How to Plan for an Extreme Early Retirement

February 02, 2012

My most popular blog post (and the most popular one on our whole blog) called “How to Be Financially Independent in 5 Years (No Matter What Age You Are)” was about a concept called “Early Retirement Extreme” in which people save very large percentages of their income to be financially independent before they even turn 40. For example, if you save 75% of your take-home pay and earn a 5% real rate of return, you would have enough savings in just 5 years to maintain that standard of living for the rest of your life (assuming a standard 4% safe withdrawal rate of your initial savings amount and adjusted each year for inflation). While this would probably not be realistic for most people, the more you can save, the sooner you can be financially independent to use your time as you see fit. (The author of the blog that inspired my post actually ended up going back to work but out of enjoyment rather than financial necessity.) But in addition to the challenge of living on much less income than we’re used to, there are some other considerations facing anyone looking to retire extremely early:

You can’t invest as aggressively. Even though many extreme retirement savers are young, they should invest a lot more conservatively than someone they’re age planning to retire in 30-40 years. For one thing, the math of early retirement makes the savings rate much more important than the rate of return. Earning a few extra percentage points over  a few years will help you a little but losing 30-40% of the savings you worked so hard to accumulate would hurt you a lot. Either stick to more conservative dividend-paying stocks (more on that later) or use lower risk asset allocation strategies like the “permanent portfolio.”

A lot of your savings might be tied up until you’re 59 ½. Retirement plans weren’t designed for people retiring at 35. This doesn’t mean you shouldn’t contribute to your 401(k) though. In fact, pre-tax accounts can be especially beneficial for you because you’ll be in such a low tax bracket when you retire. There are a couple of ways to avoid the 10% early withdrawal penalty. One is to make substantially equal periodic payments for the longer of 5 years or until you turn 59 ½, which is roughly what you’ll want to do for steady income anyway. If you want more flexibility in your withdrawals, you can start converting your pre-tax accounts to Roth IRAs once you stop working. You’ll have to pay taxes on the conversions but by spreading them out over time, you can keep the tax rates low. After 5 years, you can start withdrawing the converted amounts from your Roth IRA without tax or penalty.

Don’t expect much from Social Security. That’s not just because the system is going bankrupt. The larger issue is that your Social Security projections assume you continue to work until you start collecting. Since your work history will be much shorter, you’ll get much less once you are eligible. Plan for retirement without it and consider anything you do get to be a bonus.

You’ll have to pay for your own health insurance. One of the advantages of working until 65 is having employer-provided group health insurance and then qualifying for Medicare. Otherwise, you’re on your own. The good news is that President Obama’s health care plan could be a lot of help because you won’t have to worry about not being able to get coverage due to pre-existing conditions and your low income could even make you eligible for a premium subsidy. The bad news is that the program’s mandates could make insurance more expensive if you’re young and healthy.

Your money will need to last much longer than normal retirees. A typical retirement plan based on your assets being drawn down over 40 years may work for a 65 year old but not for a 35 year old. Annuities will be less attractive too because your young age and long life expectancy mean much lower payments. Instead, you’ll need to make sure your nest eggs grows more than you withdraw each year to minimize the need to touch your principal. One way to do that is to invest in high-dividend paying stocks yielding 3-4% income and live off the dividend income. Dividends tend to be much more stable than stock prices and generally rise faster than inflation. Qualified dividends are also currently taxed at only 5% for people in the 10 or 15% tax bracket  (where you’re likely to be in retirement) and 15% for higher brackets. Unfortunately, dividends are scheduled to return to ordinary rates next year but if GOP front-runner Mitt Romney is elected president, he wants to eliminate taxes on capital gains and dividends altogether for everyone earning under $200k (or $250k for couples). Finally, if you buy them in a fund, just be sure to pick one with low expenses since a 1% fee can reduce your income by 25-33%.

Retiring early is mostly about saving a lot but as you can see, there are other things that make retiring at 35 different from retiring at 65. In short, you can’t plan for retirement like everyone else. (You’ll also probably be the only person hoping for both Obama’s health care plan and Romney’s tax plan.)