Early retirement is a topic that’s generated a lot of buzz over the past few years. More than ever, people are talking about not just retiring a few years early, but actually retiring as early as their 30s and 40s.
It’s an exciting prospect and it is possible with a little bit of luck and a lot of careful planning. There are a number of things to consider before you make the leap and this post will help you get started.
1. Prerequisites for Early Retirement
There are two big things I look for when evaluating whether a client should even consider early retirement:
- A mortgage that’s on track to be paid off by the estimated retirement date.
- A savings rate that’s about 50% of take home pay. This can really vary depending on the situation, particularly when clients are faced with sudden wealth.
A paid-off mortgage removes what for many people is their biggest expense, which makes it significantly easier to support their needs in retirement.
And a high savings rate is indicative of both lower expenses and a resistance to unchecked lifestyle inflation, both of which bode well for someone who is planning to live off their investments for 40+ years.
With those two things in place, early retirement may be a realistic goal. Without them, it probably isn’t.
2. The Value of Additional Income
While the whole point of retirement is to be able to live off of your investments without having to work, there’s a lot of value in the ability to earn additional income, especially for early retirees.
In this excellent post on safe withdrawal rates for early retirees, Brandon notes that the returns you earn in the first 10 years of retirement are critical to your long-term success. A big downturn in that first decade could put you in jeopardy of running out of money.
But if you have even a little bit of extra income coming in — whether from part-time work, a rental property, or anything else — you have more flexibility to choose not to pull money from your investments in a down market, which can shield you from the potential harm of early negative returns.
The other thing to consider here is that once you’re financially independent, you’ll have more freedom to choose work you genuinely enjoy. If you can do that and earn a little bit of money at the same time, it’s a win-win.
3. Maintaining an Emergency Fund
Especially in early retirement, it’s a good idea to keep 6-12 months worth of expenses in cash as an emergency fund.
This is another way to protect yourself against down markets, since you can temporarily pull from your emergency fund instead of your investment accounts. And in any case it will be there for any big expenses you didn’t plan for as well as any opportunities that arise.
4. Timing It Right
Every little bit matters when preparing for early retirement, and the timing of your retirement can make a difference.
Consider waiting until February or March of the calendar year so that you can max out your 401(k) and Traditional or Roth IRA for the year before you stop working and no longer have eligible income to contribute.
And if you have access to employer 401(k) contributions or stock options, you should be cognizant of when that equity vests so that you don’t accidentally leave before you’ve maxed out your benefits.
5. Roth Conversions
It’s very likely that your taxable income will be much lower in your first full year(s) of early retirement than it was when you were working, which could make it an excellent opportunity to start converting some of your Traditional IRA money to Roth IRAs.
The conversion will be taxed, but with the right planning you can manage it such that you fill up only the lowest tax brackets. If you do this systematically over a number of years, you can eventually build up a sizable investment base from which you can withdraw money tax-free.
6. Turning off Dividend and Interest Reinvestment
For investments in a regular, non-retirement brokerage account, you might consider turning off automatic reinvestment of dividend and interest income once you retire.
Doing so provides more cash that you can draw from, and it also limits the need to rebalance your portfolio when you need a little extra money, which can reduce the tax drag and trading costs and allow your money to grow more freely.
7. Health Insurance
Health insurance, and medical expenses in general, are a big variable when it comes to early retirement, but there’s some good news on this front.
If you purchase health insurance through an Affordable Care Act plan, your premium may actually go down once you’re able to show one year of lower taxable income due to the available subsidies. That is, of course, assuming that the current ACA rules stay in effect, which is not assured.
You may also be able to take advantage of a health savings account, which would allow you to benefit from the triple tax advantage of this type of account, particularly if you preserve money in the account and pay for medical expenses out of pocket.
Much to Consider
Early retirement is an exciting goal, but there’s a lot to consider if you want to do it well.
With the right planning, you can increase your odds of success, making it more likely that you’ll actually be able to enjoy all that newfound time and freedom.
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