Advice on Cashing Out

I've been thinking lately about cashing out lately.  For those of you who've never heard the term, the concept is basically to build up your money so that you are able to effectively retire early, usually in your forties to fifties, and do whatever you want with your new found free time.  Depending on your personality, that might be taking on new hobbies, expanding the time you devote to your existing hobbies, simply spend more time with your family, or even start working a job you really enjoy, regardless of the pay rate.

So far, cashing out sounds pretty good; what could be better than calling it quits on your job a decade or two ahead of schedule and being able to live every day like it was a vacation?  Well, unfortunately, there are some downsides: because you're trying to retire so early, you're pretty much going to be on your own as far as saving for retirement.  Retiring before the age of 62 means you aren't entitled to even partial Social Security benefits, and pensions (for those lucky few who still work at companies that have them) are likely going to unavailable to someone who's only been on the job for fifteen or twenty years.

“No problem,” you say, “I'll just depend on my own retirement savings to carry me through.” Well, that's fine, except early retirement means you're not giving your best friend as an investor, compound interest, much time to work. This means, if you want to get to the amount of money you need in a much shorter time frame, you need to add much more money to your investments.  How much more?  Well, let's say that you crunch some numbers and decide that taking out $40,000 of your money each year will allow you to enjoy your early retirement.  If we assume this amount will represent no more than 4% of your total portfolio, that means you need one million dollars in your account on the day you retire in order to make your whole plan work.  If you're saving for 40 years, no problem; according to my ‘back of the napkin' calculations, an annual contribution of $2100 more than gets you to your goal.  (We're setting aside inflation at the moment, to make the calculations a bit easier; don't worry, we'll cover how inflation affects the amount you need to invest soon.)

The problem starts if you try to cut down that amount of time until retirement.  If you want to retire in 30 years, expect to contribute $5600 a year to reach one million; more than twice as much, but still a workable amount for someone who requires about $40,000 a year to meet their needs.  To retire in twenty years, you're looking at a contribution of about $16,000 a year, nearly tripling your savings requirement.  Finally, to reach a one million dollar nest egg in ten years, you will need to contribute $58,000 a year, nearly fifty percent more than you intend to spend each year in retirement.  If you are not making a six figure salary, you're going to be hard pressed to come up with nearly sixty grand year; and if you are making that much, are you really going to be satisfied only spending forty thousand dollars each year after you retire?

If that hasn't shattered your dream about retiring to a tropical paradise in just a few more years, let's note that this is an oversimplification.  For one thing, we haven't talked about inflation at all.  This is one area where the early retirees have a bit of an edge; less time until retirement means less time for inflation to eat away at the real value of your money.  Unfortunately, it also means you're have to increase the figures we just gave for the yearly contributions; even ten years from now, a million dollars just won't be worth as much.  To get an inflation-adjusted million after forty years (with a 3.5% assumed rate of inflation), you'll have to increase your yearly contribution four-fold, to $8400 dollars; in order to retire in ten years with an adjusted million, you'll need to put in $82,000, a nearly ten-fold increase in your contribution amount from a forty year horizon.

After hearing all this, are you sad, depressed, and ready to just give up on your dreams of early retirement?  No?  Good; if you realize the enormity of the task ahead of you and still are determined to retire early, you might just have the resolve and determination in order to make your dream come true.  To help you out, let's end this column on a higher note and go over a few steps for anyone who shares my dream of leaving the rat race and retiring early:

1) Plan carefully, and conservatively – Your first step should be to sit down, crunch some numbers, and see (a) where you currently are, financially, (b) where you hope to be when you retire, and (c) what path you need to travel to get from (a) to (b).  Decide just how much you will need when you retire (adjusted for inflation), the amount to invest each year, and whether it will be possible for you to pull that much from your budget to add to your future plans.  If it's simply not mathematically possible to retire at the time you want (without working two more jobs or simply never eating), try to shift your desired retirement date a bit; aiming to retire in twenty years rather than ten cuts the (inflation-adjusted) amount you need to save down more than fifty percent (to $32,000, if you are curious), and going from a twenty to thirty year time frame  (which could still lead to retirement before the AARP decides to add you to their ranks) cuts the needed amount in half again (to $16,000).  Of course, all these figures assume you're shooting for an inflation adjusted one million dollars at retirement; you'll have to adjust them to meet you own particular situation.

2) Cut down on your spending – There are two advantages to this course of action.  First, if you're spending less each month, you have more money to put towards your early retirement, making it easier for you to meet your investment goal.  Second, if you find you're able to live a good, full life spending only thirty thousand a year rather than forty thousand, you can probably adjust your final goal downward, requiring less in contributions (or netting a quicker time to reach the needed amount with the same contributions).

3) Invest More – If you're trying to retire years, if not decades, ahead of the rest of your office mates, you can't invest the same amount that they do.  Putting 10% of your paycheck into a 401(k) every year might (and I stress, MIGHT) provide you with enough of a return in order to retire at 65, but it won't be enough to give you a ‘Get of Work…Forever' card by the time you turn 50, to say nothing of when you're even younger.  Shoot for 20-30% of your gross income, and try to ramp it up a bit more, if possible.

You should also look carefully at the rules governing retirement plans, to determine if, should you invest in a 401(k), IRA, or Roth, whether you will be able to get the money out when you need it and how much it will cost you in penalties and other fees when you do.  If they look like they will benefit you, feel free to take advantage of their tax advantaged nature for a portion of your retirement savings; if not, simply use taxable accounts.  (A complete guide to all the subtleties of retirement accounts as they pertain to early retirees is bit more than we're going for right now; just be aware that usually, taxable accounts will be better when you're trying to retire early, but not always.)

And most importantly…

4) Make sure to have fun along the way – It might be tempting to take every spare cent you have and put it into your retirement savings (and you might argue that I just told you to do as much in my last point), but if you do so at the cost of your current enjoyment, you're going to spend some of the best years of your life doing an impression of Scrooge while your friends, coworkers and classmates are having the times of their lives.  Furthermore, if you spend the first twenty years of your adult life depriving yourself, you're going to be that much more likely to live it up when you do retire, and possibly blow through all the money you worked to accumulate.  Neither of these events is something I want to happen to you.

A much better strategy is to be conscious of your financial goals and how much you are trying to save, but not to let it stop you from having a life.  Go on, attend parties, go on dates, spoil your significant other every now and then, and perhaps even spoil yourself occasionally.  Just try not to go over the top when you do so; be frugal in your day to day life as well as your celebrations, and you can have your fun AND save your desired amount for an early retirement.

Here's looking at good luck to you in your attempt to retire early; I hope I'll have the chance to join you!

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