When to Retire? How About 40?

April 25, 2013

I recently saw this clip of the Today Show that discussed one man’s goal of retiring before 40, a topic I’ve written about before. He’s 30 years old, earns $50k a year, and has accumulated $100k of savings over the last 3 years. His goal is to save 60-70% of his net income to retire at age 35 with a $400k nest egg to cover his $15k of annual expenses. To do that, he’s moved to Florida to avoid state income taxes and be able to live without a car (he points out that waiting for the bus is much easier in warmer weather) and has decided not to have children. Is his plan feasible?

Let’s start with his goal of having $400k in 5 years. Since we don’t know his net income, it’s hard to know exactly how much he’s saving. But with a 4% real rate of return, he would need to save more than his entire gross income to reach his goal. Keep in mind that it took him 3 years to accumulate $100k so at that rate, it would take another 9 years to reach $400k. The good news is that he could still reach it before his goal of age 40.

But is $400k enough? At a 4% withdrawal rate, that would yield about $16k of gross income, which is more than the $15k he currently spends each year. What about taxes though? Almost $10k of ordinary income would be tax-free because of deductions and exemptions and the rest would be taxed at only 10%. Long term capital gains would be tax free because of his low tax bracket. By living in Florida, he would also avoid state income taxes. Other taxes, like property and sales, are already factored into his expenses.

However, there are still a couple of problems here. One is inflation. At a 3% inflation rate (except on his student loans, which I assume are fixed), his total expenses would be about $19k a year. That’s more than his projected income.

The other problem is that the 4% safe withdrawal rate is based on a 30-yr retirement. But retiring at age 40, he could live twice that long! A 3% withdrawal rate would be safer but that cuts his income down to $12k a year.

It sounds like he needs some expert advice on this but unfortunately the Today show financial expert was focused on other issues. Her concerns centered around disability, investing, medical insurance, and taxes. Let’s take a look at each of those areas:

Disability. As long as he worked for 10 years, he would be eligible for Social Security disability insurance. If he’s injured on the job he could get workman’s compensation. Once he’s retired, he won’t need to worry about disability at all.

Investing. The key to investing is for him to maintain a balanced portfolio. He needs to be aggressive enough to earn the returns he’ll need without taking too much risk since he’s planning to retire within 10 years. He might want to consider high dividend paying stocks in particular to help him get that 3% yield while minimizing the need to dip into principal.

Health Insurance. Once the Affordable Care Act is in place, health insurance should be less of a concern since there’s no asset test for the premium subsidies. According to this calculator, an above-average “silver plan” would currently only cost him about $75 a month at age 40 with about $19k of income. Of course, that’s still another expense he’ll need to budget for but it’s not nearly as expensive as it would otherwise be.

Retirement Plan Distributions. Her final concern was that he won’t be able to use 401(k) or IRA money without penalty because he would be under age 59 ½. That’s not really true though. Ideally, he would have enough non-retirement account money to use so he could convert any pre-tax money to a Roth IRA and start taking penalty-free withdrawals in 5 years. (There’s a 5 year waiting period before you can withdraw Roth conversions penalty-free but Roth contributions can be withdrawn tax and penalty-free anytime.) Even if he needs to tap into those accounts before then, he would only be in the 10% tax bracket because of his low income. With the 10% penalty, that would be 20%, which is still lower than his current tax rate.

So what’s the bottom line? He’ll probably have to work a little longer than he’d like to. But how many people do you know that earn $50k a year and can still retire in their 40s? With proper planning, he can make that happen.