benefit. Let’s face it, if you have the ability to aggressively save enough for retirement and the desire to transition into financial independence in your 40’s you most likely will not be relying on Social Security alone if at all. The ability to walk away from the workforce on your terms (or at least have the freedom to retire when you are ready to) typically requires a combination of the following ingredients: above average savings-to-income ratios, frugal living, and eliminating problematic debt.
Here are some additional tips about ways to position yourself for early retirement:
Save as much as possible in 401(k), IRAs, and taxable investments. The key to achieving early retirement is usually centered around aggressively saving as much money as possible. This may sound like a no-brainer and most financial planners already suggest maximizing savings. But you also want to focus on saving in the right places or asset location. Contributing up to the maximum amount possible in 401(k) plans, Individual Retirement Accounts, and brokerage accounts helps create a sense of tax diversification.
In general, retirement accounts such as a 401(k) or IRA have a 10 percent early withdrawal penalty for distributions prior to age 59 ½. Special tax rules such as Internal Revenue Code 72(t) can help avoid these penalties. But early retirees ultimately need to factor in the tax implications related to where they will generate retirement income.
Maintain living expenses that do not match your income level. Where you chose to live and your lifestyle choices will have a strong influence on your ability to save. That is because without large amounts of discretionary income those retirement dreams will stay dreams. Your living expenses during your working years must also be a good fit for your desired retirement lifestyle. Minimalism and frugal living concepts remain popular across a growing group of people interested more in accumulating meaningful life experiences rather than stuff.
If you can accomplish important life goals while requiring a smaller chunk of your earnings you will likely already be used to a lower income replacement rate in retirement while maintaining your same comfortable lifestyle.
Eliminate high interest consumer debt and maintain a low debt-to-income ratio. Lower debt obligations in retirement help free up income for basic needs and lifestyle expenses. Most early retirees share a common bond of becoming debt-free prior to their retirement transition. Manageable debt obligations for real assets like a primary residence or rental properties are an exception as long as monthly debt payments are low. A 20 percent or lower debt-to-income ratio is a suggested guideline if you are planning on retiring in your 40’s.
If saving at least half of your income isn’t a potential barrier for your financial independence plans, there are other things to consider. For one, Medicare eligibility doesn’t kick in until age 65. That means you will need to consider alternative ways to obtain affordable health insurance.
The Simple Calculation: Multiply your desired “early retirement” income by 25
How much retirement savings will you really need for retirement? Take your projected annual expenses during retirement and multiply this amount by the number 25. This will help you estimate how much you will need to reach your early retirement goal. The retirement savings benchmark assumes that you can withdrawal 4 percent of your investments each year without substantial risk of running out of money.
Here is a brief example of the 4 percent withdrawal guideline in action. Let’s assume your retirement income goal is to generate $40,000 of investment income per year. To meet this goal, you would need to save approximately $1 million at your desired age of retirement. Now let’s look at a 25-year-old earning $50,000 a year with the ability to save half of her income for 15 years. Assuming a moderately aggressive 7 percent average annual rate of return, $25,000 invested per year would grow to just over $628,000.
The 4 Percent Rule provides guidance for how much you could potentially withdraw annually once you're retired. In the previous example, the early retiree would anticipate having a little over $25,000 in annual income using a ballpark estimate.
It is important to note that the 4 percent withdrawal rule is more of a guideline than a guarantee. Recent academic research has challenged the 4 percent rule for sustainable retirement account withdrawals. Lower withdrawal rates have been shown to increase the probability rates that the retirement nest egg will be there throughout your retirement years. The reality for early retirees with a long withdrawal period is that the future is uncertain and it is important to maintain some flexibility when creating a retirement income plan.