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Two years ago, if you had asked me for an early retirement how-to, I would have said, “win the lottery or get a windfall inheritance.”
These days, my outlook is vastly different. If I’m any wiser than I was in 2017, it’s because I’ve tried to read and listen to what people much more experienced than me have to say. And I’m implementing these steps myself. The steps to achieving financial freedom and, if you desire, an early retirement are as follows:
- Examine your current lifestyle
- Clarify your ideal retirement
- Create a realistic retirement budget
- Create a plan
- Stick to your plan
Let’s get into it.
Examine Your Current Lifestyle
This is the shortest step to read, but it will take some time, especially if this is the first time you’re really analyzing your lifestyle and expenses.
This step involves examining your current lifestyle and accepting reality as it is. The only place you can start from is right where you are. Look at your monthly income, your detailed monthly expenses like housing (rent, mortgage, utilities), transportation, food (groceries and eating out), entertainment, insurance, all of it. Be brutally honest with yourself. If you have built a habit of spending more than you make, this may be very hard. Keep at it. Your financial future is at stake. So is your peace of mind.
To help track your spending and investments, I recommend using Mint or Personal Capital. I use both. These tools will provide you an in-depth and emotionless data-driven look at the realities of your spending habits.
For a deeper look at apps that can help you reach financial independence, check out The Best Personal Finance Software.
Clarify Your Ideal Retirement
This is where you clarify how you want your retirement to be. Your personal desires will shape when you can realistically expect to retire. You may realize that your fantasies of a perpetually extravagant retired lifestyle are just fantasies.
The truth is that the majority of us must be willing to make sacrifices now as well as in retirement if we aim to retire early.
Your household must spend much less than the amount of your take-home income in order to save the amount required to have invested to afford early retirement. Breaking even on your income:expense ratio will not help you here. If you make $100,000 annually and your current lifestyle habits demand that you spend $100,000, you cannot reach early retirement. That is unless you already have enough money that your current and future lifestyle is covered. In that case, you’re already financially free, and I look forward to whatever advice you send my way.
So what does your ideal retirement look like? If your idea of retirement is to live in an RV and roam around the United States, your path to early retirement will look much different from someone who wants to spend their retirement on an expensive island in Hawaii.
Now is the time to look at your desired lifestyle very honestly and ask yourself at least these questions:
- Do I really believe this lifestyle is feasible given my current age, income, and expected future income?
- Do I believe this lifestyle will make me feel fulfilled?
- Am I willing to make financial sacrifices now in order to achieve this lifestyle?
- How much do I realistically plan to spend annually with this lifestyle?
- How much of a financial cushion do I want to have available at any time to cover unexpected circumstances – medical, familial, or economic?
You should have fun dreaming of how you want to spend your time when you don’t have to spend time working. But maybe starting a business or learning marketable skills — like programming, writing, or interior design — is on your retirement to-do list. That’s great!
Whatever your ideal lifestyle is, write it down and flesh it out in detail. If you want to travel, research how much (or how little) it costs to fly to another country and travel from hostel to hostel and how many months you can support yourself traveling. I’ve heard of people spending their time traveling on cruise ships, living on house boats in Asia, and even just working the job they’ve had for decades because they want to. The best part is that it’s up to you.
Once you have a very clear idea of the kind of lifestyle you want to have in early retirement, you need to take a big step and create a realistic budget based on your desired lifestyle.
Related: Financial Freedom by Grant Sabatier
Create a Realistic Retirement Budget
First, the terribly bad news: according to a consumer expenditures report by the Bureau of Labor Statistics, the average American spends the vast majority of their take-home income.
The average annual income before taxes: $78,635.
The average annual expenditures: $61,224
In Texas, where I live, which doesn’t have a state income tax, a pre-tax income of $76,635 (filing single status) gives an income tax burden of $16,615. Simple subtraction shows that $78,635 – $16,615 = $62,020.
In California, which has state income tax, the tax burden increases to $20,772 leaving a remaining income of only $57,863, which, you may have noticed, is less than the average annual expenditure.
The average American is spending virtually 100% of their take-home income.
Fortunately for us, this report provides guidance for us to create a realistic budget.
Housing. Transportation. Food. Personal insurance. Healthcare. Clothing. Your budget plans should include at least these items. For example, let’s imagine that you have plans to retire living on $40,000 annually. (By using the 4% rule, you’ll need to have $1,000,000 in investments so that you can live off of 4% of your investment.) If you’re anything like the average American, your monthly expenditures using the “all consumer units” column would look like this:
(Note: the columns only add up to about 85%. The remaining 15%, which I have added to the expenses below, is categorized by the report under entertainment and “all other expenses”. See Table A of the report.)
- Total Monthly Allocation: $3,333
- Housing: $1,093
- Transportation: $530
- Entertainment/Other: $513
- Food: $430
- Insurance: $397
- Healthcare: $270
- Apparel/services: $100
As we saw in the previous step, being thorough in picking a goal for your retirement lifestyle will help you set a very clear and realistic goal to work towards.
Note that the amount you need to save and invest during your working years is simply a function of your desired annual income after retirement. Take your annual spending target number and multiply it by 25. This gives you your target investment value for following the 4% rule. As an example, if you can currently live on $30,000 annually, and you plan to live on $30,000 annually after you retire, you know you will need to have $30,000 x 25 = $750,000 invested before you can safely retire with plans to live on 4% of your retirement account each year.
The $10,000 annual difference – reducing your annual expenses from $40,000 to $30,000 — requires saving $250,000 less in order to reach your goal for retirement.
Create a Plan
Your plan should include the ways you will:
- Destroy your debt and reduce spending
- Build a safety net
- Invest your money wisely
- Invest in yourself
Destroy your debt first. Some debt is reasonable (like a low percentage mortgage), but other debt like a credit card at 15% needs to be put down. If you’re in a position where you have any debt that has an interest greater than the expected annual returns on investments (which is about 10% for the past century), it doesn’t make sense to invest for a lesser return when killing your debt provides the greater benefit.
If you’re in over your head with debt:
- This may seem counter-intuitive, but first put $1000 into a savings account as soon as possible. This is your initial safety net. We’ll add to this soon, after paying off debt.
- Stop using your credit cards right now.
- Cancel any recurring subscriptions, even the ones you think you need. Be brutal. You can add them back later.
- Until further notice, eat at home. In case it needs to be said, eat food you buy at the grocery store and prepare for yourself at home.
- Choose your smallest debt first and pay the maximum amount you can afford to each month without putting yourself in a worse position. Pay the minimum on all other debt. (That $1000 you saved will be a buffer in case you make a tactical error here.)
- By paying off the smallest debt first, you can stop the bleeding in one financial sink-hole and give yourself the pleasure of seeing progress.
- An alternative here is to pay off the debt with the highest interest first. You’ll have to decide which seems more feasible for you.
- If you have debt from a college tuition, you can learn how to refinance student loans with a checklist and a payment calculator for reducing your debt.
- After you file your tax return, use your refund to make a payment towards a loan or credit card debt.
Build a safety net. If you got hit with a $2,000 bill right now, where would that money come from? If you don’t have a safety net, after paying off your debt is the time to start building it. And since you have already cut unnecessary spending, you’ll be able to build this safety net quickly.
Common advice states that you should have at least 3 to 6 months worth of your expenditures covered by savings (or easily liquidated investments). If you spend $4,000 each month, you need to have at least $12,000 saved. This covers a good amount in case you have an emergency repair or you lose your job. Though watching that safety net dwindle during an emergency feels bad, it will feel better than not having a safety stash in place.
I lost my job in January 2019, and my emergency fund was a huge source of mental and financial peace. I share a bit more about losing my job and the mental shift that caused for me in my plans to save $25,000 in 2020 and the post Why Am I Exhausted After Work.
Invest your money wisely. Once you’ve paid off your debts and you have a solid safety net, it’s time to start investing, preferably passively with low-fee index funds and bonds. The management fees for index funds are extremely low so you keep much more of your hard-earned dollar’s appreciation than if you go for an actively managed account.
As you get older, you’ll likely want to invest more into your bonds. One possible method is to use your age as a guide for the percentage of your investments that you should have in bonds. For example, if you’re 60, having around 40% of your investments in index funds and 60% in bonds (and keeping that percentage in balance as the market fluctuates monthly or yearly) will keep you in a stable financial position. You’ll be able to weather the market downturns while capitalizing on the low prices since re-balancing during a recession means you are buying stocks low, and re-balancing during a bull-run means selling stocks when they’re high.
Invest in yourself. Part of investing wisely is investing in yourself. Now that you are saving and investing money, you may want to consider building skills that will make you more effective in your career now. Getting a promotion will help you save more and reach financial independence sooner, and saving more money compounded with spending less is a recipe for success. If you’re not thrilled by the idea of thinking about your current work more than you already do, perhaps you can pursue an interest that you haven’t yet given your attention.
One of the best ways to achieve long-lasting financial freedom is to have skills that can make you money after you retire. “But isn’t that working?” Well, yes, in a way. When I talk about early retirement (and its benefits), I’m really talking about the freedom to work if and how you want. If, for you, that means no working at all, then build your financial plans around that. Perhaps you chose a career for the money instead of the passion. You can make that career work for you now while you pursue your passions on the side. Many passions can be turned into a side business. A side-hustle built out of your true passions — especially when you don’t need the money — sounds pretty satisfying to me.
All of these steps work together. Skipping one (like not paying off your debt first) makes the whole plan fall apart. This isn’t easy, but it is how to get to an early retirement and have a plan to thrive.
Stick to Your Plan
Once you have a plan, the natural next step is to implement your plan. Revisit your plan every week in the beginning. Looking at your plan often will force you to be conscious of the reality of your financial situation, and it will help keep you motivated by keeping your eyes on your goals. If you feel some pain going through this process, remember that this pain is good for you, and it is setting you up for a better future. The more often you visit your plan, the more likely that you will stick to building good saving habits and, naturally, break your bad spending habits.
After you have made some good progress with your plan, start taking inventory every month instead of every week. Once you have achieved a consistent string of successful months, you will have built up good habits and a mindset that will keep you on your path to financial freedom.
To restate the early retirement how-to stages:
- Examine your current lifestyle
- Decide your ideal lifestyle
- Create a realistic retirement budget
- Create a plan
- Stick to your plan
Your path to financial freedom will be imperfect. For sure, you will have ups and downs. The most important thing is just to start with step one and make a commitment to see it through. Begin with step one, and you’ll figure out what you need to learn on the way. Your efforts will pay off in dividends.
Related: The Best Way to Make Extra Money