Want to Retire in Your 30s? Here’s How to Pay for Early Retirement

So, you’re cruising down the path to financial independence and saving as much money as you can for early retirement. Congrats! Like most people, you may have a large portion of these savings in retirement accounts, such as an IRA or 401k. These plans have great tax benefits, but they also have age restrictions and penalties for withdrawals before traditional retirement age. If you’re targeting a retirement date in your 30’s or 40’s, you might be wondering … “How will I pay for early retirement?”

I retired at 38, but that’s because I’m lucky enough to still have a working spouse. However, we expect to be financially independent and “work optional” by the time Mr. RFL is also 38, though he may not choose to retire at that time. In order to keep our options open, we’re thinking through the question of how to pay for early retirement now.

Related Post: HOW TO REACH FINANCIAL INDEPENDENCE WITHOUT A SIX-FIGURE SALARY

Related Post: HOW MUCH DO YOU REALLY NEED TO RETIRE EARLY? (What’s your FI Number?)

Why worry about how to pay for retirement?

Because most people retire in their 60’s (or later). Additionally, most tax advantaged retirement accounts are set up to penalize you for withdrawals taken before age 59 ½. These accounts are designed to prevent people from raiding their retirement accounts during the working years and don’t consider the idea that someone might want to retire well before 60.

If you’re planning to retire in your 30’s, 40’s or even 50’s, you need to plan for how you’ll pay for the early years of retirement. That means having sufficient funds saved in accounts that you can actually access before reaching traditional retirement age.

Where should you keep money that will pay for early retirement?

Our plan for early retirement is to have enough liquid assets that we can access to cover at least the first 5 – 6 years of retirement. This assumes we won’t earn any income beyond that provided by our investment portfolio.

For our anticipated retirement expense of around $50,000/year, this means we’re targeting $250,000 – $300,000 in liquid assets available for use by the time Mr. RFL fully retires. Obviously, if we earn any income from part-time jobs or hobbies that partially offset our expenses, this target would be lower.

I’d also like to point out that our investment portfolio will be generating passive income each year, which we’ll begin collecting (rather than reinvesting) at retirement. With an anticipated investment portfolio of $1,125,000, I would expect our total passive income from interest and dividends to be around 1.5% or $19,000/year. However, only a portion of that will be immediately accessible to us, since some will be locked up in retirement accounts. For this reason, and to provide some additional buffer for the unknown, I ignored passive income in my calculations above.

Here are the places that we plan to accumulate money to pay for our early years of retirement:

1. High yield savings account (“HYSA”)
2. Taxable brokerage account
3. Health Savings account (“HSA”)
4. Roth IRA
5. Other retirement accounts (401k & Traditional IRA)

Did the last two surprise you? We’ll talk about each of these in the sections below.

1. High yield savings account

Yes, that’s right. It’s prudent to keep at least a portion of your savings in cash. A high yield savings account is a great way to protect your cash while still earning decent returns. Although rates are currently at record lows (0.5% on our HYSA), I expect these to go back up eventually. And while I realize the yields on cash are never sexy, remember that this money isn’t flagged for growth. It’s for protection… just like an insurance policy or your emergency fund.

How much should you keep in cash?

I would recommend having at least a full year’s worth of expenses in cash when you finally pull the early retirement trigger… even more if you’re pursuing “lean FI/RE” which tends to have less wiggle room in the budget. We’ll probably hold two years’ worth of expenses in cash, because I’d like my early retirement to be stress free. 

While this may seem like a lot, you should remember that the biggest risk as to whether or not you will outlive your investment portfolio occurs in the first 3 – 5 years of retirement.  You don’t want to be forced to sell at rock bottom if a recession hits during the first few years. Even if you’re well prepared for retirement, eroding that much of your principal during the first few years of retirement will significantly increase the risk your portfolio will fail to outlive you, according to most studies.

There are a few ways to mitigate this risk:

• Save more than you need for retirement for some extra cushion. Although this option may not be feasible if you’re getting a late start to saving or you don’t want to delay retirement.

• Keep a couple years’ worth of expenses in a high yield savings account so that you can tap that instead of your investment accounts if there is a long-lasting market dip. How many expenses you need to cover will depend on the amount of income you plan to bring in through hobbies, part-time jobs, and passive income from investments.

2. Taxable brokerage account

By the time we retire, this will represent the largest portion of our retirement funds. After maxing out tax-advantaged accounts, we invest the rest of our savings in a taxable brokerage account.

We won’t pay taxes on any principal withdrawn since the investments are post-tax. However, we will owe taxes each year for interest and dividends received, and on any gains at the time of sale.

Because I like the yield shield concept, we invest a portion of our taxable brokerage in income generating investments such as taxable municipal bonds and Vanguard’s High Yield Dividend ETF. These will provide us with a steady passive income in early retirement with minimal tax burden now. Municipal bonds aren’t subject to federal tax, and dividends are taxed at favorable rates. We also like REIT’s for income generation; however, since these aren’t tax friendly, we hold them in our tax-advantaged retirement accounts.

Related Post: Our Investment Strategy & Portfolio Allocation

3. Health Savings Account

Our only option for health insurance through Mr. RFL’s employer is a high-deductible health plan. As such, we have access to a health savings account that we max out every year. These contributions not only decrease our taxable income, but they also grow tax free until we need them. If spent on qualified medical expenses, we’ll never pay taxes on this money!  

One more thing… we cash flow our medical expenses as they incur, never touching the money in this account. That way the money can continue to grow tax free. Because there is no time limit on reimbursement, we scan and save all our medical receipts for when we need the money in early retirement. At that time, we’ll have a large amount we can withdraw tax free to fund our first years of retirement.

Besides qualified medical expenses, HSA funds can also be used to pay for COBRA insurance, which we may utilize for the first 18 months of retirement if there are any changes to the Affordable Care Act that make it less attractive to early retirees.

4. Roth IRA

Did you know you can access the principal in your Roth IRA before age 59 ½ without any penalty? Yep!

Although any gains or earnings would be subject to a 10% penalty, your original principal is free to withdraw at any time after the account has been open for 5 years, or for certain other circumstances.

However, because of the tax preference and uncertainty regarding future tax rates, we prefer to leave money in the Roth as long as you can. But it’s there if you need it.

5. Other retirement accounts (401k & Traditional IRA)

Please, don’t make the mistake of NOT contributing as much as you can to your 401k or IRA accounts just because you are planning early retirement!

These accounts have great tax benefits, and your investment balance will be significantly larger if you continue to utilize them, rather than just investing in a taxable brokerage account. You only get one chance to take these deductions.

You just need a plan for how to get the money out when you need it… and there are actually a lot of ways to do this.

In some ways, it’s actually easier to control your tax burden in early retirement, by moving more of these payments into the early years that you’re likely to be in a low income tax bracket. As opposed to the later years, during which you’ll be taking the required minimum distributions (RMDs) and receiving social security (if it’s still around).  

The Roth IRA conversion ladder

The most popular method of accessing retirement funds early, while controlling future tax payments, is the Roth conversion ladder. In short, a Roth conversion ladder allows you to convert a portion of your investments from a Traditional IRA to a Roth IRA each year that you are in a low-income bracket. You pay taxes in the year of conversion and the money is available for you to withdraw after 5 years. You repeat the process each year to build a pipeline of funds available to you in future years.

If you don’t have any other sources of income and all your investments are tied up in retirement accounts, than you’ll want to convert enough to cover your expenses each year. However, if this isn’t the case, you can instead strategize the most tax beneficial amount to convert. For example, one strategy would be to convert the amount that what push you up to (but not over) the next tax bracket.

Many people have written about this topic already, so I won’t go into more detail here. If you’d like to learn more, The Mad FIentist has an interesting post on how to access your retirement funds early, which goes into more details on how a Roth conversion ladder works and compares some of the other options for accessing retirement money before age 59 ½.

Our plan for accessing retirement funds early

To be honest, the plan on how we’ll pay for early retirement is still a work in process, and will continue to evolve as we get closer to our early retirement date.

Right now, I estimate that we’ll be able to fund the first 15 years of retirement with our taxable accounts and savings, even if Mr. RFL retires in 2024. That would put me at age 57 and Mr. RFL at 52, so we’d only need to cover a few years of expenses by accessing retirement accounts early. If he chooses to work after becoming “work optional,” this time frame would grow even longer.  

How we’ll execute the Roth conversion ladder strategy

We currently have some money in Roth IRAs, though most of our retirement savings are in 401k plans or nondeductible (post-tax) contributions in a Traditional IRAs, since we were above the deductibility limits the last few years in which we were both working (not this year!).

Since the non-deductible IRAs are post tax, we’ll only pay taxes on the growth when we convert, rather than the entire amount.

We’ll start a Roth conversion ladder once we’re in a lower tax bracket, either due to retirement or changing to a lower paying job/hobby. After we convert all our non-deductible accounts, we’ll roll over our 401k plans into a Traditional IRA to continue building the conversion ladder.

Even though we don’t expect to need all this money in early retirement, the Roth conversion ladder is a way to control the taxes we pay, by converting the money during years we’re in lower tax rates. It’s also a great way to hedge against rising tax rates and reduce the amount of RMDs we’ll be required to take out (at high tax rates) in later years, since Roth IRAs are exempt from RMDs.

A word of warning

Keep in mind that the IRS applies a “pro-rata” rule to IRA conversions, so if you’ve made non-deductible contributions to a Traditional IRA that you plan to roll over in the future, you’ll want to wait until after those are converted to roll over any old 401k plans into a Traditional IRA. We made that mistake with one of Mr. RFL’s old 401k plans that was small before we fully understood the rules, and now his conversions are going to be messy.

Takeaways on how to pay for early retirement

If you’ve been worrying about how you’ll pay for early retirement, I hope this post has put your mind at ease!

Once you can save up an appropriate amount of money to reach your FI Number, there are plenty of ways to ensure that you can access that money in your early retirement years.

The key is to have a solid plan, keep enough cash to protect you from any poorly timed market crashes, and continue investing as much as you can in those tax-advantaged accounts.

When do you want to retire?