In the first post in this series, we discussed the essential elements of mastering your finances. We briefly discussed the Trinity Study and the 4% safe withdrawal rate, and we took a hypothetical $800,000 investment portfolio and determined that withdrawing 6% every year leaves $48,000 to be spent. In today’s post, let’s talk more about determining how much money we truly need to retire early and some of the factors that play into making the very best decision for ourselves.
The less you spend, the earlier you can retire
Retiring early is like running a marathon. It’s pretty easy in concept, but once your tennies hit the road, things get a little bit more difficult. Let’s continue using the hypothetical $800,000 portfolio for the remainder of this discussion, but please do keep in mind that $800,000 is only an example number and should not be taken as “the number” that you’ll need to retire early. With the right lifestyle, an investment portfolio of half that value can support early retirement.
Also, passive income generated after retirement (i.e.: rental homes, odd jobs, etc) can help to ease the burden of living off our investments. It might extend our retirement reach. It might enable a slightly more expensive lifestyle. However, for the purpose of this blog series, I am assuming no (or very little) passive income post-retirement.
There are two trains of thought that govern our decision to finally call it quits:
- How much do I want to spend post-retirement?
- How much can I spend post-retirement?
The first train of thought, written in red, prioritizes your lifestyle. The second train of thought, written in green, prioritizes retiring as soon as possible. How quickly you’d like to retire will play heavily into which train of thought may work best for you.
Let’s look at the first train of thought: How much do I want to spend post-retirement?
Notice my use of phrase “do I want to spend” in this train of thought. In this scenario, we pre-determine the lifestyle that we want to lead once we call it quits. Meaning, do we want to travel overseas? Do we still want to attend sporting events, keep our cable or satellite television, stay in our big house in the suburbs, drive the same cars that we always have, etc.
In this situation, we need to accurately determine how much our desired lifestyle is going to cost every year, and that number will factor into the safe withdrawal rate for us and how big of an investment portfolio will be needed to support us in retirement.
For example, let’s assume that we’ve calculated $64,000 a year to maintain our lifestyle post-retirement. This includes everything that we spend money on in a year, from our home and cars to entertainment, food, taxes, investment fees and healthcare. If we have an $800,000 portfolio, the withdrawal rate needed to sustain THAT lifestyle is 8%, which is cutting it very close to our averaged 8.2% rate of return that we talked about in the first blog post of this series. Please note that your average rate of return will be different. Be sure to use your own number.
How risky are you? For me, this introduces far too much risk. Withdrawing 8% every year places a significant expectation on the stock market to continue performing well. Unfortunately we cannot control the market, and market corrections (in other words, dips) can take its toll on our investment portfolio during years of negative economic growth (in other words, losses).
However, your risk tolerance might be higher than mine. Or, you may be willing to seek part time work if things get tight. You may also have on-the-side income streams to help pick up the slack during those periods when the market isn’t doing so great.
And remember: be flexible. We can always live on less for a couple years in a stag-tastic economy (little growth, little loss) or when it takes a dip. For example, you may consider living on just 4 or 5% of your investment portfolio instead of 8% in down years. There are any number of strategies that can help to propel you through stock market fluctuations.
For the record, my wife and I have decided to be ultra conservative and live off of a 3.5% safe withdrawal rate after retirement next year. We decided to keep things conservative for the first few years until we get comfortable with our new lifestyle and get to know how everything is going to play out. We may increase our withdrawal rate after a couple years. We’ll play it by ear.
Determining the cost of your post-retirement lifestyle will be critical in making an accurate determination of the money that you’ll need after calling it quits. Remember that an increase in spending is always possible after a couple of years of jobless bliss (though, according to studies, your spending may actually decrease as you age). It may be smart to be more conservative to start, then slowly expand your lifestyle as you become more comfortable with your new way of life.
Now, let’s switch thought-trains and discuss the other: How much can I spend post-retirement?
If you absolutely hate your job and will do almost anything to retire early, this is the train of thought that will probably work better for you. Here, you are willing to sacrifice desired lifestyle status for the sake of retiring early. You are prepared to live a much more frugal lifestyle, perhaps downsize your house and car and sell some of your possessions (if needed) for the purposes of quitting corporate America as soon as humanly possible.
Instead of determining how much your lifestyle will cost like in the previous thought-train, we instead choose a date that we would like to retire and then do some simple math to determine how much we’ll have to live on. We then make adjustments to our lives so the cost of our lifestyle fits within our budget.
In other words, we figure out a reasonable post-retirement “salary” (that will come from our investments), and then design a lifestyle that fits within it.
To illustrate, let’s use another scenario. You are 35 years old and make fairly good money, but you can’t stand your job and want to retire as soon as you possibly can. Your house is pretty big, you drive a nice car and have over the years collected a pretty stinkin’ big collection of crap that you partially store in your garage and the rest in the back of closets. Typical American life.
But, you’ve also had it with corporate America. You want out, and quickly. You’ve saved $550,000 in your investments accounts. You’ve read the Trinity Study and think that 4% is a good estimate to start with. Great, let’s do some quick math. What if we retire TODAY?
Annual spending: 550000*.04 = $22,000.
Phew. You only have $22,000 to spend every year to stay at your 4% withdrawal rate, which will require a fairly significant downsizing of your lifestyle. But lucky for you, living on $22,000 is not all that difficult, especially for you who is willing to make a few sacrifices in order to retire pretty much right away.
All that crap stored in your garage and closets will probably fetch some cash. And speaking of storage space, a smaller home would definitely decrease housing costs. Also, drive a used 2007 Honda Fit rather than your 2014 BMW 328i to save a bunch of cash on transportation. Or, sell your car and rely on public transportation. Nix your cable or satellite service. Ditch your unlimited everything cell phone plan.
In other words, we are designing our lifestyle around early retirement. We prioritize retiring early by making the adjustments necessary to our lifestyle to ensure that our investments will support us for many decades of retirement, along with – hopefully – continued long-term investment growth.
If you want to retire next year, take your investment portfolio’s value (use your average rate of return to estimate value at the time of retirement) and multiply it by .04 for a baseline estimate of what you can spend without a full time job. You may find that you’re closer than you think. Or, you might determine that a more enjoyable part-time job can hold you over for a few years as you let your investments continue to build in the market.
A word of warning: Your investments need to be “available” for withdrawal before retirement – and we’ll talk briefly about that next.
Remember, your investments need to be accessible
Throughout this series, I have generically used the terms “investments” and “savings” to essentially refer to the money that you have saved. This includes both retirement and non-retirement accounts, such as:
- Bank accounts
- Savings accounts
- Retirement accounts, like 401ks and Roth IRAs
- Brokerage accounts
- CDs, Money Markets, Treasury Bonds, etc
Most “non-retirement” accounts are accessible at any time, while retirement accounts are “locked” (or accessible through a penalty) until you hit retirement age. However, there are exceptions. To keep this article more light-hearted, I will only discuss a couple strategies at a very high level and offer links to additional resources with detailed explanations of how each strategy works.
For example, one of the most popular methods is to use what’s called the “Roth Conversion Ladder“, which allows the tax-free withdrawal of funds from Roth accounts before retirement age, penalty free.
- Root Of Good has talked at length about the Roth Conversion Ladder
- Mad FIentist wrote an excellent piece about getting at your retirement wealth
- U.S. News writes of a few strategies to maximize your retirement wealth
Another exception is IRS rule 72(t) which, like the Roth Conversion Ladder strategy, allows withdrawing from 401k accounts before retirement age penalty-free, provided some conditions are met. Check out this blog post from Retire By 40 for a nice description of how that works.
If your investment money is primarily tied up in retirement accounts, then you’ll have a tougher time accessing (and living off of) that money without paying fees or utilizing one of the methods that I linked to above. If this part sounds confusing, talk to a qualified financial specialist to determine what might be possible in your situation.
My wife and I will use our brokerage account to primarily fund our lifestyle over the first few years after retirement while converting over portions of our traditional 401k accounts into a Roth. We may then employ the Roth Conversion Ladder strategy by withdrawing tax-free from our Roth later down the line. The benefit to this strategy, other than simply getting at our money, is a significant reduction in taxes – remember, our taxes count as part of our expenses, and reducing our tax burden is very much a part of designing a more frugal and cost-effective lifestyle as nixing our satellite TV service.
Also keep in mind that your investments do not include ownership of property or homes. The proceeds from the sale of a house, land or any other significant value source can add nearly instant easily-accessible cash into your investment portfolio.
In our third and final post of this series, we will take a look at designing our early retirement lifestyle by recognizing and understanding where our money is being spent, how to stop hemorrhaging cash and tips for employing sound savings strategies to maximize our retirement wealth.
Steve is a 38-year-old early retiree who writes about the intersection of happiness and financial independence. Steve is a regular contributor to MarketWatch, CNBC, and The Ladders. He lives full-time in his 30′ Airstream Classic and travels the country with his wife Courtney and two rescued dogs.