Early Retirement: Don’t Make these Five Mistakes

Handing in a resignation letter and walking away from an unfulfilling career may be one of the most satisfying acts in an individual’s life.  By some measures, there are an increasing number of satisfied people in the world today.  Indeed, recent accounts increasingly show that people are leaving their jobs in droves.  These developments are evident in articles about quit and vacancy rates and even rising Google Search trends for early retirement.  To be sure, one study found that COVID has prompted a growing wave of early retirements, especially for people who had not planned to quit their jobs but are now thinking of doing so.  Can you relate?


Maybe your investments have performed solidly over the past 18 months, and now you have the financial resources and confidence you need to pull the trigger and finally step into financial independence.  Maybe your company has recently gone public, and you’ve come into a large financial windfall that has set you up for early retirement.  Or, perhaps you’ve had time to consider whether the work you’re doing today truly aligns with what matters most to you in your life. 

Whatever the case may be, now could finally be the time for you to take the next steps towards early retirement.  But before you walk into your boss’s office and hand in that resignation letter, you’ll likely want to consider some potential pitfalls that might derail your financial independence early retirement plans.  Indeed, not thinking through some crucial early retirement mistakes could leave your financial goals falling short.

Here are five financial mistakes that you’ll likely want to avoid as you take your next step towards becoming the master of your financial independence journey: 

Mistake #1: Underestimating your retirement cash flow needs

Let’s assume that you’re 45 years old, have saved one million dollars, and are now ready to pull the trigger on early retirement.  If this is you, I’d like to give you a round of applause because, according to a study from Fidelity, the average 401k balance for an individual in their forties is roughly $93,000.  So, if you’ve accumulated one million dollars by this age, you’re well ahead of your peers.  But will this savings be enough to cover your lifestyle expenses if you decide to retire tomorrow?

Let’s take a look at an example to understand when a million dollars may not cut it when it comes to covering your retirement cash flow needs.  First, if we assume that you’ll need $50,000 per year to keep the lights on and allow you to enjoy your current lifestyle and your investments grow by about five percent annually, you should be fine, right? 

Well, one problem with this assumption is that your living expenses will stay fixed at $50,000 annually over the next half-century.  Realistically, however, your cost of living is likely to creep higher by an average of 2% per year.  Rising inflation means that the lifestyle that costs you $50,000 today could well rise to over $130,000 in 50 years.  At this rate, your million-dollar savings could be wiped out well into retirement if specific lifestyle changes aren’t made today.

Therefore, if you’re trying to determine whether a million dollars or any amount for that matter is enough to retire early, start by figuring out what your inflation-adjusted household expenses may be throughout retirement. 

This analysis involves developing realistic expectations for your lifestyle spending in the years ahead, evaluating the effects of inflation on your annual income needs, and setting some realistic expectations about your investment return rate.  Only then can you determine with some certainty whether the nest egg you have today is enough to cover your living expenses for the rest of your life.


Mistake #2: Relying solely on your 401k or IRA for early retirement

Another mistake that some early retirees make is concentrating their savings in qualified accounts and not putting enough away in taxable investment accounts.  Why is this a problem?  Well, with some exceptions, money in a qualified account, like a 401k or IRA, won’t be available penalty-free until you reach age 59 ½.

So, if you’re 45 years old, ready to retire early, and have all of your savings tied up in a 401k, your options likely will be limited when it comes to using your savings to cover everyday expenses. That’s because tapping your qualified savings early could lead to a host of penalties that could otherwise derail your best laid financial plans.  How can you ensure that you’re prepared for early retirement without incurring unnecessary costs? 

One option is to save enough money in a taxable account to cover your living expenses until you can begin safely drawing down money from a 401k or IRA at 59 ½.  So, how much money should you have saved up in each type of account? 

Well, let’s assume that you’re 45 years old and plan to spend $50,000 per year on living expenses, inflation-adjusted over the next 50 years.  Based on several simplified assumptions, you’ll likely need to have saved 1.3 million dollars before you quit your job.  Two-thirds of that amount (or about $830,000) should be in a taxable account to pay for day-to-day expenses. 

The remaining amount of your retirement savings (about $400,000) should be spread across qualified accounts like 401ks or IRAs. As you draw down your taxable account early in retirement, your qualified accounts likely will continue to appreciate, untouched but for periodic contributions or rebalancing, hypothetically appreciating to a level of $850,000 by the time you reach age 59 ½.  At that point, you can begin spreading living expenses between both taxable and qualified accounts.

Complex calculations aside, the key takeaway here is that the farther out you are from retiring at age 59 ½, the more of your retirement savings you’ll need to have allocated to a non-qualified savings account.  Not anticipating this mistake could derail your early retirement goal for quite some time.


Mistake #3: Dismissing social security benefits entirely

One financial planning component that many financial independence retire early (FIRE) proponents often overlook is social security’s effects on how much you’ll need to have saved for early retirement.  For example, recall from our previous example that an individual might need $1.3 million to cover lifestyle expenses of $50,000 (inflation-adjusted) over fifty years. A $36,000 annual social security income benefit could reduce your investment savings need by about $200,000 starting at age 45 and put you closer to that $1 million savings target.

How? Let’s take a closer look. 

You’ll recall that between various retirement savings accounts, we estimate that an individual with an income need of $50,000 per year, retiring at 45, would likely need about $830,000 in taxable accounts and $400,000 in their qualified accounts.  Factoring in social security benefits starting at age 67, this same individual would likely need about $750,000 in their taxable account and $274,000 in their qualified accounts.  The added social security benefit lowers the amount of money drawn down from retirement savings in later years, naturally reducing the total amount of money that needs to be saved before quitting their job.

The good news is that making one million dollars work for retirement is feasible, so long as the savings are spread across the proper accounts, and social security benefits kick in as expected.  So, how can you determine the social security benefit amount to use in your financial projections?  One of the simplest ways to obtain this number is to visit https://ssa.gov/myaccount.  Here you’ll be able to get a copy of your social security benefit statement, which outlines your projected future benefits based on what you’ve already paid into the system.

But what if you’re 45 years old today, and you expect that social security will go broke by the time you start drawing down benefits twenty years from now?  This concern certainly is legitimate.  Even so, it’s possible that being such a politically sensitive topic, lawmakers won’t let the social security program die entirely.  Even so, the further you are away from receiving projected social security benefits, the more of a discount you’ll likely want to apply to projected future income benefits as a way to account for uncertainty related to the program. 


Mistake #4: Forgetting to factor in healthcare expenses

So, you’re 45 years old, in good health, and doing everything right to take care of your body and mind. You exercise regularly, eat a balanced meal, and take your vitamin supplements daily.  You don’t have any health concerns right now and expect to live a long life.  Why should you care about potential healthcare expenses? 

Well, what happens if your health situation unexpectedly changes somewhere down the road, say in 10 years or so.  Indeed, the events of 2020-2021 have taught many of us that our health, no matter how hard we try, can be drastically affected by circumstances entirely out of our control.

Add to this the fact that the cost of medical care has been outpacing the average level of inflation for years.  From this perspective, if you’re not building in rising healthcare costs into your financial independence early retirement plans, you could be setting yourself up for a big disappointment in the years ahead.

So, how do you know whether you’re accounting for the right amount of healthcare spending?

To answer this question, you’ll need to take time to think through the kind of care you will need in old age and account for their related costs.  While medical expenses (like paying for insurance premiums) may only constitute a sixth of your early retirement income need at age 45, by the time you reach age 70, those expenses could rise to a third of your income needs.  And depending on your living situation, these numbers could increase to over half of your spending by your late 80’s when considering expenses related to assisted or long-term care needs.

So, if we take a simple 6% appreciation in medical costs from age 45 and extrapolate it out through retirement, how does that affect our earlier projections?  Recall that with social security benefits, your financial independence retire early savings need would be about 1 million dollars spread across taxable and qualified accounts at age 45. 

When factoring in rising medical costs, you’d likely need to have saved an extra $300,000 at age 45 even after factoring in the bump from social security benefits.  When accounting for rising medical costs, this time around, you’d likely need $870,000 in taxable accounts and $420,000 in qualified accounts compared to $750,000 and $274,000 in our previous example when you begin early retirement.

Again, the key consideration here is ensuring that you’ll have enough saved to cover unexpected medical expenses when you’re healthy while being prepared for the unexpected over the long term.  Without employer medical coverage, you’ll need to be prepared for private healthcare coverage, which you can purchase in your state’s insurance marketplace.  You can visit healthcare.gov to get a better sense of the options available to you.  Either way, no matter how healthy you are today, don’t make the mistake of being unprepared for some form of medical care that you’ll likely need in the decades ahead.

Mistake #5: Not giving your money a purpose

One final but a fundamental mistake that some individuals who retire early make is not having a purpose for their money.  These individuals often have one goal, and it’s simple: save money so you can quit your job. But then what?  If your goal has been to live frugally and save every penny so you can leave the workforce but don’t have a purpose for life after that, then what’s this journey been about?

For many of us with financial independence retire early (FIRE) aspirations, these qualitative, squishy questions may seem irrelevant at face value.  You may say, “I already know how much I intend to spend.” Or “I’m content with my life today; nothing will change.” But honestly, how can you be so sure? Many of us don’t know where our lives will take us a year from now, let alone a decade or half-century from now.

One analogy that we use when discussing an individual’s finances is to think about it as a home divided into two parts.  The right-hand side of the house defines the financial resources and tactics used to make retirement a reality.  In other words, it encompasses a lot of the items that we discussed here today: tactics.

However, the left-hand side of the home defines your values, your relationship with money, and your life goals in retirement.  In order words, it contains the elemental component: strategy.  It represents, “where is my life headed, and what’s all this money for?”

The point here is to spend time thinking about the general direction you’d like your life to go.  One analogy that we often share is that of taking a flight from Los Angeles to New York.  A pilot’s five-degree navigation error at the start of the journey could put the plane thousands of miles off course when it reaches the East Coast.

Giving your money purpose will take some deep thought, and at times involve having uncomfortable conversations and thinking through some harsh realities.  But in the end, the outcome produces greater clarity and direction for your money’s use.  At the same time, if you do plan to retire at age 45, it can help you define exactly how much savings you’ll need to cover your lifestyle expenses over the next 50 years.


Avoiding Early Retirement Mistakes

Before we wrap things up, we need to talk about one of the biggest mistakes individuals aspiring for financial independence retire early make: blindly following the four-percent rule.  A lot has changed since this concept was introduced nearly 30-years ago, and, quite frankly, this approach to calculating how much money you need to retire early is likely outdated. 

To be sure, financial markets, central banks, and government policies have fundamentally changed since the four-percent rule was introduced in 1994.  So, what can you do to ensure that you’ve saved the right amount of money for retirement to maximize your chances of avoiding a savings shortfall?  First, start by spending the time to think through what you want your post-career years to look like.  Ultimately, answer the question, “what is this money for?”

Next, think about how you expect your lifestyle spending to change over the coming years and decades while being mindful that inflation will create a greater demand on your savings.  Here again, you’ll want to ensure that your financial plan is realistic regarding income needs as prices rise, even if you don’t anticipate a significant change in lifestyle spending today.

Then, be sure that you’ve put enough money away in savings accounts that you can access today.  Recall that qualified accounts, like a 401k and IRAs, aren’t accessible penalty-free until age 59 ½.  Therefore, you’ll want to have money socked away in taxable investment accounts to cover living expenses before tapping your retirement savings.

Finally, consider how social security benefits and medical costs will impact your overall income drawdowns, and more broadly, your retirement savings needs for the long-term. Recall that factoring social security benefits into your income projections could cut your retirement savings need at age 45 by hundreds of thousands of dollars.  At the same time, not preparing for unforeseen healthcare concerns could leave you with unexpected medical expenses not accounted for in your savings plan. 

Are you ready to quit your job and live life on your own terms?  While you might think you have enough money saved today, one way to ensure that your retirement savings are on the right track is by avoiding some common early retirement mistakes.  While calculating your retirement need is no simple task, it nevertheless highlights a key reason why developing a financial plan is an essential component of early retirement preparation.  Indeed, doing the work today could maximize your chances of success for the long term and help you finally become the master of your financial independence journey.