Over the last couple of years, Sarah and I have essentially been living on one salary. We’ve been investing every dime of my income (minus taxes and specific professional expenses) since late 2011 and living purely off of Sarah’s income. I like to think of it as if we’re saving 50% of our income.
That is an incredibly tall order for a lot of people. If I had told myself in 2005 that Sarah and I would be putting literally half of our income in the bank, I simply would not have believed it.
The question that most people ask is why. Why would we choose to not enjoy life with the income that we have? Why are you choosing to just walk away from all of the good things that you could have? The biggest reason is that Sarah and I have made the conscious decision that financial independence is the one thing that we most want.
The truth is that if we want to retire early, we need to save at an incredible rate. That’s true for almost everyone that dreams of retiring significantly earlier than typical retirement age.
Let’s walk through the math.
How Much Do You Need to Retire for Good?
In an environment with incredibly long average lifespans, where people have better than a 50% chance of living into their eighties and a pretty significant chance of living until they’re over 100, you’re going to need some serious resources in the bank to retire before age 65.
If you retire at age 60, for instance, you’ll want to be in a position where you can live for at least 40 years off of your savings. That’s a lot of years.
In fact, I think it’s best to have enough money to live forever on your investments if you’re going to retire early. That way, you’re covered no matter how long you live and no matter how many medical discoveries occur in the next fifty years.
So, how much money is that? Before you know that, there’s one key question you have to answer.
How Much Do You Live on Each Year?
The easiest way to figure that out is to start digging through your checking account. What was your balance at the start of 2014? Take that, add all of the deposits during 2014 to that number, then subtract the final balance. That’s how much you spent.
Naturally, this doesn’t include things like pre-tax retirement contributions, but you won’t need to be making those in retirement. What you will need to include is how much you spent on health insurance, which, if it’s provided by your employer, will be stated on your tax documents.
Now, there are some expenses that you have now that you won’t have in retirement. You won’t have commuting costs for work, for example, nor will you have professional wardrobe costs.
The exact estimate of those expenses is hard to specify, but I usually encourage people to figure that all work expenses add up to 20% of one’s annual spending, so just multiply that total spending by 0.8 to obtain a number equal to how much you spend each year in the absence of work.
So, let’s say that my family spends $40,000 each year. If Sarah stops working and I stop working, that means that quite a few costs go away. There are no daily commuting costs for Sarah. There’s no need for professional wardrobes. There are no expenses for me, either. We’d probably switch to having just one car. It’s completely reasonable to assume that those add up to 20% of our income, cutting our spending down to $32,000 per year in retirement.
Now, multiply that final spending number by twenty five. That gives you a very good estimate of what you’ll need to save for to retire in perpetuity.
Where do I get that number from? I’m assuming that you’ve invested that money for the long term in a broad-based index fund with very low expenses. Warren Buffett estimates that, over the long term in the future, the stock market will return 7%, and that inflation will sit around 3%. That leaves a 4% gap between those two numbers which represents the “real” growth of your money. That’s what you’re going to live on.
4% times 25 is 100% – in other words, the amount you need.
Again, let’s look at our example. We’ve estimated that we will need $32,000 per year to live on for the long haul. If we multiply that by 25, we’ll need to hit $800,000 in order to live in perpetuity at that level.
What About Taxes?
Of course, income taxes won’t go away at that point. We’ll still need to withdraw $32,000 a year from our investments to live on (and that number will slowly go up over time). Won’t I have to pay for taxes, too?
For one, a lot of that money will come from retirement accounts. When we reach age 60, for example, we’ll be eligible to start taking money out of our Roth IRA, which is tax-free.
For another, the taxes on our taxable investments are going to be very low. Let’s say I pull enough out of investments this year to cover $32,000. Since I’ve been saving for a long time, I likely have some investments that have been there for a long time and doubled in value. So, I sell an investment that originally cost me $16,000, meaning that I only have to pay taxes on the $16,000 gain. However, it’s a long term capital gain, so I only owe (at most) 15% taxes on that $16,000 gain, and I likely won’t owe any taxes on that gain because my actual total income is so low. At most, I’ll owe $2,400 in taxes on that money, but, as I stated, if my additional income is nonexistent, I probably owe zero taxes on that income.
Remember, my income here is only $16,000 in that scenario – the other half of my money is just money I held onto since I was younger.
Taxes become a bit more important if I’m earning significant additional money or if my life expenses are far higher, but if you’re shooting for a low spending early retirement, taxes are a pretty small factor.
On the flip side of taxes is Social Security and Medicare, factors which you can expect will benefit you.
My perspective on these things is that their future is uncertain. Like it or not, the demographics of the United States are changing. As the largest generation – the baby boomers – move into retirement, the work force – and the money going into Social Security and Medicare – is going to shrink while the number of retirees – and the money going out of Social Security and Medicare – is going to grow.
What does that mean for you? I’m not certain, to be honest, but I don’t consider it a certainty that strong Social Security and Medicare benefits will be around in twenty or thirty years. The simple math says that either the benefits will have to change or the funding will have to. Neither one is a good proposition.
I view Social Security and Medicare as “bonuses” in retirement. I recommend planning as though they don’t exist and, if they do, then they’ll elevate your standard of living. If they’re cut, however, you’ll still be fine.
So, we’ve established the number that you need to achieve in order to retire early (or at least seriously consider it). You simply figure out how much you spent this year, multiply that by 0.8, then multiply that number by 25. It’s not a perfect number, but it’s pretty close.
The next question is how do you get there?
The most important principle is this: the larger the percentage of your income that you can save, the faster you’ll get there. However, when you start saving more, early retirement actually accelerates.
Let me show you what I mean.
What If I Save 10% of My Income?
Let’s say that I make $40,000 a year – that’s my take-home income plus my health care costs. I decide that I’m able to save 10% of that – $4,000 per year. That means that my living expenses are $36,000 per year.
Now, as I said before, you’ll need to figure out how much 80% of your spendind is – in this case, it’s $28,800 – and then multiply that by 25, giving you $720,000 as your target number.
If that’s your situation, it’s going to take you 39 years of saving with a 7% average annual return to get to your target.
If you start saving at age 20, you’ll get there at age 59, in other words. This is why most retirement advice suggests saving 10% a year, as you’ll get to your target pretty much right on time. (Remember, inflation raises your number, but it also raises your contributions, which balance each other out over time.)
What About 15%?
On that $40,000 salary, I decide that I’m able to save 15% of that – $6,000 per year. That means that my living expenses are $34,000 per year.
80% of those living expenses equals $27,200, and multiplying that by 25 gives you a target number of $680,000.
Now, there’s something worth noting here. Your annual contribution has gone up, but at the same time your target number has gone down. This is incredibly important and it’s something we’ll get back to later.
Anyway, if that’s your situation – you’re saving $6,000 a year and shooting for $680,000 – it’s going to take you 32 years to get there. If you start at age 20, you’ll get there at age 52.
Let’s look at 20%. On that $40,000 salary, I decide that I’m able to save 20% per year – $8,000 per year. That means that my living expenses are $32,000 per year.
80% of those living expenses equals $25,600, and multiplying that by 25 gives you a target number of $640,000.
Again, note that the annual contribution has gone up and the target number has gone down.
Assuming that’s your situation – you’re saving $8,000 a year and shooting for $640,000 – it’s going to take you 27 years to get there. If you start at age 20, you’ll get there at age 47.
It’s starting to look better, but let’s keep going.
Let’s look at 30% savings now. On that $40,000 salary, I decide that I’m able to save 30% per year – $12,000 per year. That means that my living expenses are $28,000 per year.
80% of those living expenses equals $22,400, and multiplying that by 25 gives you a target number of $560,000.
Assuming that’s your situation – you’re saving $12,000 a year and shooting for $560,000 – it’s going to take you 22 years to get there. If you start at age 20, you’ll get there at age 42.
Now that’s looking sweet. But what does the plan that Sarah and I are working on look like?
All right, what happens when you save 50% of your salary? On that $40,000 salary, you’re saving $20,000 and living on $20,000 a year.
When you retire, your living expenses drop down to 80% of that – $16,000 a year. Multiplying that by 25 gives you a target number of $400,000.
When you invest $20,000 per year and are shooting for $400,000, it’s going to take you only 13 years to get there. If you start at age 20, you’ll get there at age 33. If you start at, say, age 34, you’ll get there at age 47… a comparison that speaks deeply to me.
Retiring at age 47 sounds pretty sweet, I must say.
Addressing the Challenges
Naturally, there are some serious challenges with adapting these kinds of aggressive savings approaches, so let’s wade right into this.
Saving 50% Just Isn’t Realistic for Me
For many people, it’s probably not realistic without making some major lifestyle changes. It requires making a lot of personal choices where you choose to live with a smaller living space and strongly limit your personal spending to a level that can leave some people feeling really deprived.
The point of this article is not to say that you must save 50%, but to show you that if you can commit to saving that much, you can retire incredibly early. It makes a huge difference.
Having said that, many people can do this if they commit to it. It does require putting aside a lot of short-term pleasures, but the reward is great: within a decade or two, you’re completely free of the employment treadmill and can choose for yourself what to do with your time. The question really is whether you want that kind of freedom in comparison to how much you want your short-term creature comforts.
The choice isn’t impossible. Believing in the impossibility of such a dream is the same as saying that you simply value some of your frivolous spending more highly than that dream and that you won’t actually consider giving some of those things up.
Frugality Makes the Difference
The only way to get to a point of saving 50% of your income (or 30% or 20% or whatever you choose to do) is with a strong commitment to frugality. In fact, few things show the connection between frugality and investment success than this kind of example.
In a nutshell, the more frugally you behave, the more you’re capable of investing each year and the less you actually have to save in total.
If you choose to live in a smaller house, you can save more for retirement which makes it easier to retire earlier.
If you make a ton of energy efficient changes to your home, you can save more for retirement which makes it easier to retire earlier.
If you drive a more efficient car or get rid of a car, you can save more for retirement which makes it easier to retire earlier.
It goes on and on like that. Every frugal move you make enables you to save more for retirement, which makes it easier to retire earlier.
I Don’t Want to Retire Early!
“Retirement” is being used here as a term to describe a situation where you no longer have to work for your income. You certainly have the option to work for income if you wish, but you have the complete freedom to invest your time however you wish.
Do you want to spend a few years earning no salary while learning the tricks of a completely different trade? Go for it.
Do you want to spend a year writing a great novel? Go for it.
Do you want to earn minimum wage working for a charity in your community? Go for it.
Do you want to dive head-first into a completely new career path where you might not necessarily get a great job? Go for it.
This type of “retirement” doesn’t mean that you sit at home and watch cable news all day. It’s a very active retirement, one in which you’re engaged in meaningful work that may or may not earn any kind of income. It entirely depends on what’s meaningful to you.
As an example, I have two friends who are in this sort of “retirement.” One of them is an open source software developer who spends his spare time creating really useful software for scientific research. He treats it like a job, spending a full day most weekdays improving the software he’s involved with. The other friend works for a nonprofit making a small salary, substantially less than what he was once making. I’m pretty sure he would forego the salary, but he is worried that the position might permanently become volunteer should he leave and he thinks that would be detrimental to the project.
As for me? As soon as I cross that threshold, I’m going to spend at least a year or two working on several different novel ideas I’ve had floating around. One is an urban fantasy series – think The Dresden Files – involving a young woman and her older brother. Another is a science fiction series set about two hundred years in the future when humans are beginning to explore the solar system and focuses on an intense sibling rivalry. Yet another one is a family saga set against a religious uprising that’s about to be crushed by the Roman Catholic Church in the eleventh century (one based on a lot of research I did a few years ago focusing on the schism between Roman Catholicism and Eastern Orthodox Christianity).
Once I get that out of my system, I intend to spend significant time working for a charity in the Des Moines area. I am very inspired by a number of local charities and I relish the opportunity to give my time, talent, and energy to them on a much larger scale than is currently realistic for me.
The fiction writing might generate revenue; the volunteerism probably will not.
The point here is that “retirement” doesn’t necessarily mean a lack of income, nor does it mean a lack of projects or employment into which to channel your energies. It simply means that you can make those choices completely without regarding the financial aspect of those choice, which is a powerful freedom indeed.
Extreme early retirement is absolutely possible for almost everyone, but it requires some sacrifice in many areas of non-essential spending that people often choose not to give up. The question isn’t whether a goal along the lines of retiring in ten or fifteen years is possible or not, but what you’re willing to give to make that dream come true.
In the end, the pleasures you keep for today each cause you to stay on the professional treadmill for a longer period of time. Are they worth it? Is a cup of Starbucks each morning worth another few years on the professional treadmill? Maybe, maybe not. The important thing to remember, though, is that the choice is really up to you. What do you want more?