Early retirement sounds incredible, right? Imagine being able to walk away from your nine-to-five job at 45 years old, and then spend the rest of your life doing whatever you want!
While the idea of early retirement is gaining a lot of traction in the media and in the personal finance space, the reality remains that retiring at any age is a process that takes sustained discipline for years.
In a nutshell, the most common strategy for retiring earlier than the standard age of 65 requires two key components. The first is to maximize your investment portfolio to create a large enough nest egg to support decades without working. The second is to live as minimally as possible during the early years of your career.
Before we dig in to real strategies that can be used to retire early, please understand that early retirement simply isn't for everyone. There is a significant financial risk to cutting any career short, and many early retirees still work in some capacity to support their lifestyle.
It's also important to remember that the traditional path to retirement is still very much the norm! There's nothing wrong with having a long, fulfilling career in a field that allows you to contribute to society in a meaningful way.
Here's what you need to do to retire early:
1. Understand the 4 percent rule (aka Safe Withdrawal Rate)
Over the years, the most common guideline found in the early retirement community for determining the amount needed to sustain life outside of a career is "the 4 percent rule." The idea behind the 4 percent rule is that early retirees can safely withdraw 4 percent from their overall investment portfolio every year to live on and never run out of money.
The reasoning is fairly simple. If you assume average returns of at least 6 percent on your investments, your portfolio will never decline with only 4 percent being withdrawn yearly. Depending on the source you use, the stock market rate of return averages anywhere from 6-12 percent over time (it's important to note that returns in the market are not guaranteed! These are just based on what has happened historically).
2. Find out how much income you will need
The biggest component to early retirement is figuring out what type of lifestyle you are hoping to achieve. A safe rule of thumb is to assume that you'll need 80 percent of your current income to live comfortably in retirement, but depending on what type of life you envision for yourself postcareer, the numbers may be higher or lower.
Right now, the trend for younger people who have "retired" is minimalism. The idea is that if you drastically reduce the amount of money it takes to survive on a yearly basis, the earlier you can actually leave traditional work.
This usually equates to drastic changes in lifestyle. Many younger retirees opt to downsize their homes or sell them altogether and live in RVs (yes . . . seriously). There is actually a fascinating trend happening with travel trailer manufacturers where millennials are propping up the entire RV industry!
Another common sacrifice is the type of cars that early retirees drive. Because the cost of financing new cars that rapidly depreciate is very high, those in early retirement tend to drive older paid-off cars and learn to do much of the maintenance themselves.
All of these factors should go into your calculations for how much income you will need in a potential early retirement scenario. It's important to be realistic with how you will approach your lifestyle, and it never hurts to pad the numbers.
3. Calculate how large your portfolio needs to be
Using the safe withdrawal rate detailed above in step 1 and then determining what type of lifestyle you'll live as a retiree in step 2, you can calculate how much money you will need in your portfolio to effectively retire without running out of money.
Let's say that you determined that your ideal retired lifestyle will cost $50,000 per year. Multiplying that amount by 25 (4 percent of your portfolio is 1/25) will give you the total nest egg you need to achieve before you can effectively retire.
In this scenario: $50,000 x 25 = $1,250,000
Again, assuming average market returns over time (not guaranteed), you can withdraw $50,000 per year from a $1.25 million retirement portfolio and never actually run out of money. In the perfect scenario, your nest egg would continue to grow even with the $50,000 per year taken out.
Obviously, you would also need to anticipate any future large purchases for the 4 percent rule to actually work. If you are planning on living out the rest of your life in a sailboat that costs $25,000, you'll need to build that into your nest egg along with all future estimated maintenance costs.
4. Account for inflation
It's important to understand that a nest egg of $1,250,000 won't actually be worth that amount in the future. Inflation is constantly eating away at your money's purchasing power, and the effects can be substantial.
Unfortunately, it's literally impossible to calculate exactly how much bigger your portfolio will need to be years from now to battle future inflation. But, we can use past numbers to at least get close!
Using an inflation calculator like this one from the Bureau of Labor Statistics, you can see how inflation might change the amount you need to retire over the coming years.
Let's say you want to retire 20 years from now. All you need to do is take the $1,250,000 number that we calculated earlier and plug in that number for a previous 20-year period.
From 1997 to 2017, $1,250,000 would actually need to be $1,907,958.80 to maintain the same purchasing power. So you can roughly assume that you'll actually need almost $700,000 more than the initial $1,250,000 nest egg to effectively retire early.
Again, these are just estimates, but they will allow you to plan properly for early retirement.
5. Find new income streams
If you want to comfortably retire early, you will probably find that it's a good idea to find extra sources of income when you step away from your career for good. The traditional idea of retirement is the complete absence of work, but if you want to do it early, that might not be realistic.
It may be necessary to find some type of part-time employment to avoid digging in too far to your nest egg. Another option is to start a small business, but it doesn't have to be complicated. Even something as simple as flipping old furniture or buying and selling items on eBay might be enough to provide a nice buffer.
6. Plan for the worst
My biggest concern for early retirees is unexpected costs that might come up later in life. If you planned for the absolute bare minimum amount needed to retire, all it could take is one major accident or sickness to completely derail your retirement plans.
Similar to inflation, it isn't possible to specifically plan for a future issue. However, it should be part of your approach in deciding if early retirement is even possible or worth it in the long run.
The bottom line on early retirement
Just remember—early retirement sounds great in theory. There is a large amount of risk to consider when making this type of financial decision. That's not to say it isn't possible, but you should absolutely proceed with caution.
-- Bobby Hoyt is a former high school teacher who paid off $40,000 of student loan debt in a year and a half. He now runs the personal finance site MillennialMoneyMan.com full-time, and has been seen on CNBC, Forbes, Business Insider, Reuters, Marketwatch, and many other major publications.