If you're like most people, your attention has probably been focused mostly on the present and near future as of late. Current financial concerns are understandably more pressing than longer-term goals, like retirement. But if you're not worrying about how you're going to pay your bills over the next couple of months, now is a great time to start crafting a retirement plan.
This is especially true for those hoping to retire early. Early retirement requires a strong emphasis on retirement savings while you're young, which not everyone is interested in or able to do. But if you would like to give it a try, follow the steps below.
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1. Decide what early retirement means to you
Everyone has their own ideas about what a normal retirement age is, and, therefore, what an early retirement is. For some, it might be 60, and for others it might be 40. Your first step is to figure out at what age you hope to retire so you can build your savings plan around that. If you have a more vague goal, like being able to retire as soon as it's financially feasible, then pick any age to start with and be prepared to update this estimate based on what you find out from the steps below.
2. Identify your target savings goal
You'll never know exactly how much you need to save for retirement, but you can come close by estimating. Estimate how long you're going to live and figure high. It's not unreasonable to think you could live to 90 or beyond if you're a healthy person. Subtract your chosen early retirement age from your estimated life expectancy to get an approximate length of retirement.
Then, total up your estimated annual expenses in retirement. This may include a rent or mortgage payment, utilities, insurance, groceries, transportation, medical costs, travel, and entertainment expenses. You can use your current expenses as a baseline, but remember that some costs you have now might go away as you age, like a mortgage payment if you pay off your home before retirement, while others, like medical expenses, may go up.
Plug all of this information into a retirement calculator. Use 3% per year as your estimate for inflation and figure a 5% or 6% annual rate of return on your investments. It's possible your money will grow more quickly than this, but you want to be prepared in case it doesn't. Your calculator should then tell you roughly how much you must save per month and overall to reach your goal. It's not a bad idea to build a cushion into that if you're worried about not having enough or a recession hurting the value of your savings when you need them most.
Subtract from your savings goal any money you're getting from a 401(k) match or any money you anticipate getting from a pension or Social Security in retirement. Create a my Social Security account to help estimate your Social Security benefit. The remainder is what you must save on your own.
3. Make adjustments as necessary
The above information will give you a sense of whether your early retirement date is feasible. If you're comfortably able to save what you need to and then some, you may even be able to move up your retirement date. Or if you're close to saving enough each month, you might be able to tweak your budget to free up the extra cash you need to stick to your original timeline.
If it's impossible for you to save enough for your chosen retirement date, even if you trim your budget back as far as possible, you will have to consider adjusting your retirement date. Follow the same steps as above, but run the numbers with different retirement ages until you find one that works for your budget.
4. Put your savings to work for you
You should probably put the bulk of your retirement savings in a retirement account. A 401(k) is a good place to start if your company offers one. You can contribute up to $19,500 to one of these accounts in 2020 or $26,000 if you're 50 or older, and your employer may match some of your contributions. If you've maxed out your 401(k) or your company doesn't offer one, open an IRA instead. You can contribute up to $6,000 to an IRA, or $7,000 if you're 50 or older.
You might have to make a choice between tax-deferred and Roth accounts. This dictates when you pay taxes on your money. Tax-deferred contributions reduce your taxable income this year, but then you pay taxes on your distributions in retirement. Roth contributions don't reduce your taxable income this year, but then you don't owe taxes on retirement distributions. Tax-deferred accounts make the most sense if you think you're in a higher tax bracket today than you'll be in once you retire, while Roth accounts are best if you think you're in the same or a lower tax bracket now than you'll be in once you retire.
If you plan to retire before 59 1/2, you may also want to keep some money in a taxable brokerage account. Withdrawing money from your retirement accounts before this age usually results in a penalty (though it's waived for those withdrawing money during the COVID-19 pandemic). Taxable brokerage accounts don't offer the same tax breaks, but if you hold your investments for longer than one year, they become subject to capital gains tax instead of income tax, which can save you money.
5. Revisit your plan at least once per year
Check in at least once per year to see if you're still on track for your goal. It's easier to make small adjustments annually than it is to try to come up with thousands of dollars more on the eve of your retirement. If you find you're off track, see if you can make small adjustments, like cutting spending, to get yourself back on track. If not, consider delaying retirement a little longer to give yourself more time to save.
