Simple Steps to Early Retirement

by Gary Foreman

DIY Landscaping for Less photo

An early start to saving for retirement can mean an early retirement. Just follow these simple steps to your early retirement.

Dear Gary,
I’m 22 years old, about to graduate college, and thinking about retirement. Everyone I know who is between the ages of 40 and 70 tells me how much they wished they had planned ahead for retirement when they were my age. I don’t want to say that when I’m older.

What can I be doing right now when I’m starting my career that will allow me to retire as early as possible with as much financial security as possible? I have heard great things about Roth IRAs and 401k plans.
Russell F.

Don’t Count on Social Security

Let’s begin by congratulating Russell. Not only for his graduation but also for his foresight. Because his generation faces some new challenges in retirement.

For the last 70 years, Americans have become increasingly dependent on Social Security to provide retirement income. And so far, the system has done a good job of filling that need. So good, in fact, that many people retire today without having accumulated any savings to supplement their income.

That could be dangerous for someone who’s Russell’s age. The Social Security Administration calculates something called the “Aged Dependency Ratio.” It compares how many people are over the age of 65 to those between the ages of 20 to 64. In other words, how many people are retired compared to those who could be working and contributing to Social Security. Projections show that there will be fewer workers to support the number of retirees with each passing decade (see the latest available data) and lifespans are increaing.  And we’ve all heard the projections regarding the future of Social Security. Russ would be foolish to depend solely on Social Security to fund his retirement.

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Retirement Savings Plans Options

So, what should Russ try to accomplish with his retirement savings? Naturally, he’ll want to accumulate money that can be used to pay living expenses when he’s retired. Perhaps he’d like to reduce his taxes today. And he might want access to his money for extraordinary expenses before retirement.

All retirement plans work under the same basic premise. You can pay the IRS now and then avoid taxes on the distributions later. Or you can avoid taxes now but pay them when you take the money out.

One of the advantages of the regular IRA and 401k plan is that the contributions you make are deductible now. You’ll pay taxes on the money when you withdraw it. Many people expect to be in a lower bracket after they’re retired. So they’d pay less in taxes.

The Roth IRA is different. You contribute money that’s already been taxed.

All three programs share one advantage. Earnings on the money invested in the plans are not subject to taxes each year. And that can be a significant factor.

The Big Difference the Right Savings Plan Can Make

Suppose Russ puts away $2,000 every year and earns 6%. Let’s also assume that he’s in the 28% tax bracket. By the time he’s 70, he will have accumulated $306,229.

But, if he had put that same contribution into a retirement plan, it would have grown to $513,129 because taxes aren’t due each year. A higher investment return would increase the difference.

The 401k does have one unique advantage over the IRA’s. Many employers will contribute $1 for every dollar or two the employee contributes. (See A Guide to 401k Contribution Basics.) It’s pretty hard to beat an investment that earns 50 or 100% the very first day!

But, the 401k does have some limitations. Check your plan for investment options. Generally, the employer will choose how their contribution is invested. And the employee may have limited choices for their own contributions, too. (See Should You Contribute to a 401k If Your Employer Doesn’t?)

Both the traditional and Roth IRAs offer a wide variety of investment choices. You can choose investments ranging all the way from very safe to quite risky.

Getting Your Money Out of a Retirement Savings Plan

Putting money into a retirement plan is great, but Russ will want to be able to get it out, too! And that can be a little confusing because each plan has different taxes and penalties.

The Roth IRA gives you a break if you need to take a small early withdrawal. You can withdraw an amount up to your original contributions without paying taxes. That’s because you paid tax on that money before you contributed it.

Your earnings can be withdrawn tax-free if you’re over age 59 1/2, become disabled or want to use it for a first-time home purchase, and the money has been in the account for five years. Unlike a traditional IRA, the Roth IRA doesn’t have any required distribution date. So you won’t be forced to make distributions.

If you want to take money from your 401k without paying taxes, you’ll need to see if your plan permits loans. You’ll borrow from the account and repay it on a set timetable. Each plan will specify the borrowing rules. They can restrict how you use the money. Check your plan for details. (See also: How a 401k Loan Affects Future Wealth.)

When you leave your employer, you’ll be required to close out the 401k account. You can take it as a lump sum distribution and pay taxes on it. Or you can roll it over into a regular IRA account and defer the taxes.

Getting your money out of a regular IRA is a little trickier. If you haven’t reached the age of 59 1/2, you’ll face a 10% penalty and ordinary income taxes on any distributions. And you must begin taking your money out at age 72 whether you need it or not. All withdrawals are taxable.

Where Should You Put Your Retirement Savings?

So, how does Russ decide where to put his money? In most cases, if he’s eligible for a 401k with an employer matching contribution, that’s the best option. After that, most people who haven’t seen their 40th birthday should add any additional savings to a Roth IRA. Having that money accumulating tax-free is too big a benefit to pass up. If you’re older or fighting tax problems and want the deduction, a traditional IRA would fit the bill.

One final thought for Russ. Every dollar that he saves in his 20s is the equivalent of four dollars saved in his 50s. So it’s much easier to accumulate enough for a comfortable retirement if he starts early.

Reviewed October 2023

About the Author

Gary Foreman is the former owner and editor of The Dollar Stretcher. He's the author of How to Conquer Debt No Matter How Much You Have and has been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com.

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