How much money do you need to retire early?

There are many variables that go in to determining a specific amount of money you will need to retire. Yet I constantly hear people asking the question How much money do I need to retire?

The simple answer is that you can retire as soon as you have enough money saved to support your spending for the rest of your life. Typically the number comes out to about 25 times your current annual expenses or ten times your annual earnings.

The dollar amount will be different for everybody. Anyone who says they can give you a dollar amount without knowing your individual circumstances is lying to you. I still remember the first time I performed this exercise on myself. I was sitting in traffic after a particularly draining day of work and thinking to myself how much longer do I have to do this? This is when I decided to do the research required to actually answer that question. What I discovered is a formula that can work for anyone planning their early escape from the rat race.

The following is a list of questions you will need to assume the answers to in order to determine a specific number of dollars that you will require in your next egg before telling your boss where to go.

How much will you spend in retirement?

The first assumption you will make will be your spending. In order to determine a total savings you will need to know how much you intend to spend each year you are retired. Will that amount go up or down? Will it be more or less than when you were working? Most people tend to assume they will spend less in retirement however what will you do with all that free time? Traveling costs money. Shopping costs money. You will really need to do some introspective searching here to determine your intentions in your retired years.

How many years will you spend in retirement?

It is impossible to know when our card will be pulled and we will leave this earth. We can however safely assume that if you intend to retire at age 40 you will spend more time in retirement than if you plan to work into your 60s. I always overestimate when calculating this number just to play it safe. Worst case scenario, when I die I will leave more to the people I leave behind. You do not however want to underestimate this number and run out of money. The safest bet therefore is to assume an infinite number of years in retirement. Yup, assume you will need enough money to last forever. This will make more sense later in the article.

What will your taxes be in retirement?

Taxes are another area of uncertainty for retirees. We cant know what tax laws the government will screw us with pass legislation on in the future. We can only use past experience to assume what might happen in the future. A safe assumption is that your taxes will continue to rise. Therefore it is important to take the necessary steps before you retire to protect yourself from the tax man.

Here is an example of something I am doing to prepare myself for this. I have a 401k plan that will be taxed as regular income as I withdraw from it in retirement. I can not begin withdrawals until I reach age 59 1/2. Since I plan to retire early, I will need to rely on savings as my primary funding of my retirement until I reach age 59 1/2. Since income tax has already been paid on that money, I can therefore expect my taxes will go up at when I begin taking payments from my 401k.

One way this effects my decisions before retirement is that I only contribute enough into my 401k to receive the full company match. You would be a fool to give up that free money. If your company offers you a 401k with matching contributions, you take it. I have however decreased my contributions considerable in recent years to the bare minimum required to receive the full match. Instead I am investing those same funds on my own after tax. As a result, when I go to spend that money, I can simply spend it. The tax man has already been paid.

How much money can you expect from social security?

When it comes to what you can expect in retirement, social security is a lot like taxes. The government will ultimately decide how you will be impacted. I personally do not even include social security in my calculations. If it is there for me, great. If not, at least I won’t be disappointed. Furthermore, I plan to retire long before I qualify for social security.

If you absolutely must include social security, you can assume current payouts will continue as well as the current trend of rising qualifying age and hope for the best.

As you can see, there are quite a few variables to consider. So how do we put this all together to come up with our estimate?

The 25x Rule and 4% Rule!

What is the 4% rule? The 4% rule attempts to provide a safe withdrawal rate and steady income stream in retirement while maintaining an account balance that will keep the income stream flowing throughout the duration of your retirement.

The first thing I determined when figuring out how much my nest egg needed to be was how much my annual spending needed to be. I used my current annual spending and assumed it would remain constant, plus inflation, throughout my life. Next, I multiply by 25 and voila! I have my magic number.

Do the math.

If you spend $50,000 per year, under the 25x rule you will need 25 times that in your nest egg. That total comes to $1,2500,000. So if you can save $1,250,000 you will never need to work again.

The reason the 25x rule works is because of the 4% rule. The 4% rule states that you can safely withdraw 4% of your nest egg, increase that by inflation annually, and never run out of money.

So if we follow our earlier example of $50k per year at 25x or $1,250,000 your first year withdrawal of 4% would be, you guessed it, $50,000. The next year, you would increase that by inflation to cover your cost of living increase.

The key to why this works and you will never run out of money is that you will need to find an investment mix that averages a 7% increase annually. The stock market has averaged just slightly higher than that over the last 100 years. If you have 7% annual growth, lose 3% to inflation and spend 4% your principal never changes.

The 4% rule has been backtested by experts using over 70 years of historical data and they found that the probability of running out of money was “highly unlikely”

I was skeptical myself at first so I did my own research. I used every calculator I could find and filled up pages and pages of notebooks with my own calculations. The math works out every time. Here is an article I wrote all about the 4% rule.

Reverse engineer your retirement

Now that you have a simple mathematical formula for how much money you need to retire, you can begin to engineer what type of life you want to live in retirement. You can start at the end and know exactly what steps to take in order to build the necessary nest egg.

You want to spend $100,000 each year in retirement. Save up $2,500,000. Unhappy at work and can’t wait to retire? You are willing to live on less in order to quit the rat race and you decide you can live on $20,000 per year? And you know you will only need to save $500,000 to make that happen.

Also, you can use this formula if you wish to just quit your job for a few years. How much are you willing to live on over the next year or 2 while you start a new career. Maybe you want to stay home with the kids for 5 years. How much will you require to do that?

Now that you know how simple it is to plan, the possibilities are endless.

Play around with the math and have fun.

As always, thanks for reading and Happy Planning

Earl