The big financial goal that Sarah and I have in front of us is to reach a point where we can live off of the proceeds of our investments, allowing us to walk away from work.
In essence, that’s what retirement is. Between Social Security (which one can see as an investment built up over a lifetime of working) and additional retirement plans and pensions, people often live out their later years by using the proceeds of their earlier working years.
Our goal, however, is early retirement. We want to do it as quickly as possible. I thought it might be interesting to walk you through our game plan.
Why do we feel the need to do this?
Simply put, Sarah and I both feel called to do things with our life that don’t necessarily earn any sort of income. We both have some big dreams about volunteerism. I’d like to write novels (which is a pretty poor guarantee of income).
Those kinds of plans don’t lend themselves at all to earning an income. Sure, we might earn some income from those things, but we want to be able to do them on our terms by doing things and writing things because they feel like the best thing to do, not just because they line our pockets.
Our life goals push us toward reaching this level of financial independence.
What about you? Everyone has different reasons for wanting to reach this kind of goal. I do think that this type of big goal works better if you have a strong life reason for doing it.
How Much Will We Need?
Because we’ve spent the last several years budgeting our money and tracking our expenses, Sarah and I recognize that we could enjoy more or less the same life we’ve enjoyed for the last several years on about $26,000 a year in today’s dollars.
Our actual annual expenses are higher than that. If Sarah no longer worked outside the home, we could easily drop down to one vehicle. She’d also lose the extra expense of fuel and of a professional wardrobe. Eliminating those expenses drops our requirements quite a bit.
What about you? The easiest way to figure out this number is to just track your spending over the course of a year and see what it all adds up to. Then, remove expenses from that total that are related to your job, like travel expenses, clothing expenses, and so on. That’s what your income expenses need to be.
How Will You Invest?
Right now, we’re investing almost all of our money for early retirement in the Vanguard Total Stock Market Index. If you take a look at that fund, you’ll see that it has a pretty strong track record. It’s returned an average of 8.31% per year over the past ten years and 9.60% per year since the fund’s inception (remember, that’s an average).
Still, Sarah and I are sticking with Warren Buffett’s projection for the future health of the stock market. He projects that broad stock market investments will have a 7% annual average return. That’s the number we’re using for future projections.
The Vanguard Total Stock Market Index is exactly that – a broad stock market investment. It has really low fees and we’ve been happy with how Vanguard has treated us.
Sure, 8.31% per year looks like a lot sweeter than 7%, but we’re also riding on the fifth or sixth year of a bull market, so I expect that number to go down over the next several years. Plus, we’d rather slightly underestimate our returns and have things go a bit ahead of schedule. 7% seems very realistic for us.
What about you? You can use whatever estimate you want for future projections. Using the average annual return since inception of your investment would likely work just fine.
What About Inflation?
Inflation can be a really tricky problem with calculations like this. Clearly, prices are going up over time, so we’re going to need to have more money in the future.
Our solution is to just subtract 3% from our investment growth each year. Since we figure that inflation is going to stick at 3% or below annually, we’re going to use that as our benchmark. By subtracting 3% from our annual investment return, we’re keeping all of the dollar amounts in today’s dollars, making the calculations a lot easier.
This 3% number is based both on the Consumer Price Index and on Warren Buffett’s projections for the future.
What about you? You can adjust that number as you wish, but subtracting 3% from your investment returns is probably a great way to adjust everything for inflation.
How Much Do We Have to Save Each Year?
Here’s where the rubber meets the road. Right now, we’re assuming that our investments will pay out a 2% dividend each year which is based on the dividend history of our investment. So, in order to pay out the $26,000 a year we would need to live in perpetuity, we would need to save $1.3 million. This amount would definitely allow us to live in perpetuity at that income level, even accounting for inflation (remember, our investment is growing at a faster rate than inflation, so our dividends would also grow at a rate faster than inflation).
So, our target number is $1.3 million in today’s dollars.
I’m fully aware that such a target is pretty conservative. We’re assuming a slowdown in the growth of the stock market and also assuming that we need our investments to continue to grow after inflation.
Now, as we mentioned earlier, we’re assuming a 7% return on our money and we’re also assuming 3% inflation, so we’re figuring that our money’s actual value will grow at 4% per year. We’re only looking at actual value here, so that’s the number we’re using – it takes inflation out of the picture.
Let’s look at a few simulations, then. First, let’s assume we start at $0.
If we were able to save $10,000 a year for early retirement and we reinvest all of our dividends along the way, we would have to save for 37 years to make our investment target. That’s pretty rough. Sarah and I would be 72 at that point, so it would be a normal retirement.
If we were able to save $20,000 a year for early retirement and we reinvest all of our dividends, we would only have to save for 27 years to make that target. That would put us at age 62 – a bit of an early retirement. We’d also have Social Security at this point to help us.
What if we were able to save $30,000 a year? This would be a very significant chunk of our annual income. In that situation, we’d only have to save for 22 years to get there, letting us retire at age 57.
Of course, this isn’t completely accurate. We do have some retirement savings. As many of you know, we’ve been living on Sarah’s income and saving my entire income each year for retirement, so we currently have a healthy savings built up, plus we have our pre-existing retirement savings. Let’s say we already have $200,000 saved for retirement.
In that situation, saving $10,000 per year would get us to our goal in 25 years (retiring at age 60), saving $20,000 per year would get us there in 20 years (retiring at age 55), and saving $30,000 a year would get us there in 16 years (retiring at age 51).
Given our current account balances and current trajectory (remember, we’re saving my entire salary right now), we’re hoping to be able to do it in the next decade or possibly even sooner than that.
How Can We Increase Our Income?
As I’ve stated many times, the key to personal finance success is to spend less than you earn. It’s the fundamental rule, in my opinion.
In between those two numbers – the amount you spend and the amount you earn – is a number I like to call “the gap.” It’s the money you can use to save for your future and make all your giant dreams come true. The bigger the gap, the faster you get to your dreams.
There are two ways to make that gap bigger – earning more and spending less. Let’s start with the “earn more” part of the equation. Here are five strategies Sarah and I could apply to earn a little more income.
Publish a book on the Kindle Store. I could write a book of some kind and publish it on the Kindle Store. If I could sell it for $2.99, earn a 70% royalty on it, and sell 100 copies a month, that earns us $210 per month. Of course, this requires us to write a decent book worth reading, format it correctly, design a cover for it, and then promote it.
Publish some Youtube videos. We could create a set of Youtube videos on a certain topic. Individual videos might not earn much money (via ad revenues), but a healthy collection of videos on a topic of wide interest can earn a surprising income stream (say, $100-200 a month).
Hang out my freelance shingle again. In 2003 to roughly 2007, I did freelance computer work for people. I’d go to their house, diagnose computer problems, and fix them. I had a nice little network of customers – mostly elderly people – and I’d often stay and share a cup of coffee with them after I finished their computer work. While the work was irregular, it did earn a decent income for the time I invested in it.
Design a standalone ad-supported website. I could invest the time to develop a standalone website that focuses on information on a specific topic. I’d just put some ads on it then link to it in a few places, causing the site to generate a bit of traffic over time. I’ve designed these in the past (in 2006, I designed several, some of which are still earning a trickle of money with no upkeep for almost a decade).
Buy and sell trading cards. I’m strongly familiar with the secondary market for Magic: the Gathering cards and other trading cards and I’m pretty good at exploiting inefficiencies. With a nice bankroll to start with, I could get back in the business of buying and selling cards, something that I earned a bit of money with in 2006 and 2007.
All of these strategies could contribute to our total income, and all of that income would go straight into our gap, bringing our retirement income a little closer. If I could come up with just $5,000 in additional income a year from these sources, I could literally shave years off of our goal.
How Can We Decrease Our Spending?
On the flip side of that coin is the “spend less” objective.
Sarah and I are frugal people. We find lots of ways to avoid spending money to the extent that more than a few readers have called us cheap. So, how can we possibly spend less?
Here are four strategies we could consider to cut back on our spending right now.
Sell one of our cars. We could very easily drop one of our automobiles. I work from home, so I don’t have any commuting needs. The biggest restriction is that I’d be stuck at home during the day, which could cause a few minor difficulties but nothing we couldn’t work around. Doing this would give us a big burst of cash, plus it would reduce the ongoing cost of that automobile – registration, maintenance, fuel, insurance, and so on.
Move to a smaller home. We really don’t need a larger home; in fact, we really don’t need a home of our current size. We use an awful lot of our space just for storage, so if we simply sold off a lot of our unused stuff, we could easily move into a smaller home. That move would save us money on insurance, property taxes, home maintenance, and energy bills.
Cut out cable. We still have a cable television service, something that I basically don’t use. Sarah watches a handful of programs and the children watch a number of recorded PBS Kids shows, but aside from that, it’s not used. We could easily ditch cable, stick with Netflix, and save ourselves $50 a month.
Eliminate all of our magazine subscriptions. We subscribe to five or six magazines, adding up to perhaps $100 a year. Most of those magazines go unread, with only occasional browsing happening in our living room during idle moments which could easily be supplanted with web surfing.
These techniques would each cut a big chunk out of our annual spending. All told, we’d save thousands per year with these changes, which would bring our early retirement goal at least a couple of years closer.
Can We Utilize Tax-Advantaged Accounts?
For example, if we’re saving for retirement, does it make sense to use 401(k)s or Roth IRAs? That’s a complicated question without an easy answer.
First of all, you can tap into money that’s in a 401(k) before a normal retirement age by taking SEPPs – Substantial Equal Periodic Payments. In other words, you have to subscribe to a very specific method of pulling money out in a series of very small payments over a number of years, but if you do that, you can get the money out before age 59 1/2 without a big tax penalty. This Forbes article explains things.
So, you can do this, but should you do this?
The big benefit obviously is the tax benefit. If we save some of our money in a 401(k), we don’t have to pay income taxes on it right now. Instead, we pay it later on – theoretically, when we’re in early retirement and thus our income taxes should be really, really low.
But it’s not all roses. This isn’t an automatic decision.
For one, Sarah’s retirement plan does not offer investment options anywhere near as good as the options offered by Vanguard. If you compare similar investments, you’ll find that you’ll be paying 0.3% or so more in expenses to use the options in her 401(k). Over the course of twenty years, that difference eats up most of the tax advantage, at least in my calculations.
There’s also the issue of whether something significant changes in our life, which I discuss a bit more below. If we choose not to retire early, that money in the 401(k) essentially becomes strict retirement savings. We can’t really use it for most other things without a tax penalty. What that means is that by using a 401(k) for retirement savings, we do lose some flexibility.
So, what are we doing? We’re balancing. We’re making very healthy contributions to her retirement plan, but we’re saving far beyond that in normal taxable investment accounts. When we do retire early, we’ll use her retirement savings first during that period where we’ve had the minimum number of years for the poor options in the 401(k) to work against us and also when our income taxes are at their lowest because Social Security hasn’t kicked in yet.
Not only that, mixing our strategies protects us as much as possible against future changes in the tax code. Will the SEPP rules change in the next ten years? I’d say it’s likely that they’ll change at least a little. Spreading out our money protects us in any event.
What If Something Changes?
When you look at a giant goal like this, particularly one that’s many years in the distance, it’s easy to paint a mental path that leads straight to that goal.
However, over the course of the next decade, things are bound to change in my life. Will someone get sick? Will our goals for the future change? Will someone unexpectedly pass away? The landscape of our lives can drastically change.
Here’s the nice part of this goal, though. It’s all about the savings.
No matter what might change in our lives, that money we are saving will be there for us. If we decide we don’t want to retire and want to follow other goals, that money will still be there for us.
That’s the advantage of savings-oriented goals. Even if your life path does change, you’ll have that money to support that change.
Goals that worry me with regards to changing plans are the ones that aren’t as transferable. For example, if you spend three years going to school to study a subject only to realize that it’s not something you’re skilled at or passionate about, then it’s going to be devastating. If you invest all your money into building a workshop for a side business, only to find that you didn’t enjoy it as much as you thought (or an injury leaves you incapable of using it), you’re suddenly selling everything at a big loss.
Savings, on the other hand, will always be there for you. Money folds itself around almost any goal that you have, so even if our life changes or our goals change, that savings will work perfectly fine for our new goals.
That’s our game plan. Right now, our big goal is to retire as early as we possibly can. We’re throwing almost everything we can at that goal – living on one income and living a pretty frugal lifestyle. We’re planning ways to increase our income and we have options for further reducing our spending.
Is it perfect for everyone? No. No investment plan is. There are always options that work better for some people and work worse for other people. Some people might prefer to put their money in real estate, buy homes for rent, and spend their spare time being a landlord. Others might want to be more risky with their investments – or perhaps more conservative. Still others might believe in a higher average annual return going forward or might believe in a higher (or lower) inflation rate going forward. All of those factors would change our plans, of course.
For us, though, our path to early retirement follows the road I’ve described here. Hopefully we achieve that dream and I can write to you in several years announcing that we’ve made it.