Today, I’ll give you the simple and easy answer to how much money you need to retire early. The answer may sound too simple, but truth be told, many advanced, multi-step methods might end up with answers that are roughly the same.
A little warning before we start: As with anything simple, you should not quit your job before having carefully considered all aspects of retirement – especially if you are planning early retirement as this blog advocates and teaches.
The good thing about this method is that it does not depend on how old you are or how many years you expect to live. Now, let’s get started.
1. Calculate how much money you need to retire early
The first step is fairly simple.
You should calculate how much money you need per month once going into (early) retirement.
This should include everything from housing, food, insurance, entertainment, gifts, travel etc. In essence, all the money that leaves your account every month.
Now multiply this with 12 to get how much money you need to retire per year. Be aware that certain costs might increase in retirement as you have more time to for example travel – if you expect this to increase, you should factor that in as well.
Example: My monthly expenses are currently $1,500, thus the money I need every year to retire with the same lifestyle is 12 * $1,500 = $18,000
2. Multiply your annual expenses by 25
Putting it simply, once you have 25 times your annual expenses, you will have enough to retire.
Using the expenses from the example above: You will need $18,000 * 25 = $450,000 to retire.
I know that the readers of this blog are clever, so by now you have figured out that the lower your monthly expenses are, the sooner you can retire.
Why do I multiply with the magic number 25?
You might be wondering where the 25 comes from? It is actually pretty simple and comes implicitly from the ‘safe withdrawal rate‘ or the ‘four percent rule’.
The safe withdrawal rate is the rate at which you can safely withdraw money from your bank account on a yearly basis without risking running out of money.
A lot of studies have been done on what the optimal safe withdrawal rate should be. This is done by going back in time and applying the safe withdrawal rates to certain portfolios over time to see whether you can safely withdraw 4% of your net worth without ever running out of money.
The magic answer to the safe withdrawal rate is approximately 4%, although very conservative people argue 3%, whereas people that are a bit more risk tolerant suggest 5% (or perhaps even higher).
Nonetheless, there are many good arguments for using a 4% safe withdrawal rate and it is still considered relatively conservative. Furthermore, a study named the ‘Trinity Study’ from 1998 suggests a “4% safe withdrawal rate rule-of-thumb”, and this has recently been confirmed by other researchers as well.
The number 25 is simply just making sure that a year’s withdrawal of 4% from your net worth will be equal to your annual expenses.
Continuing with the example above, imagine you withdraw 4% of the $450,000. This is equal to $18,000, which is exactly the amount we need to cover our annual expenses. Convinced? You should be! Now go and figure out your how much money you need to retire early.
If you still want a more detailed view on how to achieve financial freedom and early retirement, I suggest that you read my detailed blog post on The Bulletproof Way to Financial Freedom and Early Retirement.
Even though we just agreed that we would make matters simple above (and they are to a large extent), I am throwing in a bit of complexity for people that are interested (sorry!).
Inflation and average rate of return
I haven’t mentioned anything about inflation or average rate of return above. Does that mean that it is not important? No! It just means that this is already accounted for with the 4% safe withdrawal rate when looking at studies like the Trinity Study – even including extreme periods with interest rates at over 20% or inflation above 10%.
Don’t believe me? Read the studies, or add your own conservative assumptions about the future to the calculations above (why are you not making millions of dollars every day if you can predict the future?).
If you believe that inflation will be 2% and average rate of return (after taxes, but before subtracting inflation) will be 5% (this is quite conservative by the way), then you should use a safe withdrawal rate of 5% – 2% = 3% per year.
As long as you use sensible investment portfolios that are highly diversified across different stocks and bonds (more on this in another post) and don’t go all-in on a biotech stock, the investment portfolio should not matter that much to the above.
Using history to predict the future
As with everything in finance and economics, you can never use historic data to predict the future, but unfortunately it is the best we got.
Thus, you should always be careful when basing your future strategies on strategies that would have been optimal in the past.
Nobody knows how the economic, business or geopolitical environment will look in the future nor how this could impact the above. But we still have to make plans plan – and saving up with a goal is never a bad strategy, although we might have to tweak the numbers slightly on the way.
Do you believe in a 4% safe withdrawal rate? Let me know in the comments below.