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How to Retire Early in 7 Steps

If you're thinking about early retirement, it's important to understand what this means to you and to have a plan to make it happen.

Early retirement is a hot topic in the financial press of late. It's fueled in part by the rise of the FIRE Movement -- the Financial-Independence-Retire-Early trend of making more, spending less and quitting early. If this is a goal of yours, or you are at least thinking about early retirement, it's important to understand what this means to you and to have a plan to make it happen.

Here are some steps for you to consider on this journey.

How To Retire Early: A 7-Step Guide

1. Define Retirement 

For prior generations, this was pretty simple. You worked until age 65, collected Social Security, kicked back, and enjoyed life: This might mean travel, golf or whatever.

For those contemplating early retirement nowadays, this may mean retirement from the 9-5 corporate world of sitting in a cubicle, in favor of earning money from a hobby or other gig. Often this is some sort of self-employment, such as consulting or starting an online business.

The first step on your journey to early retirement is to define what early retirement means to you.

2. What Will You Do? 

As part of defining what early retirement means for you, it's important to give a lot of thought to what you will do once you do pull the trigger on your early retirement. You've no doubt read stories of people who retire early and travel the world. Some of these people run online businesses while traveling. While this may look like an easy and carefree lifestyle, those who are successful at it planned hard first.

Beyond the initial euphoria of early retirement and whatever you might do initially, early retirement is a long-term proposition. Those who retire at the traditional retirement age in their 60s can reasonably expect to live 20 to 30 years or longer in retirement. If you retire in your 30s or 40s, your time in retirement could be decades longer. It's wise to plan around what you will be doing with the rest of your life.

3. Save, Save, Save

Regardless of how you define early retirement, it's important to save for it while you are working. This means a combination of retirement accounts like a 401(k) plus investments in a taxable account.

While you will want to establish a savings goal, more is always better. The saving and investing that you do while working will go a long way towards allowing you to achieve your early retirement goals.

4. Set a Spending Budget

Whether you retire early or at a more traditional age, having a spending plan in retirement is crucial. What level of monthly cash flow will it take to support the lifestyle you envision? Whether you intend to live in your current home, move someplace else or travel the world, this all costs money. It's critical to understand how much money you will need to support your lifestyle after retiring.

5. Establish a Withdrawal Plan 

How will you access your savings and which accounts will you tap into and in what order? The rules for retirement plans such as a 401(k), IRAs and others tend to favor those who retire at a more traditional age.

Money held in a taxable account may be subject to taxes, but will not be subject to early withdrawal penalties as may be the case with a 401(k), IRA or other retirement plans. Withdrawals prior to age 59 ½ are generally subject to a 10% penalty, in addition to any income taxes.

For those who need to tap these types of retirement plans, one alternative is to take a series of substantially equal withdrawals under the 72(t) rules. This exception will eliminate the 10% penalty, but you will still need to pay taxes on the withdrawals.

These withdrawals will need to be made for the greater of five years or until you reach age 59 ½, whichever is longer. If you begin taking 72(t) distributions at age 37, you will need to continue taking them for 22 ½ years. These rules are complicated and it's easy to make a mistake that could trigger costly tax consequences, so it's important to work with a custodian or an adviser who understands these rules.

Beyond the tax aspects of your withdrawal strategy, remember that your money needs to last longer than for those who retire at a more traditional age. You will need to be especially conscious of how much of your nest egg that you withdraw each year and be ready to make adjusts to both your withdrawal rate and spending as needed.

6. Determine How You'll Keep Health Insurance

For those contemplating early retirement, dealing with the cost of healthcare needs to be a major consideration. Medicare coverage doesn't kick in until age 65, for those retiring in their 30s or 40s this means that they will need to find health insurance coverage for many years until they become Medicare eligible.

In the case of a married couple, if one spouse is retiring early and the other will continue working at a job that offers health insurance, the working spouse can add the other spouse to the policy for coverage.

If this is not the case, then it is imperative that you figure out a plan for health insurance coverage prior to pulling the trigger on early retirement. Even for those who are young and healthy, health issues do arise. The cost of one major health event if you are uninsured can wreck even the best-laid financial plan.

7. Consider the Risks and Have a Plan 

A well-thought our retirement plan should give careful consideration to the risks you might encounter along the way once you do retire. Retirement at a more traditional age is fraught with financial risks. Retiring 10, 20 or 30 years early magnifies those risks.

The two main risks to be considered are the risks of inflation and of a prolonged slump in the stock market.

Inflation is the worst enemy of any retiree at any age. Even the low levels of inflation we are currently experiencing can erode the purchasing power of your assets over time. The average inflation rate since 1900 has hovered around 3% annually. At this level of inflation, your purchasing power will be cut in half every 24 years. Be sure your cash flow, whether from your investments or some sort of earned income can keep pace with even modest inflation.

For those who retire early and who plan to generate a significant portion of their cash flow from their investments, it's important to monitor the downside risk inherent in your portfolio. One thing that can derail anyone's retirement is the sequencing of returns in retirement. If the market suffers a pronounced downturn just as you retire, this could put a major crimp in the ability to generate sufficient cashflow from investments.

It's important to have a plan to deal with these and other risks a long retirement can bring. Your planning doesn't stop once you commence your early retirement. Be flexible and be prepared to adjust as you move through your life. This just might be the biggest key to a successful early retirement.