If you ask most of the internet, there is only one way to retire early. You have to live minimally, spending less than 50% of what you make from your full time job, and invest the rest in retirement funds and the stock market.
You can absolutely retire early this way, but I don’t want to spend the next 10 years of my life eating ramen noodles and never going on vacation.
Kate quit her job less than three years after our first real estate purchase, and I’m on my way to retiring well before 40. But my household invests only about 20% of our combined income.
The key to retiring early is collecting investments that can put the money in your bank account to support your life’s expenses. It’s important to realize that there are two dials that influence your retirement ability. One is obvious, it’s the amount of money you make. The second is how much money you spend. You can move both of these dials to your advantage, fewer expenses and more income both mean faster retirement.
Today we’re looking at the income dial, and I know of two ways to crank it up!
What Are The Two Ways?
Popularly called FIRE (Financial Independence Retire Early), the first way is simply to invest at least 50% of what you earn into the stock market.
I don’t have a catchy name for the second method. You can also retire early through the acquisition of cash flowing assets (some of which can be in the stock market). This method allows you to retire early without needing to save 50% or more of your income.
The FIRE Method
Let’s start with the FIRE method. This is more or less the technique I’ve seen written about in everything I read to research this article.
I want to be clear on two things.
- The FIRE method is absolutely a path to early retirement, and it fits some people great
- I’m not using the FIRE method and I’ll retire faster than most people using it
The basics (with math)
In order to show how a person can retire early by saving most of what they earn and putting the rest in the stock market, let’s do some math.
Let’s make one important assumption.
The stock market will get 10% average return on investment.
Keep in mind this is an assumption, not a guarantee. The stock market has seen long periods of time with average returns above and below 10%. But we need a number for our math and 10% is optimistic, but realistic.
Let’s say we have a job with a $60,000 salary.
Taxes will claim probably around $10,000 of that salary, so we take home $50,000.
- We live off $25,000 per year (50% of our take home income)
- We invest $25,000 per year in the stock market
So the question is, how long does it take for our stock market investments to safely provide us with more than $25,000 per year?
How big does our portfolio need to be?
There is not a clear and obvious answer to this question. Some like to use the 4% rule, meaning they can safely withdraw 4% of the total value of their stock portfolio each year without risking their fund losing value over time.
Note: it is important to remember that the effects of inflation will be in the background sucking away about 3% of the buying power of our money each year. Our inflation adjusted return becomes 7%, not 10%.
I don’t personally think the 4% rule is conservative enough. In fact, I’d prefer to never sell a single stock in my portfolio and live only off the dividends. The annual dividend yield of the S&P 500 for the last 20 years is about 2%.
I think it’s reasonable to go halfway and use a 3% rule. 3% of the total value of our portfolio can be counted on as income each year.
So in order to provide us with $25,000 per year our portfolio will have to reach a size of $833,000. This would be the absolute earliest we could consider retiring.
Another note: Qualified dividends and stocks sold are taxed at 0% up to $39,375 so taxes will be kind to us up to that point.
How long to reach the number?
Using my favorite investment calculator, I can see that it will take me about 16 years to reach that $833,000 portfolio.
But there’s something we forgot to consider with our $25,000 target number. 16 years from now $25,000 will be about the same as $16,000 is today (remember the effects of inflation).
We can mostly write off this effect with another assumption. Hopefully our $50,000 take home pay increased over time in accordance with the inflation rate. If it did, and we continued to invest 50% of our earnings, then our portfolio should be around the number needed to support our previous lifestyle.
How to speed up the time frame
There are a few ways that this time table may be shortened. The easiest way is to invest more than 50% of your income. As you invest more and spend less, your time frame gets shorter and shorter.
The same example using a 30% spend, 70% invest ratio, puts your retirement time frame at around 10 years.
The other thing that can have an effect on your time frame is debt. Most young adults these days have some form of monthly debt payment that eats away at their living expenses.
If you have a $350 per month student loan payment, a $200 per month car payment and a $1100 per month mortgage payment, then you can lower your cost of living by paying them off.
These would be a part of our $25,000 yearly budget, but our yearly budget can shrink when we pay off this debt. A smaller budget means a lower target portfolio number and a faster path to retirement.
To invest in retirement funds or not to invest in retirement funds
I’m also seeing a lot of the articles I’ve read on early retirement recommend maxing out your 401k and IRAs.
I was very skeptical of this advice for early retirees because of all the fees associated with taking money out of them before the age of retirement. If I retire at 40, but I can’t take money out of my IRA without fees until I turn 60, then do I really want to max out my IRA?
The answer is, as always, it depends.
First, I want to make clear that I’m not an expert in stock investing. My investment philosophy leads me primarily to real estate and business investing. For experience based advice for retiring early from stock investing I suggest jlcollinsnh.com stock series or madfientist. They both have stocks in their primary wealth building strategy.
So the big problem with non-retirement accounts is they are subject to normal taxation. Your gains are tax free to a certain point, but then you’ll get 15%, then 20% taxation on all your gains after that.
The big problem with retirement accounts is the fees for early withdrawal. It turns out there are some methods to avoiding those fees, but they are a big pain. Basically, you can slowly convert the money your fee laden 401k over to a no fee Roth IRA. The process is slow if you want to be tax free, but it shows that in some cases the retirement funds do make sense.
Again, I want to emphasize that for early retirees, whether or not to utilize your gains tax free retirement accounts, is not a black and white answer. It depends on your goals and your specific situation. There are situations where it makes sense to forego the retirement accounts, but certainly not all situations.
The Cash Flow Method
There is really only one problem that needs to be solved for a person to retire early. They have to be able to cover their expenses.
And the best way I know to cover my expenses is to have enough money in my bank account every month. The cash flow method of early retirement is one where you begin acquiring assets, or investments, with the primary goal of maximizing the amount of cash you have flowing into your bank account each month.
The difference is first, you don’t care much about your net worth, you care mostly about your cash flow, and second, you will probably be investing outside of the stock market. Like I mentioned earlier, the S&P 500 dividend rate over the last 20 years is only 2%. We’ll be looking for assets that give us cash returns of 10-20% or even more.
Let’s go back to our example where we have a $60,000 salary and we take home $50,000. By investing half our take home salary we were able to retire in about 15-16 years.
I’m going to show how you can retire even faster without having to invest half your take home pay.
Let’s assume we’re again shooting for $25,000 per year of income, that will make for an easier comparison. This means we need a little over $2,000 of monthly cash flow to get there.
Let’s assume we can buy something every time we save $25,000.
If we allocate 25% of our take home pay to investing, we’ll save $12,500 the first and second year, then we can buy our first property.
That $25,000 investment will turn into $5,000 of cash flow per year, or about $415 per month.
In year three we our new take home pay is $55,000 ($50,000 plus the $5,000 from our first property).
25% of that is $13,750, so we can buy another property in a little under two years, and this property will add another $5,000 of yearly cash flow to our bank account.
Third, fourth and fifth properties
You can quickly see that after we acquire five properties, we’ll hit our $25,000 per year cash flow goal. And our current pace of one property every two years (or less), is going to get us to our $25,000 goal in under 10 years.
So we put half as much towards investing and we reached our retirement goal 5-6 years earlier! And we did this with a 20% cash on cash return. Kate and I have been getting cash on cash return of 40% or better on our Airbnb properties.
For me, this all seems like an easy choice, but I understand why many prefer the passive nature of the stock market.
Real estate investment also provides some amazing tax benefits. The biggest of these is the depreciation. Where other tax avoidance techniques usually only work up until you start earning a certain amount, depreciation is a tax deduction which is based on the value of your rental home.
If you’re making a lot of money from a property, chances are that property is worth a lot of money and therefore giving you a pretty big depreciation tax deduction. This allows the vast majority of cash earned on investment properties to be tax free!
Not only this, but it helps real estate investors to scale their investing to create very large amounts of cash flow with very low tax burdens. That’s one of the reasons that so many of the wealthy have made their fortunes in real estate.
I want to look at another example of a cash flowing asset that easily beats investing in the stock market. I haven’t done it yet, but I’m highly interested in buying an online business.
Generally, you can buy an online business for around 3 times the yearly profit, maybe a little less than that.
So if a business makes $25,000 per year, you can probably buy it for $75,000 or less.
Pretty quickly, you can see that if we save half our $50,000 take home pay for only three years, we can purchase an online business that replaces our $25,000 yearly income goal. Taking taxes into consideration would probably require a slightly bigger yearly income, but either way we’re looking at no more than four years to purchase a cash flowing asset that replaces our target income amount.
How To Do The Cash Flow Method
Hopefully I’ve at least piqued your interest in this cash flow method to retire early. I’ve written in some depth about reaching financial freedom by acquiring cash flowing assets, and Kate has a great article about the necessary steps for quitting your job.
If you want to get into more of the gritty details, then I suggest reading those articles. But what are the high level most important steps for actually succeeding using this method? Because there’s no doubt you can reach retirement faster this way.
Specialize and study
I believe one of the most important things you can do as an investor is to specialize. You will have more success if you are an expert in your area of investment. It’s possible to specialize in more than one type of investment, but I say start out with one.
In my view the two investments that put you on the fastest path to retirement are real estate and business. Pick one of those and start reading some books.
I had success starting out in real estate, but ended up specializing in a different area than I had originally planned.
When Kate and I first decided to start acquiring cash flowing assets, we thought we were going to take the fix and flip approach.
We read some books, found a realtor, and viewed some houses. When we made our first offer on a house we got shut down…by the bank! The bank told us that in order to do a fix and flip we needed more money in our bank accounts. In fact, they wanted us to have so much money that we wouldn’t have even needed a loan.
So we decided we ought to change direction. We decided to try a long term rental and called up I think 8 banks to schedule meetings with loan officers. We found a few banks that were willing to pre-approve us for a construction loan. That’s just a type of loan where you bundle in the costs of renovating a property with the purchase of that property. The banks were more flexible with terms for long term rentals. So we had our financing squared away.
We found a house that needed work at a great price and ended up buying it (after having offers declined on several other houses). There were ups and downs, but eventually we got the house fixed up and fully rented. We’ve made a profit on the house ever since.
But we did something else when we bought this property that changed our specialization again. We put some work into the lower level of our primary residence and listed it on Airbnb.
The place booked like crazy! And every property we’ve bought since then, we’ve listed on Airbnb.
The point of this story is that we studied and specialized and ended up on a different path than we expected, but we got there because we took those first important steps (studying, viewing houses, making offers and putting ourselves and our money out there).
You may end up in a place you didn’t expect, but the important thing is to try and specialize right from the start so you develop enough knowledge to make informed decisions.
Don’t skimp on your due diligence
How do you make informed decisions anyways? You have to research your investment to the point where you know just about everything that can go wrong and right.
In a real estate deal you need to gather lots of numbers:
- Property insurance cost
- Property taxes
- How much can you rent the unit for?
- Utility costs
- Maintenance and repair costs
- Vacancy costs
And you use all these numbers to decide what you can offer to purchase the house while still remaining profitable.
But that’s not all.
You also want to think about what types of things can cause the investment to lose you money.
Are there city ordinances or a home owners agreement that can affect how you are able to use the property? For example some cities or HOAs may not allow short term rentals, or even certain types of renovations.
Are there market conditions that could make it hard for you to continue making money? Do winter or summer months change the amount of money you’ll make? Maybe a single company employs a huge percentage of the citizens and that company closing or moving could cripple your business.
Are you properly insured in the case of a lawsuit, or an event that makes the property uninhabitable? If the property gets flooded or has a fire, you want your investment to be protected.
These are all examples of due diligence items to think about before making the decision to purchase a cash flowing asset.
Risk mitigation and diversification
Yeah you’ll want to consider company structures and insurance before buying a property or business, but even after you begin building your investment portfolio you’ll have to think about mitigating risks in other ways.
We have several short term rental units in the same city, so there’s a risk that a change to city laws could affect our business. If the city changes the rules for short term rentals or decides to make them against the law, then our business could be destroyed.
So we have to keep these things in mind as we continue to acquire assets. Ideally, one change would not be capable of stripping away all our earnings. So we would want some form of diversification, or at least a back up plan.
Since we’re worried about city laws changing, we may look at every potential property as a short term rental AND a long term rental. If short term rentals are outlawed, we may have several houses all of the sudden that need to find long term tenants.
We could also consider buying property in other cities that have different laws.
Regardless this is a topic to keep in mind especially when you’re buying your second and third cash flowing asset.
Treat your investments like a business
This is what turns a lot of investors away from real estate and business and towards the stock market. The stock market is much more passive, and the responsibility for growth and profitability is on someone else, not you.
When you own the business, the responsibility for growth and profitability is on your shoulders. You will be putting time in and if you lose money it’s because you missed something, or made a bad decision, or didn’t properly plan for all your risks.
This causes people to feel that these investments are very risky. And if you don’t bring knowledge, work and planning to your investments, you will lose money. So come to the table expecting to invest not just money, but your brain and your sweat.
Until you can afford to begin hiring others to replace the work you do, you’ll be working overtime.
Replacing Employer Benefits
When the topic of early retirement comes up, I like to mention employer benefits. It’s easy to forget that your employer offers you more than a paycheck.
Some benefits are meaningless to you.
For example, my employer offers deals on gym memberships, but I work out in the work room in my garage, so I don’t care about losing that benefit. I also have adequate vision, so I don’t need the vision insurance (although Kate does). Since I’m retiring early, I don’t super care about my 401k benefit, but that doesn’t mean you won’t.
And some benefits are important.
For me, being a U.S. citizen, the health insurance provided by my employer is a necessary benefit for me. And again, some may feel that the 401k is an important benefit for them.
Just make sure you have a plan in place for the benefits that you can’t afford to lose. For some extra details on this, check out Kate’s article.
If you’re taking the path to early retirement, you must invest! I’m aware of two prominent investment styles that can result in self sustaining investments.
The first is the popular FIRE method, which relies on investing a huge percentage of your income (usually at least 50%) into retirement accounts and stock market portfolios.
The second is the cash flow method, which relies on the acquiring cash flowing assets, which require specialized knowledge and extra work to make profitable. This is the route I’ve taken and it’s already allowed Kate to quit her job in under 3 years.
Whichever path you choose, I hope you make it!