Early retirement isn't just the subject you daydream about during boring work meetings. It's a real pursuit for the community of people who make up the FIRE movement -- which stands for Financial Independence, Retire Early. If you want to join the FIRE ranks and say goodbye to work life before your 60s, here are four steps to make it happen.
1. Downsize your living expenses
Downsizing your living expenses is a strategy that's straight out of the FIRE handbook. And if you're thinking this means you need to cancel your cable, you're only a tiny bit right.
FIRE proponents take downsizing to an extreme. You might move out of your two-bedroom place and into a studio in a cheaper neighborhood, for example. Trade in your car for a bicycle, and you'll forgo maintenance costs along with gas and insurance expenses. Swap out your iPhone for a generic smartphone with a low-cost provider. And yes, cancel that cable. You might hang on to your Amazon Prime membership, but only because you can use it to access free movies, shows, music, and books as well as shipping.
Your goal would be to live on 50% of your income or less. That frees up the other 50% for savings. There's another benefit, too. Scaling back your lifestyle today forces you to rethink what's really necessary. Learn to live comfortably on less now, and that naturally lowers your income needs in retirement.
2. Increase savings
This is an obvious point, but funding an early retirement generally requires a radical level of saving. The retirement saver who's on a more traditional timeline usually has to set aside 15% of income for a few decades to retire comfortably. That assumes this traditional saver needs to remain solvent for about 30 years. In your case, you may not have a few decades to save and you'll definitely need your money to last longer than 30 years. So, you have less time -- but you have to save more.
Here's a look at the numbers. Let's say you are 30 years old and you make $48,000 a year. If you saved 15% of your income including employer match for the next 35 years, you'd accumulate about $1 million. That assumes your contributions are growing at 7% a year on average. To reach that $1 million target in 20 years, though, you'd have to save and invest more than $2,000 monthly -- which is about 50% of your salary.
3. Diversify your savings
You could dump $2,000 monthly into your 401(k), but you may not want to. The IRS normally prohibits 401(k) distributions until you reach the age of 59 and a half. There is an exception to this rule, though. If you leave your job after the year you turn 55, the usual 10% penalty is waived. That age lowers to 50 if you are a public safety worker. You do have to take the money out of the 401(k) from your most recent job.
If your goal is to retire in your 50s, your 401(k) can support that -- assuming you have enough in your most recently active 401(k) to survive for a few years at least until you reach 59 and a half.
To retire in your 40s, though, you'll want to save additional funds outside your 401(k). Two options are a Roth IRA or a taxable brokerage account. You can withdraw your Roth contributions, but not the earnings, at any time. The earnings have to remain in the account until you are 59 and a half and it's been at least five years since you first made a Roth contribution.
The taxable account has no withdrawal restrictions, but you do have to pay taxes annually on interest, dividends, and realized gains -- which is not the case in your Roth account.
4. Step up your investing game
Since your timeline to retirement is short, you don't have much room for investing mistakes. You can't get too aggressive because you can't afford a lot of volatility. But you can't be too timid, either. You'll have a tough time reaching your savings goals unless you're seeing at least market-level returns in your portfolio.
So this year, become a student of investing. Learn about index funds, diversification, and asset allocation. Study the best practices of buy-and-hold gurus like Warren Buffett and Benjamin Graham. And -- this one's important -- review history's major stock market cycles. Read up on downturns and the recoveries that followed them. You want to get comfortable with the idea that the market can be volatile in the short term, and that you can ride out those cycles.
This could be your year
It likely takes some planning to start saving 40% or 50% of your income, but there's no better time than now to get moving in that direction. When your thoughts drift to carefree days with nothing on the calendar, shift your focus to the steps you're taking to retire early. Outline your efforts to downsize and save more, think through your strategy for avoiding IRS early withdrawal penalties, and plan out your self-directed investing education. Make 2021 the year you take action so your dream can take shape in the real world.