What You Should Know About Achieving Financial Independence And Early Retirement

Have you ever thought about retiring early…extremely early? We’ve been seeing an increasing amount of interest in the concept of FIRE, which stands for financial independence, retire early. The FIRE movement is largely one of younger people planning to achieve financial independence before 50 and sometimes before 40 or even by 30. If you’re interested in pursuing FIRE, here are some things to consider:

What does FIRE mean to you?

In other words, what would you do if you didn’t have to wake up to an alarm clock and go to work anymore? Would you continue to work at a job that you find fulfilling even if it doesn’t pay the bills or start a risky business venture? Travel or spend more time with family and friends? Move to a new area? Your FIRE lifestyle can have a huge impact on how much money you’ll need.

How much will you need to save?

Speaking of how much money you’ll need, saving enough is the biggest challenge to achieving FIRE since you generally have to save at least 50% of your income. You can use this popular FIRE calculator to see how your early retirement plan would have fared over every time period of your choosing since 1871. (Don’t enter any commas in your numbers since one quirk is that it treats commas like periods. Keep in mind that you won’t qualify for the full projected Social Security benefits on your statement if you don’t work until you collect so you’ll want to use a reduced amount.

The FIRE blogosphere (Mr Money Mustache is probably the most popular) is full of ideas on how to cut back on expenses, both to save more now and to require less income in retirement so you don’t need to save as much. Just be aware that many of these ideas may require significant lifestyle changes if you’re living beyond a college level standard of living. For example, I live in a small studio apartment that I bought in cash, only recently bought an inexpensive used hybrid car that I generally only drive on weekends, and have no student loans, children or pets. FIRE is like the financial equivalent of training to be an Olympic athlete. In other words, it’s not for everyone.

How will you invest those savings?

If you’re planning on FIRE, you may be able to invest more aggressively than an older person with the same number of years to retirement. Higher expected returns can give you a better chance of hitting your target nest egg in time. If your investments underperform, you always have the option of working longer. In addition, studies have found that more aggressive stock-heavy portfolios actually have a higher success rate than more traditional balanced retirement portfolios over longer periods of time. Just make sure you have a matching risk tolerance for aggressive investments.

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Of course, the future may not look like the past. One way to have an aggressive portfolio while reducing the risk of running out of money in a bear market is to try to live off the dividends during retirement from stocks that have a history of raising their dividends over the last 25 (Dividend Aristocrats) or even 50 (Dividend Kings) years. If the dividends are cut, you can make adjustments to your income or spending as needed. Many FIRE enthusiasts also invest in rental real estate.

How will you minimize taxes on those investments?

The high savings rate means that you’ll likely be able to max out all the tax-advantaged retirement accounts available to you like a 401(k), IRA, and HSA. Use your taxable accounts for your most tax-efficient investments like direct real estate (you can write off expenses and depreciation), international investments (you can take the foreign tax credit), and individual stocks and ETFs. The latter investments allow you to qualify for the lower long term capital gains tax for winners and harvest losses for losers.

The tougher part is getting your money out of tax-advantaged accounts in early retirement without penalties. First, you can withdraw Roth IRA contributions at any time without tax or penalty. Earnings in a Roth IRA are subject to taxes and a 10% penalty before age 59 ½, but the contributions come out first. This is why you’ll probably want to roll any Roth 401(k) money into a Roth IRA since Roth 401(k) withdrawals are a mix of contributions and earnings.

Second, you can convert traditional IRAs to Roth and then withdraw the converted amount tax and penalty-free after 5 years. (The converted money also comes out before earnings.) Converting money to a Roth IRA each year and then withdrawing it penalty-free after 5 years is called a Roth conversion ladder.  

Planning for FIRE is much like standard retirement planning…on steroids. Most of it is about simply saving much more for retirement. However, you may want to speak with a qualified and unbiased financial planner to make sure your plan is realistic and that you’re not overlooking anything. See if your employer offers access to one for free through a workplace financial wellness program. After all, you’ll likely need every penny you can save to achieve your FIRE dream.

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