How Much Do You Need to Save to Retire By 40?

Early Retirement Is a Possibility for Frugal Savers and Extreme Planners

Woman working in an office dreaming of working toward an early retirement at age 40.
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For extreme savers with ambitious goals of achieving financial independence by age 40, the general lack of retirement preparedness does not affect their desire to challenge conventional wisdom. According to the 2019 Retirement Confidence Survey conducted by the Employee Benefit Research Institute (EBRI), 77% of workers are less than very confident they will have the necessary funds to enjoy a comfortable retirement. However, the percentage of people who responded that they were very confident—23%—rose from the 2018 figure of 17%.

The Challenges of Retiring by Age 40

While early retirement may seem like a farfetched idea for most of us, it is a real possibility if you are willing to put your journey to financial independence on high-speed rails. Early retirement is a dream many people would like to achieve. But the reality is that transitioning to an early retirement creates some financial planning challenges. The first challenge is trying to figure out how much money you will really need to have saved once you reach Day One of Financial Independence. The answer to this question is that it depends on how you define retirement.

How Much Savings Is Enough?

A general guideline for most retirement savers is to strive to replace around 80% of your pre-retirement income. This income replacement goal is the target amount. It is set to maintain the same comfortable lifestyle during retirement.

Retirement benchmarks like this may work for the majority of workers planning on a more traditional retirement start date in their mid to later 60’s. However, traditional retirement saving benchmarks are less effective if you are planning on early retirement. This is because early retirees are likely already used to requiring much less than 100% of their income to cover their living expenses.

Retirement Income Sources

Other challenges include the realization that retirement income sources such as Social Security will not be available until age 62, at the earliest. When early retirees are eligible for Social Security the actual benefits will likely be reduced due to their shortened work history.

Lessened benefits are because Social Security benefits are based on an average of indexed monthly earnings during the 35 years in which you earned the most taxable income. Any early retirement years with zero or limited earnings will lower your anticipated monthly benefit.

Most prospective early retirees view Social Security as an added benefit. Let’s face it if you have the ability to aggressively save enough for retirement and the desire to transition into financial independence in your 40’s you most likely will not be relying solely on Social Security, if at all. The ability to walk away from the workforce on your terms—or at least have the freedom to retire when you are ready—typically requires a combination of:

  • Above-average savings-to-income ratios
  • Frugal living
  • The elimination of problematic debt

401(k), IRAs, and Taxable Investments

If you do want to work toward an early retirement there are specific steps you should take immediately. Save as much as possible in 401(k), IRAs, and taxable investments. The key to achieving early retirement is usually centered around aggressively saving as much money as possible. This may sound like a no-brainer and most financial planners already suggest maximizing savings. However, you also want to focus on saving in the right places or asset location. Contributing up to the maximum amount possible in 401(k) plans, IRAs, and brokerage accounts help to create tax diversification.

In general, retirement accounts such as a 401(k) or IRA have a 10% early withdrawal penalty for distributions before age 59 ½. Special tax rules such as Internal Revenue Code 72(t) can help avoid these penalties. Under the IRS rule, you must take equal periodic payments that have a value based on an IRS-approved life expectancy calculation. Most often the rule is used in cases of illness or disability.

With or without a penalty for early withdrawal, the early retiree must ultimately factor in the tax implications related to where they will generate retirement income.

Living Expenses

Where you chose to live and your lifestyle choices will also have a strong influence on your ability to save. That is because without large amounts of discretionary income those retirement dreams will stay dreams. Your living expenses during your working years must also be a good fit for your desired retirement lifestyle.

Minimalism and frugal living concepts remain popular across a growing group of people interested more in accumulating meaningful life experiences rather than stuff. If you can accomplish important life goals while requiring a smaller chunk of your earnings you will likely already be used to a lower income replacement rate in retirement while maintaining your same comfortable lifestyle. Such lifestyle changes include living in small spaces and buying second-hand clothing, furniture, and automobiles.

Eliminate High-Interest Consumer Debt

Eliminate high-interest consumer debt and maintain a low debt-to-income ratio. Lower debt obligations in retirement help free up income for basic needs and lifestyle expenses. Most early retirees share a common bond of becoming debt-free before their retirement transition.

Manageable debt obligations for real assets like a primary residence or rental properties are an exception as long as the monthly debt payments are low. A 20% or lower debt-to-income ratio is a suggested guideline if you are planning on retiring in your 40’s.

Medical Considerations

If saving at least half of your income isn’t a potential barrier for your financial independence plans, there are other things to consider. For one, Medicare eligibility doesn’t kick in until age 65. However, younger people with disabilities or end-stage renal disease may apply earlier. That lack of Medicare coverage means you will need to consider alternative ways to obtain affordable health insurance.

Out of pocket medical expenses can add up quickly—even with good coverage. You will also need to consider covering the cost of dental, vision, and hearing disorders—none of which are covered even under Medicare.

The Simple Early Retirement Calculation

There is no magic number that you can point to and say that is how much you need to set aside to pay for retirement living. However, there is a general estimation rule. Take your projected annual expenses during retirement and multiply this amount by the number 25. This will help you estimate how much you will need to reach your early retirement goal. The retirement savings benchmark assumes that you can withdraw 4% of your investments each year without substantial risk of running out of money.

Here is a brief example of the 4% withdrawal guideline in action. Let’s assume your retirement income goal is to generate $40,000 of investment income per year. To meet this goal, you would need to save approximately $1 million at your desired age of retirement. Now let’s look at a 25-year-old earning $50,000 a year with the ability to save half of their income for 15 years. Assuming a moderately aggressive 7% average annual rate of return, $25,000 invested per year would grow to just over $628,000.

The 4% Rule provides guidance for how much you could potentially withdraw annually once you're retired. In the previous example, the early retiree would anticipate having a little over $25,000 in annual income using a ballpark estimate. 

It is important to note that the 4% withdrawal rule is more of a guideline than a guarantee. Recent academic research has challenged the 4% rule for sustainable retirement account withdrawals. Lower withdrawal rates have been shown to increase the probability rates that the retirement nest egg will be there throughout your retirement years.

The reality for early retirees with a long withdrawal period is that the future is uncertain, and it is important to maintain some flexibility when creating a retirement income plan.