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Early Retirement Planning: 5 Steps to Prepare and Invest

Oct 29, 2018 3 min read Susan Johnston Taylor

Key Takeaways

  • Know your numbers as you plan future expenses in early retirement.
  • Make sure you have adequate funds in taxable accounts you can access now.
  • Anticipate that costs will rise over time.

The FIRE (financial independence, retire early) movement is gaining popularity, as younger adults save aggressively so they can leave the workforce before reaching traditional retirement age. They may continue working on creative projects that can bring in income, but the idea is to work because you want to, not because you have to.



People who want to retire early need to ask themselves: How much do I need to retire?

Before deciding whether or not you can afford an early retirement plan, you first need to determine how much savings you have, what your living costs in retirement will be and how far your savings will stretch to fit your desired lifestyle.

Here's a look at the steps to consider in early retirement planning.

Calculate the value of your entire portfolio

Add up the value of your entire portfolio, including taxable investment accounts and tax-deferred accounts such as an employer-sponsored 401(k). Keep in mind, though, that you won't be able to access some of this money until later in retirement. Early withdrawals from a 401(k) or a traditional Individual Retirement Account (IRA) may be subject to taxes and penalties, so it's preferable to keep enough money in taxable accounts (not subject to early withdrawal penalties) to live off until you reach full retirement age. Some people include their home in their net worth statement, but you can't live off the equity in your home unless you take out a home equity loan (which has to be repaid), get a reverse mortgage (which typically isn't available to younger homeowners) or sell the property. However, income from rental properties could be included along with other income streams that aren't tied to your job

Just as some investments might not be accessible to you in early retirement, some income streams won't be available to you until later. Unless you become disabled, you can't collect Social Security benefits until age 62, and Social Security's full retirement age for people born after 1960 is 67. If you have an employer pension, that money may be available to you later in retirement as well.

Estimate future expenses

To determine your cost of living in retirement, look at your current annual spending and spending trends over time. You may be planning some lifestyle changes in early retirement — for instance, moving to a less expensive area or getting rid of a second car, as you no longer need to commute to work — so you'll want to adjust accordingly. Work-related expenses such as dry cleaning suits, pricey lunches and contributions to a retirement account may disappear once you leave the workplace. But if your plans involve lots of travel or other activities, those costs may offset the savings on work-related expenses.


Understand the impact of rising costs and inflation

Once you've approximated your annual spending, you need to assume that inflation will drive those costs higher over time. Inflation rates vary over time, but according to the U.S. Labor Department's Consumer Price Index (CPI), the 12-month change was 2.4% in July 2018. Because inflation rates typically outpace the interest rates offered on savings accounts, the bulk of your retirement assets should be invested in a diversified portfolio based on your risk tolerance, not stashed in a savings account.

Factor in health care costs

Future healthcare costs are one of the biggest unknowns for early retirees, because it's nearly impossible to predict what your future medical needs might be and what might happen to insurance costs in the future. However, if you already have ongoing medical needs or a chronic health condition, you'll want to budget accordingly and anticipate that insurance premiums, co-pays and prescription drug costs are likely to rise over time.

The future of the Affordable Care Act has yet to be determined, but, at least for now, you can use this HealthCare.gov calculator Opens in new window to see if your income qualifies you for subsidies on your insurance premiums. Medicare eligibility starts at age 65 and COBRA plans through an employer tend to be expensive, so many early retirees purchase health insurance through exchanges.

Know your withdrawal metric

How much money do you need? That depends on whom you ask and how much you plan to withdraw each year.

Some experts recommend using the 4% rule, which states you can withdraw 4% of your retirement savings each year and avoid running out of money because investment returns will hopefully offset withdrawals.

Other experts argue that the 4% rule was created in a time of higher market returns and does not apply to early retirees, who may need their money to last four or five decades instead of the traditional three. Instead, some early retirees use a more conservative withdrawal metric, such as the 10-year Treasury bond yield, which as of this writing was 2.87%.

Keep in mind that research shows the real returns of your portfolio over your first decade of retirement are a key indicator of whether it will be able to sustain you over your entire retirement. This is called sequence of return risk. The reason for this risk is that, with poor returns over the first 10 years, there's less money to compound and grow over the remainder of retirement.



What you can do next

Because early retirees need their money to last longer than traditional retirees, you may want to run the numbers for a few different scenarios. What would your spending look like if the market performs better than expected? If market returns lag or your health care expenses rise faster than predicted, how much could you reduce your spending while still meeting your basic needs? Would you consider returning to work part-time? Create best- and worst-case scenarios for spending, as well as contingency plans so you can adjust as conditions change.



Susan Johnston Taylor has written about personal finance and business for The Atlantic, The Boston Globe, Fast Company and U.S. News & World Report.


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