I remember the summer after graduating from high school. I was 18 with long blonde, surfer dude hair, working as a luggage handler at a hotel. One day at work, my coworkers and I were sitting around during down time. Somebody asked, “Hey bros (*hair flip*), what if you had enough money in your savings account that you could live off the interest and never run out?” The idea of financial independence intrigued us, so we looked it up.
Given the abysmal interest rates that banks offer, we found that we would need $17 million dollars. Ugh. Even though it seemed like a ludicrous idea at the time, that discussion always stuck with me. Living off the interest from your savings account may not be feasible, but what about living off the returns from investments? This is how my plan to financial independence was born. Get ready to learn how I plan to retire early.
My Fail Safe Plan
My plan to financial independence has multiple fail safes and is broken up into three tiers. Each tier acts as a backup plan in the unlikely event that the previous tier fails. The tiers are set up to provide passive income to support my wife and I indefinitely.
This is it, people, the plan that will allow us to retire early:
Tier 1:
The first tier is investments in 401k and IRA accounts. Our goal is to put 40% of our combined salary away in these accounts. It’s a lot, I know. If you want to follow the same path to financial independence, check out my previous budgeting post to help you find ways to squirrel that money away.
I invest in index mutual funds (and you should too!). For IRA accounts, I use Vanguard and invest in VTSAX, which invests in every publicly traded company in the United States. 401k plans, however, are typically limited with their investment choices. Check out this post, which gives some simple strategies for which funds to pick for your 401k.
Investing in index mutual funds is a simple approach to investing that’s been proven to beat professional brokers. Save yourself the time and effort of picking stocks or using a financial advisor and use this approach instead.
Think you can outsmart my simple caveman approach to investing? Check out the Warren Buffet challenge if you’re in doubt.
If you’re familiar with 401k and IRA accounts, you know that withdrawing money from these accounts before 59 ½ results in a 10% penalty. When I first started my financial independence plan, this deterred me from these accounts. However, not taking advantage of tax deferred accounts is a big mistake. There are tax loopholes for accessing this money penalty free before 59 ½, and even without the loopholes, the 10% penalty is likely less than the taxes you would pay otherwise.
How Much Will You Need?
How much will you need to invest before you are financially independent? First, you’ll need to know your living costs. If you’re budgeting every month, you should know your average monthly spending. I’ve put together what a typical budget might look like for a couple. See below:
Note: This budget does not consider the four extra paychecks a couple would receive each year if they’re paid bi-weekly. Also, check out my post on HSA’s for info about paying for healthcare during your early retirement years.
The example couple above is spending $28,908 per year (12 x $2,409). Let’s talk about how much money they need in index mutual funds to be financially independent. This is where the term safe withdrawal rate (SFR) comes in. A safe withdrawal rate is the amount you can spend each year without running out of money, ever. Remember that conversation about living off the interest only? Well, this is how we can actually make that happen.
Over the past 100 years, the U.S. stock market has averaged 8% yearly returns after inflation. Research suggests that 4% is an adequate SFR, because it’s half of what the historical average return is (at 8%). So, if you’re spending $28,908 per year, you will need $722,700 ($28,908/4% = $722,700) in order to be financially independent.
How Long Will it Take?
Yikes, $722,700 sounds like a lot, right? You might be thinking you’ll never be able to reach financial independence. If the example couple above invests their savings every month ($1,591) in an index mutual fund, they will have a savings rate of roughly 40% ($1,591/$4,000 = 40%). With a 40% savings rate, you will find that math works out such that you will be financially independent in 18 years. Or to put it another way, if you graduate at 22, start working, and follow this approach, you’ll be able to retire at 40!
Check out the table below to see how your savings rate can supercharge your years to financial independence. The table assumes 8% yearly investment returns and a 4% safe withdrawal rate. Note that this table translates to any income level. A person making $20,000 or $100,000 per year with a 40% savings rate will be financially independent in 18 years. That being said, it’ll be much more difficult for a person making $20,000 per year to have a savings rate of 40%.
Tier 2:
The safe withdrawal rate already has a 50% safety margin built into it (because you are only using half the returns your investments are making) but it’s still good to have a backup plan. My backup plan is rental property income.
In 2017, my wife and I bought our first duplex, and it generates over $1,000 a month in passive income. Our plan is to accumulate enough rental properties that the passive income is able to replace Tier 1 in case our money evaporates from a stock market crash. Investing in real estate isn’t as scary and difficult as most people make it out to be. If I can do it, anybody can do it. Check out this post on how to analyze rental properties, which will hopefully alleviate some of your fears.
Tier 3:
In the unlikely event that both Tier 1 and Tier 2 fail, I also have Tier 3. Tier 3 is money set aside in a taxable investment account. The current limit for 401k contributions is $19,000 per year and the limit for IRA contributions is $6,000 per year. After reaching these limits, my wife and I invest the rest of our money in a taxable investment account. During our working years, the strategy for investing this money is the same as Tier 1: Index mutual funds (VTSAX). Once we enter our early retirement years, we will switch our asset allocation for this account to be mostly bonds. Stock and bond returns tend to be uncorrelated. With this approach, if we lose all our money from Tier 1 due to a stock market crash, Tier 3 will be preserved due to its large bond asset allocation.
Wrapping it All Up
There you have it. That’s my fail safe plan for financial independence. You may feel that this plan is too safe, and I wouldn’t argue with you. Any one of these tiers can stand alone to provide my wife and I financial freedom. However, I have multiple fail safes built in, because I don’t want to run into a situation where I’m forced to return to working for somebody else.
If you have any questions or want further clarification on anything, feel free to reach out to me!
If your curious about our path to financial independence thus far, check out this post where I give a year by year snapshot of our journey to early retirement.
What’s your plan for an early retirement? How will you get there?
Summarized links in this article:
Our Path to Financial Independence Retire Early
Budgeting: A Dreaded Necessity
How an HSA Can Pay for Healthcare During Retirement Years
How to Analyze Investment Rental Properties
Portfolio Strategies for How to Invest your 401k
The Best Way to Save Money on Your Taxes
Aron,
I like the thinking and theory behind your plan. I hope it gets more people realizing how starting now to retire makes retirement more attainable, sooner than later. I do have some questions about your assumptions. I see no planning for the costs of children or retirement health care. Also there are no insurance premiums, transportation costs or “have some fun on the journey” expenditures. What are your thoughts about addressing these costs? Best to you
John,
You bring up some great points.
Having children will definitely add to monthly costs. This is something that those with children will have to take into consideration while planning for their retirement. We plan on waiting until we are nearing retirement before having children, which will all but eliminate the high costs of child care. Food, clothing, along with other miscellaneous expenses will need to be accounted for, but I don’t see it getting in the way of an early retirement. There is a great post on it linked below if you want to read more: https://www.mrmoneymustache.com/2011/05/26/what-is-the-real-cost-of-raising-children/
There is $200 allocated per month for fuel (transportation). As far as “have some fun on the journey”, in the sample budget I didn’t account for the extra 4 paychecks that a couple will get each year (52 paychecks / 12 months a year = 4.33 paychecks on average per month). This equates to an extra $4,000 a year, which is more than enough for a nice vacation. Also, people will typically get raises over the years. So if the couple in the sample budget is able to keep their expenses the same, the extra money earned from their raises can be used for additional fun money.
Concerning health care, in later posts I’ll talk about how to use HSA’s during your retirement years. But looking at https://www.healthcare.gov/, a family of three can get on a $1,000 deductible plan for $150 a month.
Also, in the sample budget, I didn’t account for the fact that you won’t have to pay for a mortgage for the entirety of your retirement years, so that is an expense that will go away after time (except for property tax and home insurance).
Thanks for your questions!
Aron