Ready For Retirement

[Case Study] How to Prepare for Early Retirement

June 20, 2023 James Conole, CFP® Episode 168
Ready For Retirement
[Case Study] How to Prepare for Early Retirement
Show Notes Transcript Chapter Markers

For people who are planning to retire early, planning for retirement can be especially daunting. 

There are many different points to consider, but the most important is ensuring that your income stream will sustain you for the rest of your life.

Today’s case study examines someone who is looking to retire early so that you can understand what framework and approach to apply to your own situation.

Questions Answered:
What do you do for income when you no longer receive a paycheck?
What sort of strategies do you use for taxes, medicare, withdrawal, etc?

0:00 Intro
1:11 Today’s question
4:11 Considerations
6:55 Strategy and Expenses
9:34 Recommendations
11:30 Implications
13:27 Are they on track?
18:35 A couple of things you can do
22:22 Adding in Social Security
25:42 Quick thoughts
27:34 Outro

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Speaker 1:

Planning your retirement is daunting regardless of how old you are, but for people who are planning to retire early, it can be exponentially more scary. And while there's dozens of different planning points you need to consider before you retire early, the most important is ensuring that you have a sustainable income stream that will last for the rest of your life. In today's episode, we're going to take a look at a case study of someone who's looking to retire early, so you can understand what framework to apply and best approach this with your own situation. This is another episode of Ready for Retirement. I'm your host, james Kanol, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. A lot of times when you're looking for guidance for things like how do I retire or how do I invest or what should I do, it can be helpful to see you know. Here's five tips to do this, or here's three things to consider. A lot of times, looking at an actual case study someone else's specific example I find is most helpful because, even though your details aren't going to line up perfectly with theirs, you can start to see the little nuances that come into play, and those are what's most important for you, as you understand how this applies to you. So today we have a question. This question comes from Tanner and we're going to use Tanner's question as a case study to help unpack this question of how can you prepare to create a reliable stream of income if you're going to retire early. So Tanner says this. He says I really appreciate your content and I've been listening since you started. I like the mindset of educating everyone on personal finance and the depth of your answers. My question is if you think we can step away from work when I hit my number. My goal would be to leave full-time work at the age of 50 and have my wife and I only work part-time or do consulting to cover expenses and carry health care without drawing from the portfolio until we hit our number, which we think is $3.5 million. We're both age 40. We have $900,000 in liquid assets, not including our home equity. Of that amount, $500,000 is in Roth IRAs, $250,000 is in traditional IRAs, $130,000 is in brokerage accounts and $20,000 is in a health savings account. We have a 90-10 portfolio, so 90% stocks, 20% bonds and a few diversified ETFs, and our combined income is $300,000. Today we spend $85,000 in after-tax. We save, slash, invest about 60% of our income and if you add employer match in the total it's about $115,000 per year towards investments. Our mortgage will be paid off by the time that we're 50 and the kids will be in college. We'd like to forecast spending about $90,000 in today's dollars in retirement. So in about 10 years, will we reach enough to execute our plan of having options, and how large should our brokerage account be to cover our plan of spending our 50s doing some part-time work to cover expenses and then withdrawing our portfolios from mid-50s and beyond? Well, tanner, thank you very much for that question And I think that that's going to be a great jumping off point to understand this predicament a lot of people have of when I no longer receive a paycheck, what do I do for income? How do I combine various income sources, regardless of what age I'm actually retiring from? and that's exactly what we're going to address. Before we jump in, i want to highlight the review of the week and thank you to all of you who are leaving reviews, and not just leaving reviews, but thank you to all of you who are listening. It's fun to see how many people are tuning in and getting emails from you and responses from you, so really appreciate you taking 20 minutes of your week and spending it with me here on this podcast. This most recent review comes from a user named JS Texan. Js Texan leaves a five-star review and says I listen to many retirement podcasts, but this is by far the best. Not only the content is very relevant and informational, it is also precise and no nonsense talk to waste time, which plagues most of the podcasts. Keep it up and I'll continue to follow, learn and enjoy the content. Well, thank you, js Texan, for that. I always try to keep these condensed just enough time to give you valuable information, but no longer, in order to not waste any of your time. If you have not left a review, i would really appreciate you doing so. It is one of the best ways for people who are looking for good retirement content to find this show and find these things will ultimately help them create a better retirement and get the most out of life with their money. With that said, let's actually jump into the episode for today, when we think about retirement, and specifically early retirement, so much goes into that. There's your withdrawal strategy, there's the right portfolio allocation, there's making sure you have a tax strategy, have you incorporated estate planning considerations, do you have the right insurances in place, so on and so forth. While that is all very important, a lot of that stuff isn't stuff that you actually start actively working through until you're retired. It's good to have a general idea ahead of time of what is that going to look like, but the specifics are going to change because so much in your life is going to change between now and retirement, even if retirements may be only one, two, three years away. So the first step is to see when will you be in a position to retire, and to see if you're in a position to retire comes down to your ability to generate income to meet all of your expenses. So we're going to use this question Tanner submitted as a case study to help you understand that. Here's what we know about Tanner. We know that Tanner and his wife want to stop full-time work at age 50. We know that they're also 40 years old today, so we have 10 years to make this happen. Today they have $900,000 in investable assets. So investable means excluding the house. Since they're not investing the house, they're living in it, and on top of the $900,000 that they have today, they're adding $115,000 per year for retirement. When we factor in both what they're putting away and what their employers are matching on those contributions, their goal is to spend $90,000 per year in retirement, but that's in today's dollars. So when we look at a situation, that's what we do know. Now a couple important things of what we don't know is well, one important thing is will Tanner be eligible for any Social Security or pension benefit? He'll almost certainly be eligible for Social Security unless, for some reason, this income he doesn't pay into Social Security for. Probably not a pension, just because those are fewer and fewer, or rarer and rarer, i should say. But Tanner's also only 40 years old, and so it could be that he's planning to see how would his plan work out if there was no Social Security. Now, highly unlikely that there's zero in Social Security for Tanner when he reaches Social Security age, but it almost certainly will not look like what it does today. So I know a lot of people who are younger than, say, 50 or so just prefer not to plan for Social Security, just to be conservative and see what that would look like. So as we're going through this, i'm going to start by assuming no Social Security, then I'm going to show you what I would adjust if I did want to include Social Security in an analysis like this. So here's where I would start if I were walking Tanner through a financial plan. Now, obviously, tanner, in everyone listening, this is not a specific recommendation. This is not advice. This is just a general way of thinking. Things are thinking through things So you can see how it might apply to your situation. But to start, tanner might ask well, hey, what's my track strategy going to be? What's my Medicare Social Security strategy going to be? What's my precise withdrawal strategy going to be? Those are all incredibly important things to have in place by the time that you do retire, but we're looking 10, 15 years in advance. I would not pay too much attention to those at all. So let's start with what we don't need for today. We don't need a tax strategy today. Now it's good to diversify what types of accounts you're saving to Roth, pre-tax and brokerage, to give yourself maximum flexibility to implement a tax strategy, but you don't actually need the retirement tax strategy quite yet. You don't even need a Social Security or Medicare strategy. You don't need a portfolio drawdown strategy. You don't need many of these things because, while they're all really important, when you're in retirement, or at least much closer, those things are going to change so much. So, yes, it does not hurt to consider those things. It doesn't even hurt to make assumptions as you're running planning projections about those things. But don't stress too much about them. Those are going to change a ton by the time that you actually retire. By change a ton, i mean taxes will look different, social security might look different. What the markets have done is going to be different than what we expected, same with inflation and other details like this. So instead of being overly focused there, here's what you should do. You need to understand two things What will your expenses be and how will you create income to meet those expenses? So let's walk through a plan to show what I mean. We'll start with expenses. We know that Tanner said he wants to be able to spend $90,000 per year, but he's not actually leaving his full-time work for 10 years. So if we take $90,000 per year, that might be sufficient if his kids were through college and if his mortgage was paid off and he was retired today. But inflation is going to happen. So if we're planning a $90,000 starting in 10 years, it's not going to be enough, because the cost of everything that $90,000 could buy today is going to have gotten more expensive. So what do we need to do? Well, to start, we need to adjust that for inflation. If we assume an inflation rate of 3% per year, which is more or less what it's been historically, the $90,000 per year today is equal to about $121,000 per year in 10 years. In other words, $90,000 today, the goods and the services that could buy those same goods and services could be purchased with $121,000 10 years from today. So the question we need to look at is we need to say, starting at age 50, how do Tanner and his wife generate $121,000 per year for the next 40 plus years? Well, that can be an overwhelming and really daunting thing to ask, because you look at different stages of retirement. So what would I recommend? Well, i would start by breaking this down into segments And right off the bat, the first segment. We actually don't need to worry too much about their portfolio, because the first segment in my mind is from age 50 to 55. We don't know exactly what part-time would look like or part-time work would look like for Tanner, but what he said is the goal is to earn enough money from part-time income or consulting to fully cover their lifestyle. So from 50 to 55, they're working part-time and earning enough to cover their living expenses. The way I'd translate that from a retirement plan standpoint is that their withdrawal strategy doesn't actually need to start until age 55. So, yes, they've stepped down from their previous jobs at age 50, but they're not having to live on their portfolio quite yet. So, even though work changes, i wouldn't even think of starting the quote-unquote retirement part of their projection until 55, because the biggest part of your retirement projection is understanding where's income going to come from. That's essentially covered from 50 to 55, even though work is changed. The only thing that's really different that I care about is from 50 to 55, they're putting less money in their portfolio. I shouldn't say that I care about what I'm talking about. That I would put most focus in, as we're looking at this in the initial projection. So from 50 to 55, they don't need to live on their portfolio, but we also need to understand they're no longer saving to their portfolio. Today, Tanner's wife are contributing $115,000 per year to retirement assets, which is a pretty significant contribution. So we can assume that for 10 more years, but then, even after the next five years of that, they're earning income to cover expenses. They're no longer putting money into their portfolio. So, phase two, or segment two, of this would be from 55 and beyond. Well, from 55 and beyond, i'm assuming there's no salary and, as I mentioned before, i'm going to assume no social security benefits in this first iteration, to see how might we need to plan for this. Well, what is the practical implication of that? The practical implication of no salary and no social security is that their portfolio needs to cover all living expenses for the rest of their life. Well, if you recall, what we just did is we took the living expenses today of $90,000 per year and we said what's that going to equal in terms of equivalent purchasing power in 10 years? and that equal to $121,000 per year. What we just saw is $121,000 per year that's not coming from their portfolio because they're still working for another five years. So really, what we want to know is what does $90,000 turn into after 15 years, because today they're 40, and we want to know what's the equivalent of that at age 55, which is when they're actually going to start dipping into their portfolio. Well, if we assume an inflation rate of 3%, and we do that for 15 years, $90,000 per year turns into $140,000 per year by the time they're 55 years old. In other words, their portfolio needs to support $140,000 per year, starting at age 55 and then rising every year beyond that. Well, this is the point at which standard withdrawal rates come into play. So if you assume something like the 4% rule, for example, that says you can take 4% of your portfolio and assume you're invested the right way, that can last you for 30 years At least, there's an extremely high probability of that lasting for 30 years. What would that look like in Tanner's situation? Well, to figure that out, what we do is say $140,000 needs to represent 4% of the larger portfolio value in order for them to be able to implement this. So $140,000 divided by 4% equals 3.5 million. So that's kind of exactly the number that Tanner seemed to be thinking in his question. The question, though, is are they on track for that? So let's assume they need 3.5 million I'm not saying that's the precise number yet, because there are some other nuances that you need to factor in But the question is, if that was the number, are they currently on track? Because today they're at $900,000, which is certainly not 3.5 million, but they're going to be saving and we can assume some growth between now and then. So here's what I'd look at. $900,000 is what they have today. They are investing $115,000 per year for the next 10 years. After 10 years they're going to stop investing, but their portfolio will continue growing for the next five years after that. So here's what that would look like. If they can grow their portfolio by 8% per year and again, that's not a guarantee, but you always have to start with some growth rate or assumption If they can grow their portfolio by 8% per year on average for those first 10 years and continue to save $115,000, then their $900,000 will turn to $3.6 million after 10 years. Well, after the end of that first 10-year time period, they're going to stop making new contributions for years 11 through 15, but let's assume they're still getting that same growth rate. Well, if their portfolio continues growing at 8% from years 11 to 15, by the time that Tanner and his wife are 55 years old, they will now have $5.3 million in their portfolio. Now, is this guaranteed? Absolutely not. But what I'm doing is I'm taking a growth portfolio like he says he has. So he says he's in a 90-10 allocation and I'm applying a growth rate that's a little less than the long-term average of how that mix of assets would have grown. That's not to say you should take 8% and make that the only part of your planning. You should test this of what would it look like if you got 6% per year growth or 4% per year growth. So you have a range of outcomes that you might be able to expect. Hey everyone, it's me again for The Disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. So if 8% would grow their portfolio to 5.3 million by age 53, what would it look like at 6%? or what would it look like at 4%? Well, at 6% growth over that time period, assuming the same savings, their portfolio would grow to 4.2 million dollars by age 55. They only got 4% growth and their portfolio would grow to 3.3 million by age 55. So you can see here there's a huge difference between growing at 4% per year and 8% per year The range of outcomes, if we assume that's the range of potential returns, the range of outcomes is somewhere between having 3.3 million dollars and 5.3 million dollars in their portfolio at age 55. So this is one reason why you can't run a financial planning projection just one time and think you're all set for retirement. These numbers can and will change, and seemingly small numbers or small changes to the assumptions, like what growth rate you can expect or what inflation will be, can have significant impact on your plan as a whole. So I'm using 8% in this simple example because I would say it's not unlikely to receive that as an average return over the next 15 years. But use whatever you feel is most comfortable with and also, most importantly, understand that just because we assume something in no way guarantees it. So are you staying up to date with this and updating it as you go? So where have we gotten so far? Well, here's where we are. We know we need 3.5 million dollars at age 55 to generate sufficient income using the 4% rule to support Tanner's income needs from 55 and beyond. We know, on top of that, that we're on track to have 5.3 million dollars at age 55 if we get 8% per year growth rates. So we look at that and we say we're good right. In fact, we're more than good right. And to this I would say not quite, because, as a reminder, this is early retirement that we're planning for. In the 4% rules, research looked at seeing what withdrawal rates were sustainable for 30 years. Now, for most people, if you get 30 years out of your portfolio once you retire, you're good. That's probably taking you to the end of your life and then some. Well, if Tanner only gets 30 years out of his portfolio, he's going to be in a tough spot sometime in his 80s, especially if there's some type of a long term care event or health event or something dramatic that happens in his situation. But because he's planning at 55, if he only gets 30 years now, he's not guaranteed life expectancy beyond 85, but it's certainly something we probably want to plan for. So that's a unique thing to plan for. If you're retiring early Now. This is probably a really important time to remind you of something that most of us don't really think about, and that's this There is no perfect science that will guarantee the financial outcome you are looking for. Financial planning is based upon back testing, different withdrawal rates, back testing different things that we know, so there's no standard answer for exactly how much is needed to make your retirement a reality. So much of this is yes, let's base this upon what we know, let's base this upon how things have been. But a lot of this is making sure that you're adapting, making sure that you have a plan that's resilient, making sure that you have contingencies in place, because so much can happen over 30, 40 years that we can't possibly plan for. So here's a couple of things you could do as you determine how do you approach this unique situation for Tanner. You want to retire at 55, maybe use the 4% rule, based upon research about retirement withdrawal rates, but you realize that might only get you so far. That might only get you to age 85, assuming that you get 30 good years out of that portfolio. Well, here's one way to look at it. Again, this is not a perfect science, this is not the way, but it's just one way I might think about this, again, understanding there's no perfect solution for anyone's situation. It's all about understanding how can we properly view different assets or different planning points in a way that maximizes our odds for success. So, anyways, what I might think about doing for Tanner is do you quote, unquote carve out from his portfolio the exact amount needed for the first 30 years of retirement, and then what you would do is invest the rest as a form of longevity insurance, so to speak. So, for example, tanner has $5.3 million in his portfolio, based upon the projection we just ran by the time he hits 85. Well, do you take $3.5 million of that and do the standard portfolio allocation for retiree? Now, by the way, i don't necessarily recommend in fact, i don't recommend you invest the same way that the 4% rule was based upon, but think of investing that in a way that will support income for the next 30 years. We'll take the rest, so in this case, $1.8 million, the difference between what Tanner will have and what he's projected to need for the first 30 years. So take the rest, the $1.8 million, and think of setting that aside for life, 30 plus years from now. Now, because that's money that you're not going to spend for 30 years, with the assumption being the first $3.5 million you carved out is going to get you through the first 30 years of retirement, you can take that $1.8 million and be a lot more aggressive with that. Even though you're retired, you're not going to touch that money for 30 years. So if Tanner invested $1.8 million in a separate quote, unquote longevity insurance account and grew at 8% per year on average, well, he'd have about $18 million and then account by age 85. Yes, inflation's gone up quite a bit by the time that he's 85, but $18 million is almost certainly going to be far more than enough to offset the impact of inflation during that time. So what you're essentially doing in this example is you're investing part of your retirement portfolio for standard retirement withdrawals, using just literature and white papers and science around at least historically speaking what portfolio size would generate sufficient income for the first 30 years and then taking another part of your portfolio and investing that for longevity, knowing you're not going to touch that for 30 years but for future needs, for longevity needs, for long-term care needs, for significant capital needs in the future. You've got a separate side fund to support that And, as I mentioned before just another aside I never recommend that someone invests exactly the way that the 4% rule is based on. I have a lot of other podcasts where I discuss that in more detail, so I won't go too in depth today, but just want to help you understand how you should look at this in terms of using some withdrawal rate in this example, 4% to calculate how much is needed. So, in these examples, tanner seems to be right on track and probably even ahead of schedule. Now, as I mentioned, portfolio returns can influence this heavily. We saw the difference in final portfolio balances based upon using growth rates of 8%, 6% and 4%. So this speaks to the importance of monitoring this regularly to make sure you're on track. Don't make a financial plan and then assume you're good for the rest of your life, but make sure that you are accounting for that. That being said, as we look at that and say, okay, tanner, that seems to be on track. A lot of you out there. You are probably dealing with other income sources. Let's call it social security, or maybe pension, or maybe rental income. So what would this look like if we were to add social security into the equation? Well, i won't go through the whole analysis because we don't have time on today's podcast to do this, but here's a framework, or here's how the framework would change, and then a couple resources if you want to know more. But I would still try to approach this in that same mindset of how do you segment different time periods to understand what your portfolio's role in income creation needs to be. So, as a reminder, age 50 to 55, that's one segment And even though Tanner's quote-unquote retired from his full-time job, he still has outside income coming in to meet all of his needs. The second segment if we were to assume Tanner and his wife collected social security, say, at age 67, well, the second segment would be from 55 to 67. During that segment or during that time, they are depending on their portfolio to meet all their living expenses. Income is stopped from work and social security hasn't quite kicked in yet. So that's the second segment. How much do they need each year? and then work backwards to understand how much of a portfolio do you need to generate those 12 years of living expenses? Then the third segment would be from age 67 and beyond. The reason this segment is different is, whereas previously they were dependent on their portfolio for all their living expenses, now they have social security coming in and social security is covering part of their living expenses. So now their portfolio only needs to cover I don't know maybe 70 to 75% of their living expenses, depending on what their social security benefit actually needs. So when you look at that, you now need to understand what portfolio amount is required to cover those living expenses after social security from age 67 and beyond. I know I'm breaking this down real high level, but if this is something that's peaking your interest, you're saying yes, that's exactly what I need to try to calculate. Go back and listen to episode number 160. It's called avoid this major pitfall of standard withdrawal strategies, where I talk about just this How do you plan for a portfolio withdrawals when you have maybe staggered income or staggered expenses, or both? So make sure you check out that episode. If you're hearing this and saying, yes, that's exactly what I need to do in my situation. And then finally, ideally you have some type of planning software to really run this for you, because planning software it can synthesize a number of different variables into one output to help you understand what's needed when you factor in everything from portfolio returns to inflation, to cost a living, adjustments on pensions or social security, to the taxation of IRAs or Roth IRAs or brokerage accounts in so many more factors. So I'm breaking this down in a very basic way of looking at it, which I hope is helpful to at least understand the methodology of approaching this. But ideally you have some type of a software that can do this for you. So that's the general approach I'd look at. And, as you see here, as you've probably noticed, we haven't talked about portfolio allocation. We haven't talked about portfolio drawdown strategy. We haven't talked about tax strategy. There's so much we haven't talked about, and the reason for that is retirement is still far enough away. The talking about those things, what could be interesting and maybe good to know generalities being overly focused on those is just you spinning your wheels. So much will change that will deem those things irrelevant by the time that you actually get there. The more important thing is understanding how much do you need to save? What are you generally on track for? What else can you do to optimize your current situation to best prepare yourself for that time and beyond? A couple other quick thoughts I'd have on Tanner's situation that aren't fully related to what we just discussed, but if we're looking at things comprehensively, the first of which is do you or should you continue prioritizing Roth? Looks like a lot of Tanner and his wife's balance is in Roth accounts, which I love. I think that's wonderful. But if your income's at $300,000 today and that's going to drop by about 70% in retirement, could it make some sense to potentially flip that. Today, if you're earning a combined $300,000 per year, that's most likely putting you in the 24% federal tax bracket from a marginal standpoint. Well, based upon today's brackets, if you have $90,000 of income in retirement, that would put you into the 12% bracket. So the whole goal of Roth versus pre-tax is can you save money on taxes when your income is higher and pull money out or pay taxes when your income, or at least your taxable income, is lower? So there's benefits and there's other things that you want to consider as well, but that's one thing that I'd quickly point out. And then the second thing is even as we're going through this analysis, don't plan for one single expense amount for all of retirement. Now, this is perfectly fine, for now Tanner's 40 years old and not going to retire for 15 years. Totally fine to use one number, call it $90,000 per year. But you don't necessarily want to use just one single number if you're in retirement or nearing retirement forever, because you're not going to have regular expenses forever. Oftentimes your expenses start out higher and then tend to diminish over time. And if you're just planning for one single number that's adjusted for inflation over time, that's fine, but it means in most cases, you'll have to work longer or save more to hit that goal, which means you wouldn't be able to retire as soon as you otherwise would have wanted to, or wouldn't be able to cut back saving or increase spending. So there's just some natural tradeoffs for that. So I hope that was helpful. As we look at this, even at a high level point of view, tanner, i hope that was helpful for you as well. Specifically, again, not advice, not a recommendation, but just a general way of thinking about what are you on track for. So, as always, to everyone who's listening, thank you so much for listening, for spending a few minutes of your week with me here. If you have not already done so, please make sure to leave a review if you're enjoying this podcast or getting anything out of it, and if you haven't already, make sure you check us out on YouTube under root financial That's a channel name. We have this episode. We have an additional great content to help you get the most out of life with your money. That being said, thank you for your time and I'll see you all next time. Thank you for listening to another episode of the ready for retirement podcast If you want to see how root financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartnerscom Click start here where you can schedule a call to one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.

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