6 Pitfalls to Avoid if You Want Financial Independence and to Retire Early, a.k.a. “FIRE” (And What to Do Instead)
Retiring early is a dream for many but it requires careful and diligent planning. The "Financial Independence, Retire Early" (FIRE) concept has gained significant popularity, promising freedom from traditional employment at a younger age. However, without proper preparation, several pitfalls could derail your plans.
Understanding FIRE
FIRE stands for Financial Independence, Retire Early. This movement gained traction with the publication of Vicki Robin and Joe Dominguez's book, "Your Money or Your Life," in 1992 and has since flourished through personal finance blogs and online communities.
If you dream of achieving Financial Independence and Retiring Early,
here are six pitfalls to avoid and what to do instead:
DON’T: Wait to have a plan
DO: Start planning as early as possible
Outline your financial goals, calculate how much you need to retire, and develop a roadmap. For example, if you aim to retire at 45, begin by determining your annual expenses. You'll want to include all fixed costs (housing, utilities, insurance, etc.) and variable expenses (entertainment, travel, etc.). After you decide what you need, you can roughly calculate how much you will need to save.
For instance, if your projected annual expenses amount to $100,000, employing the widely recognized 4% rule can provide a rough estimate of the retirement savings required. According to this principle, you would need to accumulate a nest egg equivalent to 25 times your annual expenses to sustainably withdraw 4% annually without depleting your funds prematurely. In this scenario, achieving financial independence would necessitate accumulating $2.5 million ($100,000 x 25) in retirement savings or liquid assets (careful to exclude any real property (i.e., your home) from this calculation).
However, it's important to note this calculation does not account for taxes on withdrawals, which can significantly impact your net income in retirement.
DON’T: Neglect your health or insurance
DO: Prioritize your health & insurance
Maintain a balanced diet, exercise regularly, and schedule routine medical checkups. Additionally, ensure you have sufficient funds to cover health insurance costs.
If you're targeting an early retirement at 50 or 55, you must account for healthcare expenses until you become eligible for Medicare at 65. Health insurance premiums can comprise a significant portion of your budget, with private health insurance costs varying as much as $500 - $1,000+ per month for an individual, depending on coverage extent, geographical location, and age.
Consider leveraging a Health Savings Account (HSA), if available, through your health insurance plan to soften healthcare expenses during this interim period. HSAs offer an advantageous solution by providing triple tax benefits:
Contributions are tax-deductible
Growth accrues tax-free
Withdrawals for qualified medical expenses remain tax-exempt
Maximize your HSA contributions to support your healthcare funding, reduce taxable income today, and ensure financial preparedness for future medical costs.
DON’T: Only save in retirement accounts
DO: Diversify your savings
When planning your savings and investments, it's important to consider diversifying your savings across different types of accounts and investment vehicles. By spreading your savings across taxable accounts and other assets, you can gain more flexibility in accessing your funds and improve your ability to plan for taxes. Withdrawing money from retirement accounts before 59 1/2 can lead to a 10% early withdrawal penalty and ordinary income taxes. To avoid these penalties and create financial flexibility, maintain a buffer in taxable accounts or generate passive income streams.
There are some exceptions to the early withdrawal penalties under specific circumstances. For example, the "Rule of 55" and Substantially Equal Periodic Payments (SEPP) provisions offer options for penalty-free withdrawals before the age of 59 1/2. Still, they require careful planning and adherence to strict criteria.
In addition to contributing to traditional retirement accounts like a 401(k) and IRA, it's worth considering investing in a taxable brokerage account. A taxable brokerage account provides flexibility and liquidity before 59 1/2.
DON’T: Overlook tax optimization
DO: Diversify your tax buckets
Strive for a balanced mix of taxable, tax-deferred, and tax-free accounts. This approach provides flexibility and tax efficiency, which can significantly impact your retirement savings.
Let's see an *example of how this approach can optimize tax liabilities and your retirement income.
For simplicity, let's consider a single filer (with no other income sources - social security, pension, etc.) planning to withdraw $100,000 for retirement expenses from a 100% tax-deferred only vs. a diversified approach.
This example only illustrates federal taxes and is not state-specific.
Withdrawal from Tax-deferred Only:
Total withdrawal: $100,000
Marginal Tax Rate: 22%
standard deduction: $14,600
taxable income: $85,400
10% of the first $11,600 = $1,160
12% of the next $35,549 = $4,265.88
22% of the remaining $38,249 = $8,414.78
Tax Liability: $13,840.66
Net Income: $86,159.34
Withdrawal from Three Accounts:
Taxable Account:
Withdrawal: $20,000 (assume: $15k original investment / $5k Long-term Capital Gains)
Tax Rate (Long-term Capital Gains): 15%
Tax Liability: $750
Tax-Deferred Account:
Withdrawal: $60,000
Tax Rate (Effective): 12%
standard deduction: $14,600
taxable income: $45,400
10% of the first $11,600 = $1,160
12% of the next $33,800 = $4,056
Tax Liability: $5,216
Tax-Free Account:
Withdrawal: $20,000
Tax Rate: 0% (No taxes on withdrawals)
Tax Liability: $0
Total Tax Liability from All Accounts: $5,966
Net Income: $94,034
By strategically distributing the withdrawal across taxable, tax-deferred, and tax-free accounts, the overall tax liability is significantly reduced compared to withdrawing the entire $100,000 solely from a tax-deferred account. Additionally, in the second approach, we optimized the tax-deferred distribution by withdrawing only the amount that remains within the 12% tax bracket. This method enhances tax efficiency and preserves more of your retirement savings for future financial security.
*THIS EXAMPLE IS PROVIDED FOR EDUCATIONAL AND ILLUSTRATIVE PURPOSE ONLY. THIS DOES NOT CONSTITUTE TAX ADVICE, NOR SHOULD IT BE CONSIDERED AS SUCH.
It is important to note this example does not consider state taxes. Individual circumstances and tax situations vary greatly. Tax laws are complex and subject to change. Therefore, consulting with a qualified tax or financial professional who can consider your unique financial situation and provide personalized advice is essential. Always seek professional guidance for your specific tax needs.
DON’T: Assume everything will go as planned
DO: Stress test your plan
It's crucial to stress-test your retirement plan against various potential scenarios to ensure its resilience and sustainability. By evaluating your strategy under different conditions, such as market downturns, higher taxes, and unexpected medical expenses, you can identify vulnerabilities and implement necessary safeguards to protect your financial future.
Collaborating with a fiduciary financial planner is invaluable in conducting thorough stress testing and scenario analysis. A fiduciary financial planner acts in your best interest, providing objective advice and customized strategies tailored to your needs and goals.
Fiduciary financial planners will provide sophisticated tools such as Monte Carlo analysis to simulate potential outcomes based on various market and economic scenarios. This quantitative modeling technique evaluates the probability of success for your retirement plan across different market conditions, tax scenarios, and life events.
Key Stress Test Scenarios You Need:
Market Downturns
Increased Taxes
Health Care Costs
Long-Term Care Needs
By stress testing your retirement plan against these critical scenarios and working closely with a fiduciary financial planner, you can enhance the strength of your financial strategy and achieve greater peace of mind. Remember, proactive planning and risk management are essential in safeguarding your financial future and enjoying a secure retirement.
DON’T: Forget to reevaluate your plan
DO: Regularly review and adjust your plan
Just as life changes, so should your financial plan, especially if you aim to retire early. Avoid the "set it and forget it" mentality. Periodic reviews allow you to assess effectiveness, address challenges, and adjust strategies to stay on track. Life's unpredictability underscores the need for regular updates to adapt to changes such as job shifts or market fluctuations. Failing to review regularly can jeopardize long-term goals. Commit to periodic reviews, assess progress, and update strategies for sustained financial well-being.
DON’T: Overlook having hobbies
DO: Find purpose in your life before your retire
Engaging in activities such as gardening, joining a book club, or volunteering in your community keeps you occupied and provides invaluable social interaction and a sense of purpose.
Research indicates individuals with a strong sense of purpose tend to live longer and enjoy a higher quality of life in retirement. A sense of purpose nurtures resilience, reduces stress, and promotes overall well-being. Engaging in meaningful activities and hobbies fills your days with joy and fulfillment, contributing to longevity and health.
CONCLUSION
Planning for retirement, especially aiming for early retirement, demands meticulous attention and strategic foresight. Rather than settling for a traditional 25-30-year retirement timeline, you can extend this period by another 5-15 years through careful planning. However, achieving financial independence and retiring early (FIRE) requires more than a desire—it necessitates a solid plan executed with discipline, precision, and ongoing review.
Remember, the allure of early retirement can quickly dissipate if not backed by a comprehensive strategy. While returning to the workforce may not be a dire prospect, true financial independence means working because you want to, not because you need to.
To embark on the journey to FIRE successfully, avoid common pitfalls and adopt prudent financial practices. You can significantly enhance your chances of retiring early and enjoying financial independence through proactive financial planning, disciplined spending, and strategic investing.
Remember, the path to FIRE is a marathon, not a sprint. Stay focused on your goals, remain informed about market trends, and stay committed to your financial objectives. You can realize your early retirement dreams and secure a prosperous future with perseverance and determination.
Whether you are a millennial looking to retire early or a boomer nearing or already in retirement, we can help you with comprehensive retirement planning. Contact us for a complimentary consultation and take the first step towards securing your financial future.
Disclaimer
This blog is for informational purposes only and does not constitute financial advice. The strategies and opinions discussed herein are our own and are not comprehensive. They do not encompass all possible approaches to achieving financial independence and retiring early. Individual financial situations vary, and the information provided may not be suitable for everyone. Before making any financial decisions, we strongly recommend consulting with a qualified financial professional who can provide personalized advice based on your specific circumstances.
