3 Different Lanes To Financial Independence For Early Career Workers
November 30, 2018You’ve heard the cliché: When it comes to saving for retirement, young people have time on their side. The earlier they start saving, the better. So what would happen if you started saving for retirement at age 22? A lot can happen in the years between, but here’s a look at three different retirement roadmaps that a 22-yr old earning $50k a year (with no raises) and earning an 8% average annualized return on their investments might take:
The slow lane
How you’d save
In the “slow lane,” let’s say you contribute 6% to your 401(k) to get your employer’s full 3% match. You’d retire at age 65 with $1,678,104. Yes, you’re a millionaire, but before you get too excited, that would only be about $716k in today’s dollars assuming a 2% inflation rate.
What that will look like in retirement
Using a 4% withdrawal rate, that 401(k) would produce about $29k of annual income. You would also receive about $15k in Social Security benefits at age 65 or about $11k if we factor in Social Security’s projected shortfall. Your total income would be $40k or about 80% of your current income, which is in the range of what most retirement experts figure the average retiree will need.
What to do if you are getting your match but don’t think you’re on track
If you’re getting your match but think that a comfortable retirement is out of reach, you may be underestimating the power of compound interest over long time periods and may actually be on track to retirement. On the other hand, it’s more likely that you got to a later start and didn’t start saving to your match at 22. The best way for you to find out is to run a retirement calculator and see if you’re on track. If not, you can see how much more you would need to save to get on track.
This all sounds okay, but who wants to drive in the slow lane and work until 65? Keep reading.
The center lane
How you’d save
In the “center lane,” you would max out an HSA (health savings account) and contribute 10% to your 401(k) with a 1% automatic annual increase. You retire at age 55 with $1,937,807. In today’s dollars, that would be about $1 million or enough to produce $40k of income, which hits that magical 80% mark even without the Social Security benefits you would later receive!
How to make it happen
To make this happen, you would need to be eligible for an HSA by choosing a high-deductible health insurance plan, which are becoming increasingly common. It also makes sense to try to max it out after getting the match in the 401(k) because the money goes into an HSA pre-tax, can be invested and grow tax-deferred, and can then be taken out tax-free for qualified medical expenses. No other account has that triple tax benefit.
Finally, you would need to use the HSA as a retirement account by not dipping into it even for medical expenses. One other note about HSAs, in addition to tax-free distributions for medical expenses in retirement (including Medicare and long term care insurance premiums) you can also take taxable distributions without penalty for non-medical purposes starting at age 65—i.e., it can be another source of retirement income.
Things to think about in the center lane
There are a couple of possible concerns with retiring early though. First, you would need to cover the cost of health insurance until qualifying for Medicare at age 65, but with access to the Affordable Care Act exchanges this shouldn’t be too much of a problem. In fact, if you have tax-free money in a Roth account, you can qualify for higher health insurance subsidies since eligibility is based on taxable income.
This brings us to the second potential issue. Isn’t there a 10% penalty on retirement plan withdrawals before age 59½? Yes, but there’s also an exception that as long as you work until the year you turn age 55 or older, you can withdraw money from your then current employer’s 401(k) with no penalties. (This doesn’t apply to a prior employer’s 401(k) or IRAs so keep that in mind before you roll money into one.)
The fast lane
How you’d save
As exciting as retiring at 55 sounds, how about retiring at 50? In the “fast lane,” you would max out both your HSA and your 401(k). At age 50, you would have $2,111,194—or about $1.2 million in today’s dollars—in retirement! That produces 97% of your working salary plus you’d still get Social Security later. (To avoid early withdrawal penalties, you can take “substantially equal periodic payments” under Rule 72(t) until age 59½.)
Of course, the challenge to driving in the fast lane is being able to save that much. The key is to max out those accounts before you even have a chance to spend that money and live on the rest of your income. If that sounds impossible, keep in mind that lots of people are living on much less.
Things to think about in the fast lane
The hardest part is potentially having to downscale your standard of living. This is where being 22-yrs old really has an advantage. After all, you may have just been recently living with no income at all in a dorm room or in your parents’ home so less of an adjustment might be needed.
Finally, keep in mind that our calculations assumed no raises, which is probably not realistic, especially for someone so young in their career. That means any income from raises or promotions could be used to finance a growing lifestyle. The upside for delaying that lifestyle is being financially independent at age 50 and having an extra 15 years to do whatever you want. In the meantime, your extra savings would provide a greater level of financial security and freedom.
So if you’re just getting started in your career, which lane will you drive in? Do you want to take the slow and easy approach to retire comfortably at age 65? Would you rather drive a little faster to retire early at 55? Or are you up to the challenge of life in the fast lane?