By Ekenna Anya-Gafu
In Silicon Valley, there is a fairly new phrase called "F.I.R.E." No, not the "Fyre" festival on Netflix, but F.I.R.E. meaning Financial Independence, Retire Early. The average person retires at age 67, which also coincides with the average full retirement age for Social Security. Here are five actionable steps to beat the average and retire younger.
The most important step on the path to early retirement is to create a budget. Having a clear understanding of how much and where you are spending your money is essential. If you have a deficit (in other words, making less than you are spending), take a look at your spending pattern to see where you can make cuts or adjustments going forward. The easiest places to make cuts are unused subscriptions and your food bill.
If you have a surplus (meaning you are making more than you are spending), how you use this "excess" will make all the difference in the world.
There are a variety of tools that can help you create a budget like Mint, Personal Capital and Pocket Guard. In today's technology age, there’s really no excuse for not having a budget.
Save early and save often. A great way to visualize this is the Rule of 72, a fast and easy way to picture your wealth growing. If you haven’t heard of it, here’s how it works: take the number 72 and divide it by the average rate of return that you expect to get on your investments. For example, if you had a 10% return and started with $10,000, in 7.2 years your $10,000 would be worth $20,000. In 14.4 years (14 years and 5 months for the people wondering what the decimal was), your money would be worth $40,000. As you can see, compounding is key to growing your wealth.
If you work for someone else, the best place to start is with your employer-sponsored plan because many employers offer a match, which is generally around 3%. So, let’s say that you’re 30 years old and make $65,000 per year. You put $10,000 per year into your 401(k) and your employer contributes 3% of your salary or $1,950. In an account returning just 7%, on average, you will have over $800,000 by the time you’re age 55. Note that the maximum you, as the employee, can contribute to a 401(k) or similar employer-sponsored plan for 2022 is $20,500. If you’re age 50 or older, you can make an additional catch-up contribution of $6,500 in 2022.
To retire early, save in a Roth savings account when you can. If you could earn money on your money and then take your contributions and earnings tax-free, would you do it? Most of us would say yes.
The Roth IRA works something like the traditional IRA except with a twist: you don’t get a tax deduction for contributions you make to the Roth IRA. Whatever you put in your Roth this year is money on which you have already been taxed. But you NEVER have to pay taxes on the gains that your contribution generates. All you need to do is reach the age 59½ and have the account open for 5 years before you can take a withdrawal. And although not generally recommended, if in a bind you can actually take out what you put in without any taxes or penalties.
There are income limits you should be aware of prior to contributing to a Roth. If your income is too high, you can make a “backdoor” Roth contribution. Here’s how it works. First, you need to create a traditional IRA and a Roth IRA. To avoid the income limitation, you would move your money into the traditional IRA first, then you move your money to the Roth IRA (generally I wait a day to avoid any confusion in reporting, but it isn’t necessary). [Editor’s note: Always review your specific situation with your tax adviser before doing any Roth conversion.]
Some employer-sponsored plans offer Roth options within the 401(k). Unlike with Roth IRAs, there are no income restrictions on contributing to the Roth option of your 401(k) because you are contributing after-tax money. You don’t have the tax deduction upfront, but you gain from not paying taxes on the growth when you withdraw the funds.
In addition, there are no required minimum distributions (RMDs) on Roth IRA or Roth 401(k) funds when you reach age 72.
For some people, the pretax deductions for contributions to a traditional IRA or 401(k) could actually lower your overall tax bracket. Check with a tax professional about your own personal scenario prior to doing a back-door Roth or Roth conversion.
To retire early, maximize your employee benefits. One way to manage your expenses and maximize the disposable income left for investing is to take advantage of every applicable employee benefit. If your employer offers a true high-deductible health insurance plan, consider opting for that one and opening a health savings account or HSA. You can contribute up to $3,550 to an HSA for yourself, and up to $7,100 for your family. Keep in mind that once the money is in the HSA, there is a 20% penalty for any withdrawals for non-health expenses. However, contributions not used in the current year can roll over indefinitely, grow tax-deferred, and even be invested.
Other employer benefits that can add to your bottom line if used correctly are accounts that collect pre-tax contributions for child- and dependent-care expenses, as well as employer-provided assistance for you and your children or dependents. For example, some employers offer tuition assistance if you’re taking classes related to your job, or free or discounted public transit or parking, to name a few. Check with your employer to review your benefits as soon as possible.
Start now. The sooner you begin your journey to retirement and focus on the previous four steps, the earlier you’re likely to be able to retire.
These steps are proven to put you in a better overall financial position, as well as putting you on the path to retire earlier than your peers and live the F.I.R.E. movement lifestyle.
About the author: Ekenna Anya-Gafu, CFP®, AAMS®
Ekenna is Bay Street’s Director of Planning and Chief Financial Officer. He provides institutions with customized support for retirement plans, from development through review and optimization. Ekenna also leads Bay Street’s comprehensive financial planning strategy aimed at turning clients’ financial dreams into reality.
Prior to Bay Street Capital Holdings, Ekenna spent five years in the brokerage world with Charles Schwab and TD Ameritrade.
Ekenna is a CERTIFIED FINANCIAL PLANNER™ (CFP®) and an Accredited Asset Management Specialist (AAMS®). He is a graduate of Black Hills State University where he completed 4 years of collegiate football with a double major in Finance & Economics and Behavioral Science.
This communication is general in nature and provided for educational and informational purposes only. It should not be considered or relied upon as legal, tax or investment advice or an investment recommendation, or as a substitute for legal or tax counsel.