6 Tips and Investing Strategies to Retire Early (and Without Penalty)
Ready to quit work or begin a financially independent lifestyle? Laura covers six tips and strategies to help you amass enough money to retire early and on your terms.
Laura Adams, MBA
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6 Tips and Investing Strategies to Retire Early (and Without Penalty)
Megan M. says, “My husband is a teacher who makes around $50,000 per year and loves his job. I’m an engineer and make about $120,000 per year. We currently live off of my husband’s salary except for our car and mortgage payments. While I enjoy my job, I’d like to retire early, perhaps in my 30s. How should that affect my choice to contribute to a Roth or a traditional IRA?”
(correction_with_script)
Thanks for your great question, Megan. I love hearing from a growing number of young people who are planning for an early retirement. There’s a growing movement called FIRE, which stands for financial independence, retire early.
No matter if you’re fed up with a high-pressure job, want to travel more, or just dream about a different lifestyle that doesn’t require full-time work, being ready for retirement sooner rather than later is a wonderful and wise goal.
I’ll cover six tips and strategies to help you amass enough money to make a transition to a less lucrative career or to quit working altogether and enjoy an early retirement.
6 Tips and Investing Strategies to Retire Early
- Calculate your savings target.
- Invest consistently.
- Watch your investment fees.
- Minimize taxes.
- Know the retirement withdrawal rules.
- Understand 72(t) payment plans.
Before covering each tip, let’s consider what early retirement is and whether it’s a goal you want to achieve.
What Is Early Retirement?
The concept of retirement as a time to spend your days in a rocking chair after you stop working for a company is completely outdated. Now, retirement is when you no longer have to work. But many who retire early still choose to work.
Maybe you want to “retire” and work part-time if you enjoy it. You might choose self-employment or volunteer work that keeps you involved in your community. Or you might take a sabbatical to travel and work remotely.
The idea is that retirement doesn’t have to be the end of income-producing work. It can be shifting from work you must do, to work that you truly want to do. If you want to join the FIRE movement, use these strategies to make early retirement a realistic goal.
1. Calculate your savings target.
To know if and when you can retire early, you must figure out the amount of savings you’ll need. A good place to start is to know the total of your living expenses, such as housing, food, insurance, medical bills, and transportation.
Remember that once you’re retired some expenses may end, such as commuting, buying work-appropriate clothes, and saving. But you may have larger expenses, such as travel and hobbies, or costs that are no longer picked up by an employer, such as health insurance, life insurance, and a smartphone.
Using financial tools, such as Mint or Quicken, you can track your expenses to get an idea of your typical weekly, monthly, and annual expenses by category. There’s no way to know exactly how much you’ll spend in the future, but you need an estimated budget in order to calculate an early retirement savings target.
There’s no hard rule, but a good guideline is to save 10 to 15 times your annual budget by your mid-60s. For example, if you live on $100,000 per year and will receive Social Security retirement benefits, a good savings target is between $1 and $1.5 million.
But in order to retire early, perhaps at age 30 or 40, you’ll need much more savings to ensure your nest egg can last for a 45- or 55-year retirement. You won’t have Social Security retirement benefits to back you up because age 62 is the earliest you can start collecting it.
How much you need to begin an early retirement depends on a variety of factors, including:
- Your desired retirement age
- How much you plan to spend or withdraw
- How much you earn during retirement
- Your average post-retirement investment return
Since the math can get complicated, the best way to create an early retirement savings goal is to work with a financial advisor. You might also use a retirement planning calculator, such as the free ones found at Personal Capital or AARP.
As your income, debt, and lifestyle changes, reevaluate how much savings and income you’ll need for an early retirement and whether you’re on track to achieve it.
See also: How to Retire With Enough Money and Income
2. Invest consistently.
The real trick to retiring early is investing early and often. The more money you set aside the better off you’ll be.
Never wait for the “right” time to invest because it doesn’t exist. No matter what’s going on in the financial markets, your money can’t grow if it’s sitting on the sidelines. Every day of investment growth matters, especially when you want an extra-large nest egg to retire early.
My favorite way to invest is to put it on autopilot so I don’t have to think about it. With any type of investment account, you can set up automatic contributions on a set schedule, such as daily or monthly.
Increase your savings rate until it hurts and then reach a little higher. If you’re investing 5% of your income, push it to 10% by the end of the year or increase it by 1% every month. Some investing platforms can even automate your savings increases.
Try cutting back on the largest expenses in your budget first, such as housing and food. It’s also smart to reduce unnecessary small expenses, but slashing big costs are bigger wins that can intensify your investing results.
Also, supplement your savings with additional income when you earn a raise, bonus, or receive a cash gift. You can create more income by starting a side business or getting a second job to consistently boost your retirement account.
Retiring early is an aggressive goal that you’ll need to attack with gusto to pull off. It won’t be easy—but it’s possible.
See also: 14 Tips to Stop Impulse Buying and Save Money
3. Watch your investment fees.
Fees are important because they impact your retirement account’s investment growth and how quickly you can retire. Various fees get deducted right out of your account, which reduces the amount of money that can compound.
While no one likes the idea of paying fees, they’re largely unavoidable. Companies that manage investments and administer accounts have lots of expenses to cover. For example, if you participate in a company 401(k), you pay a fee to the investment firm that manages the plan, and you pay fees on each of the investments you choose inside the plan.
Over time even a small difference in fees, such as paying 1% instead of 0.25%, can really add up. Your job is to choose investments that leave as much of your earnings as possible in the account so you can hit your early retirement goal.
See also: How to Tell If You’re Wasting Money on Hidden Financial Fees
4. Minimize taxes.
As you know, taxes take a big bite out of your income. To keep more money and protect your future investment earnings, do everything legally possible to cut your tax liability.
Tax-advantaged accounts, such as workplace retirement plans, IRAs, and health savings accounts, were designed to help you save and pay less tax at the same time.
With a traditional retirement account (such as a traditional 401(k) or a traditional IRA), contributions are made on a pre-tax basis, and then your withdrawals of contributions and earnings are taxed based on your ordinary income tax rate.
With a Roth account (such as a Roth 401(k) or a Roth IRA), contributions are taxed upfront, but your withdrawals of contributions and earnings are generally tax-free.
The more you defer or eliminate taxes the more you can invest now to reach an early retirement goal. Additionally, having tax-free accounts to withdraw from in retirement leaves you more money to spend.
The allowable contribution limits for tax-advantaged accounts increase with the cost of living index, so check each year for the maximum amount, and plan to hit it. If you max out these accounts first, you’ll get the biggest bang for your buck.
Also, make sure to claim as many legitimate tax deductions and credits as possible each year. These might include deductions for:
- home mortgage interest
- student loan interest
- state and local taxes
- charitable contributions
- medical expenses
- child tax credits
Keep detailed records so you know when you should itemize deductions to save money, instead of claiming the standard deduction.
Working with a qualified tax accountant to minimize your tax liability can really pay off. If you’re not sure what expenses are tax-related, or you have a complex situation because you own a business or rental property, be sure to consult with a tax pro.
See also: 7 Financial Accounts You Need for a Richer Life
5. Know the retirement withdrawal rules.
This takes us back to Megan’s question about using a retirement account when you plan to retire early. After all, you’ve probably heard that taking money out of a retirement account before age 59½ typically means paying a 10% early withdrawal penalty, on top of income tax. The good news is that there are legit ways to avoid the penalty.
The first option is to use a Roth retirement plan at work or a Roth IRA, which you open on your own. As I previously mentioned, a Roth requires you to pay tax upfront on your contributions. Therefore, you’re allowed to withdraw your contributions at any time without paying a penalty or additional tax. This makes it a great option for early retirees.
However, your investment gains in the account haven’t been taxed. So, if you choose to withdraw earnings from a Roth before age 59½, those amounts would be subject to tax, plus the 10% penalty.
The only hiccup is that high earners aren’t eligible for a Roth IRA. But that rule doesn’t apply to a Roth at work. You can contribute to a Roth 401(k) or a Roth 403(b), regardless of how much money you make.
Here are the Roth IRA eligibility rules for 2018:
If you file taxes as a single and your modified adjusted gross income is higher than $135,000, you cannot contribute to a Roth IRA. When you earn from $120,000 to $135,000, your contribution total is reduced.
If you’re married and file taxes jointly, you cannot contribute to a Roth IRA when your household’s joint modified adjusted gross income exceeds $199,000. And when you earn from $189,000 to $199,000, your contribution total is reduced.
Megan didn’t mention how she and her husband file taxes. But if they file jointly with $170,000 of total household income, they each qualify for a Roth IRA. Additionally, they can also max out a retirement account at work or one for the self-employed in the same year.
But what if you earn too much to qualify for a Roth IRA or don’t have an employer that offers a Roth retirement plan? You can still retire early using a traditional 401(k) or a traditional IRA and avoid the early withdrawal penalty using a couple of workarounds.
The first exception applies if you have a workplace retirement plan and decide to retire at age 55 or later. If you are no longer employed, you can use the “rule of 55” to take penalty-free withdrawals from your 401(k) or 403(b).
For certain government workers, this exception can apply as early as age 50. But note that this rule doesn’t apply to any type of IRA or SEP-IRA, only to workplace plans and solo 401(k)s.
In the next tip, I’ll cover the second key way to avoid an early withdrawal penalty if you’re an early retiree younger than age 55.
See also: 7 Simple Reasons to Invest in a Roth 401(k) or Roth IRA
6. Understand 72(t) payment plans.
There’s also a little-known rule you can use to avoid the early withdrawal penalty no matter your age. This exception goes by a few different names, including:
- 72(t) payment plan
- 72(t) distribution
- substantially equal periodic payments (SEPP)
- SEPP plan
The name 72(t) comes from its numbered section of the IRS tax code. This regulation allows you to set up a plan to take equal monthly or annual distributions from your retirement account, such as a traditional IRA or a Roth IRA. You can also set up a 72(t) distribution for a workplace plan, such as a 401(k) or 403(b) if you no longer work for your employer.
The amount you can withdraw using a 72(t) plan is calculated using one of three accounting methods approved by the IRS. They use factors such as your account balance, age, and life expectancy. The payment calculation can be based on the amount in a single retirement account or on the aggregate of all your retirement accounts.
Problem is, a 72(t) comes with restrictions and some risky consequences if you don’t use it the right way. It’s important to understand that once you begin taking 72(t) distributions, you can’t stop taking them for a certain period of time.
Once the plan is put in place you must take the periodic payments for a minimum of five years or until you turn 59½, whichever is longer. In other words, if you started a 72(t) at age 30, you’d have to continue payments for 29½ years.
After you complete a series of 5-year distributions or reach the age of 59½, you can take retirement distributions any way you like. However, for most traditional accounts, once you reach age 70½, you generally must take annual required minimum distributions, no matter if you used a 72(t) plan or not.
Another issue with a 72(t) plan is that you can’t make new contributions to your retirement account or add rollovers while you take payments. And, of course, all distributions that weren’t previously taxed will be subject to ordinary income tax.
When executed properly, taking 72(t) payments can be a smart way to tap your retirement funds early without penalty. However, figuring out the allowable payment schedule can be very complex—you can’t just name your own amount. Always get help from a tax professional who has experience setting up a 72(t).
Taking too little, too much, or missing a distribution deadline can result in expensive consequences. In addition to owing income tax, messing up your 72(t) payments means that all your distributions will be subject to the 10% early withdrawal penalty—plus, interest on unpaid tax and penalties calculated from the original date you made an error.
Megan and every early retiree should weigh options carefully and never enter a 72(t) plan lightly. Make sure you can afford to trade your nest egg for an immediate cash flow. Taking payments now means that you drain the resources that would be available to you later in retirement.
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.