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

Early retirement is a possibility for frugal savers and extreme planners.

Person places bundles of cash beneth a mattress to save for retirement
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Extreme savers who expect to achieve financial independence by age 40 challenge the norm when it comes to retirement planning and timing.

According to the 2020 EBRI/Greenwald Retirement Confidence Survey, only 14% of retirees quit working when they were under the age of 55, compared with 19% at age 55 to 59, 11% at 60 or 61, 26% at 62 to 64, 13% at 65, 11% at 66 to 69, and 6% who either retired at 70 or older or said they would never retire.

Key Takeaways

  • One general guideline for most retirement savers is to strive to replace around 80% of your pre-retirement income.
  • Remember that retirement income sources such as Social Security will not be available until age 62 at the earliest.
  • A 20% or lower debt-to-income ratio is a suggested guideline if you are planning on retiring in your 40s.
  • To estimate your early retirement goal, take your projected annual expenses during retirement and multiply this amount by the number 25.

What Are the Challenges of Retiring by Age 40?

While early retirement may seem like a dream for most of us, it is possible if you are willing to address some major financial planning challenges. The first is to figure out how much money you will really need to have saved in order to reach day one of your financial independence.

How Much Savings Is Enough?

A guideline for most retirement savers is to strive to replace around 80% of your pre-retirement income. This is the target amount that should allow you to enjoy a comfortable lifestyle after you stop working.

Traditional retirement-saving benchmarks like this may work for people who are planning to retire in their mid to late 60's. However, they are less effective if you are planning on early retirement. And if you are a frugal saver with a plan to be done working by 40, you are likely already used to covering your living expenses with a small fraction of your income.

Seeing Social Security as Bonus Income

Another challenge includes the fact that one source of retirement income, Social Security, will not be available until age 62, at the earliest. Also, when early retirees are eligible for Social Security, the actual benefits will likely be reduced due to their shorter work history.

Social Security benefits are based on average 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.

The age at which you are able to receive full Social Security benefits depends on the year in which you were born. For example, if you were born in 1960 or later, your full retirement age is 67.

Most people who want to retire really early view Social Security as an added benefit. If you can aggressively save enough for retirement in your 40s, you will probably not be relying on Social Security for income.

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 an above-average savings-to-income ratio, frugal living, and the elimination of debt.

A Mix of 401(k) Plans, IRAs, and Taxable Investments

There are specific steps you should take right away if you want to work toward early retirement. Save as much as possible in 401(k) plans, IRAs, and investments that are not tax deferred. The key to achieving early retirement is socking away as much money as possible.

Almost as important as the amount you save is where you save it: asset location. Putting the maximum amounts in 401(k) plans and Roth and traditional IRAs and large amounts in brokerage accounts helps to create tax diversification.

In general, retirement accounts such as 401(k)s and IRAs have a 10% early withdrawal penalty for distributions before age 59½. Special tax rules such as Internal Revenue Code 72(t) can help avoid these penalties. Under that IRS rule, you must take equal periodic payments that have a value based on the IRS's 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 their retirement income.

You can withdraw the value of contributions you have made to a Roth IRA at any age without paying a tax penalty. But you can not withdraw earnings from those contributions without paying the penalty if you are under the age of 59½.

Living Expenses

Where you choose to live and your lifestyle choices will also greatly affect your ability to save. Your cost of living during your working years must be a good fit for your desired retirement lifestyle.

Minimalism and frugal living concepts remain popular with a growing group of people who are more interested in accumulating meaningful life experiences than stuff. If you can reach big life goals while burning through a smaller chunk of your earnings while you are working, you will be prepared to maintain that same enjoyable lifestyle in retirement. These frugal choices include living in small spaces and buying used clothing, furniture, and cars.

Avoiding Most Debt

If you hope to retire early, you must 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 goal 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 debt-to-income ratio of 20% or lower is a good goal if you are planning on retiring in your 40's.

Medical Considerations

You can't think about early retirement without considering how you will pay for medical expenses. For one thing, Medicare eligibility doesn’t kick in until age 65. That lack of Medicare coverage for most people means that you will likely need to consider alternative ways to obtain affordable health insurance.

People younger than 65 with disabilities or end-stage renal disease may apply early for Medicare.

Out-of-pocket medical expenses can add up quickly, even with good coverage. You will also need to think about the costs of dental, vision, and hearing care because almost none of those kinds of expenses are covered by Medicare.

The Simple Early-Retirement Calculation

There is no magic number for how much you need to set aside to pay for your retirement, whether you do it in your 30's or 70's. However, there is a generally accepted way to estimate that amount: Figure out how much money you expect to spend in a given year during retirement, and multiply the figure by 25.

The resulting estimate will give you a number to aim for as you prepare for your life after work. This method assumes you can withdraw 4% of your income each year without substantial risk of running out of money.

If you plan to retire early, following this rule may not provide you with enough funds to last until you die. You might want to discuss any retirement plan you have with a financial advisor.

Here is a brief example of the 4% guideline in action. Let’s assume that your goal is to have generated $40,000 of income per year of retirement. To meet that goal, you would need to have saved about $1 million by your desired retirement age.

Now, let’s look at a 25-year-old who earns $50,000 per year and saves half of their income for 15 years. Assuming a pretty aggressive 7% average annual rate of return, $25,000 invested per year would grow to just over $628,000, or almost two-thirds of the goal amount.

It is important to note that the 4% annual withdrawal rate is more of a guideline than a guarantee. There are many criticisms of the 4% rule, including the need to keep a large part of your nest egg in stocks even as you get closer to your retirement age. And withdrawal rates lower than 4% have been shown to increase the likelihood that your retirement money will be there for as long as you need it.

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