This is the fourth post in a series called Saving With Purpose: Living a More Intentional Financial Life. In this series, I plan to highlight a number of specific savings goals my family has identified we would like to achieve over the next few decades.

In the last series post we discussed ways to reach early retirement through a combination of taxable investments and retirement contributions that may be withdrawn before traditional retirement age. This post picks up where the other left off; we’ve now reached that golden age of 59 1/2 and may begin withdrawing from our traditional retirement plans.

Should we invest in both a Roth IRA and a 401(k)? Should I count on social security income, and if so, should we elect to receive early payments? What alternative investments can we make to fund retirement?

Forget Everything You Thought You Knew About Retirement

Our strategy for retirement is different from the more traditional idea of working somewhere 40 years, retiring, and drawing social security for the next two or three decades (hopefully). Our plans for retirement have been influenced by a shift in some of the long-held financial beliefs.

Things like a guaranteed 8% return in the markets may be soon be a distant memory. Sure, some years will be good and some bad, just as it always has. However, I suspect there will be more volatility and negative financial news than anyone my age remembers. So our plans have been molded by life experiences, the political climate, and even larger economic trends that have developed in our lifetimes. Our investments will be more conservative, and we will always lean to being “cash heavy,” because we value preparedness over the chance of hitting it big.

Maximize Roth IRA Contributions

Each year, my wife and I will contribute the maximum amount to a Roth IRA. I’m a big fan of the Roth IRA, for several reasons. First, the earnings in a Roth IRA grow tax free, and since you are using after-tax dollars, contributions can be withdrawn at any time, for any reason (making the Roth sort of a 2nd pseudo-emergency fund).

The Roth IRA also has no mandatory distribution age, meaning if you hit 59 1/2 and don’t want to tap your Roth IRA balance, you don’t have to. Traditional IRAs require distributions at age 70 1/2, meaning you could be forced to reduce the amount you leave to heirs thanks to mandatory distributions.

With about 27 years until we reach that 59 1/2 years-old threshold, my wife and I could save a large amount in our Roth IRAs, assuming we don’t tap contributions early to fund early retirement (something I mentioned as possibility in the last series post). Assuming a 6% average return on our $10,000 yearly investment, we would have nearly $700,000 in Roth IRA savings in 27 years.

Maximize 401(k) Contributions

In Adam’s recent post asking whether or not he should save for retirement or pay off debt, it seemed the consensus in the comments was Adam should contribute through his employer’s match, but use any remaining funds to reduce his debts. I agree; there is nothing like “free” money in the form of matching contributions.

However, there is a larger question here. After becoming debt free, should one continue to increase 401(k) contributions to the maximum yearly amount (currently $16,500), or should they invest that money elsewhere in a more diversified mix of asset classes (paid-for real estate, business ventures, etc.)? I don’t believe there is a right or wrong answer here. but it seems to me that if all you can afford to do is stretch to max out your 401(k), you may do better to spread that money around a bit. On the flip side, if you can afford to save above and beyond the yearly maximum, then you should first fund all tax-advantaged accounts, such as a 401(k).

What did we decide? After much deliberation, we decided to slash a few budget items and go after the max 401(k) contributions, recognizing we may not be able to do this every year going forward. Fortunately, we are now debt free, and through my blogging pursuits, we have what amounts to a second income. I recognize this does not work for everyone, and it certainly didn’t work for us until just recently. In fact, I haven’t even contributed to a 401(k) in the last few years while we whittled away debts and built emergency savings.

If we could find a way to continue maxing out 401(k) contributions until retirement age, we would have $1.1 million, assuming a 6% return. Add in Roth IRA contributions and growth, and we’re approaching $2 million. Of course, as I mentioned in my last post, this is not likely to happen because I want to move away from full-time employment in the next 12-15 years. If we kept up our goal of maxing 401(k) for just 15 years, we could still build a 401(k) nest egg of just over $400,000, and another $250,000 in Roth IRAs. Not bad at all.

Will We Receive a Return On Our Investment In Social Security?

In a word, no. I don’t believe we will. Put another way; don’t count on it. I personally believe social security as we know it today will not exist in another 15-20 years. It can’t, mathematically, as soon there will be many more people receiving benefits than paying in. That sort of upside down pyramid doesn’t work – just ask anyone associated with a failed Ponzi scheme.

Now, I am not as radically anti-social security as some. I just like the idea of controlling my own investment dollar, because I’m confident I can earn more than the U.S. government can. Enough of that, I’m not out to make a political statement. I am simply trying to reinforce the idea that people in their 20’s and 30’s should not expect to be able to live on social security in retirement.

If we do receive some form of payment from social security, just consider it a bonus, but certainly don’t count on it for financial survival. If the program is still solvent when I reach the age eligible to receive early payments, I’ll likely sign up. After all, nothing is guaranteed – neither my health or the continued viability of the program. Unfortunately, several people close to me paid in their whole lives and never received any benefits, or received very limited benefits through disability before dying young.

Alternative Investments for Retirement

In addition to the traditional types of investments I’ve listed here (and in earlier series posts), we are also interested in things like paid-for real estate. Specifically, we’d like to pay off our own home well before contemplating an early retirement. I have always thought living mortgage-debt free must be the ultimate in financial freedom.

Just imagine no credit card debt, no car payments, and no mortgage payments. Imagine the options available to someone in that position. Imagine the freedom they must feel with the only income requirement to earn enough to cover basic living expenses, and save for future ones. That’s it.

In addition to real estate, I will always have a side hustle or two going, and in the future may elect to invest more money to grow a current hustle, or develop a new one, without introducing too much risk into our lives. I started Frugal Dad over two years ago on less than $50, so it might be tough start something even more frugal!

In the final post in this series, we’ll look at one last topic: giving. Yes, part of our saving strategy is to give a lot away. I’ll share a few ideas I have on the subject, and as usual, try to put some specific numbers to our giving goals going forward.

This is the third post in a series called Saving With Purpose: Living a More Intentional Financial Life. In this series, I plan to highlight a number of specific savings goals my family has identified we would like to achieve over the next few decades.

Any post about saving for early retirement should first define the author’s meaning of “early” and “retirement.” Combined, these words are typically understood to mean walking away from paid employment earlier than the traditional retirement age. I guess I agree with that broad definition, but I’d like to take the definition a little further before getting into the actual numbers.

What Does Early Retirement Mean To Me?

The older I get, the more my definition of retirement changes. When I was young, I envisioned retirement as a time of leisure, where older people traveled to exotic locations, took cruises, and when they weren’t traveling, played golf, went fishing, and generally enjoyed a life of leisure.

Of course, now that I’m older, I recognize this is not how the average retiree’s years are spent. Unfortunately, thanks to the Great Recession of 2008, many soon-to-be retirees saw half of their retirement saving disappear. This has lead many retirees to hang on to their jobs, or return to other types of jobs (often times lower paying) than the careers they had for most of their adult lives. This is a sad reality for many, and a cautionary tale for the rest of us.

For me, early retirement is all about options. Living without the worry of needing to work a traditional 8-5 job frees up many opportunities for more worthwhile ways to spend time. For us, that means doing some travel and doing more things with our time to make a difference in the lives of others, particularly young people. We married young, had kids young, and skipped over the period in our lives where we would be able to do these types of things, so we’d like to recapture a bit of that after the corporate grind is completed.

Saving For Each Phase of Retirement

Uncle Sam has dictated retirement for many people to mean age 59 1/2 (the age you can tap most retirement accounts without penalty), or 62 (if you plan on receiving early benefits from social security). Personally, I use neither of these age milestones as a guide, and plan to save in such a manner that I can experience freedom from paid, full-time employment long before reaching 59 1/2.

To identify the types of savings we’ll need to have in place to meet our own milestones, it’s best to work backwards from the next upcoming event. In this case, let’s start with early retirement at 47 years-old, some 15 years away.

Phase I: Early Retirement on Taxable (and Tax Free) Savings

Over the next 15 years my wife and I plan to maximize both our Roth IRA accounts, and my 401(k) through my employer. Using the current maximum contribution levels for Roth IRAs, this would provide $150,000 in contributions. Remember, Roth IRA contributions may be withdrawn at any time, without tax or penalty. Assuming we plan to live on about $50,000 a year, this would only last 3 years, barely getting us to 50 years-old.

A better plan would be to use taxable savings to bridge the 12-year gap between 47 and 59 1/2 (the age we can begin to withdraw from retirement accounts).  We’d only need about $600,000 in savings outside of retirement accounts to pull this off. Only. I laughed at myself after writing that.

Pretty tough to carve out $600k in savings in the next 15 years (even earning a modest 6.5%) while maxing out retirement accounts, funding college savings, and meeting our previously mentioned short-to-medium range savings goals. Not like we have an extra $25,000 a year sitting around to invest.

So the numbers appear unattainable, but the exercise was still worthwhile. It provides us with some real feedback for the variables we set, and we can now tweak those inputs to determine the impact. For instance, if we delayed early retirement just three years to age 50, we’d have another $30,000 in Roth IRA contributions. Our taxable nest egg required to fund the gap from 50 to 59 1/2 would drop to $500,000, and since we’d have a little longer to save, we would only have to divert $1,200 a month to taxable savings. The $1,200 a month figure sounds eerily similar to an average mortgage payment, doesn’t it?

When you break the numbers down this way, two things become apparent. First, early retirement is not just a pipe dream, if you are a disciplined saver and avoid debt. Second, I sure wish I had started this plan 10 years ago!

Up next – Retirement Savings Phase II: Drawing from the Nest Egg

This question is especially important if you are considering retiring soon or if you have been offered an early retirement package.

If you’re like me, when you try to imagine what lies ahead, you think about your most recent experiences and extrapolate going forward.

Investors do this more than anyone – at least as far as I’ve seen. While I can see why folks do this, it’s really not a very good exercise and I’ll show you why.

If you think back over the last 10 years, you’ll agree that it hasn’t been a picnic for investors. Depending on when you calculate the 10-year average, you could get a slightly negative return or a slightly positive return for that period. But either way, it’s a lousy return.

Based on that, investors might forecast a crumby 10-year return going forward.

Even though we’ve heard that old expression that the past is no guarantee of the future when it comes to investing, what else do we have to base our decisions on other than the past?

Well…I do want you to consider the past when you think about the future.  Just think about it a little differently.

Let’s look at an example to help explain this idea.

If you review the chart below, you can see that the 10-year trailing return in 1974 was an ugly -3.8%. That means had you invested in 1965 and held on to your investments through the end of 1974, your annualized return was -3.8%.

S&P 500 Trailing 10-Year Annualized Return

Real Returns Over the Next:

But what happened over the next 10-year period? The market had an annualized 6.9% return. In fact, after each of the last 5 decade-long market meltdowns, the market did pretty well.

Is that a guarantee that the next 10 years will be years of wine and roses for all?  Not by a long-shot. But it does indicate that history is on our side. It shows the importance of not falling into the trap of thinking our most recent experience is going to be repeated in the future.

Exactly one year ago, did you predict that the market would do so well by the end of the year?  I sure didn’t.

While we face real challenges ahead as a nation and as investors, it would fly in the face of all the facts to become pessimistic right now.

What do you think we’re in store for over the next 10 years?

Do you dream of one day leaving the rat race? Who doesn’t? For me the idea of “retirement” does not evoke visions of fishing and golfing, rather the ability to do whatever it is that I truly want to do. Personally, that looks a lot like writing, coaching youth sports, and perhaps working with a non-profit for a cause I strongly believe in. Unfortunately, much talent is wasted doing the 30-year corporate shuffle to pay for “stuff.” What if you could begin to eliminate some of this “stuff” and find new ways to diversify your income to cover basic expenses?

Step 1: Tracking Expenses

One of the best ways to begin any new plan is to figure out a baseline. Dieters often begin a new fitness plan with the dreaded measurements of weight, BMI and bodyfat percentages. Think of this portion of your plan for an early “retirement” as your financial fitness evaluation. The very first thing you should do is figure out what you’ve been doing. Stop reading this and estimate in your head how much your monthly expenses are (debt payments, utilities, food, gas, etc.). Keep that initial estimate in mind as you move forward with this exercise.

At the beginning of the next calendar month start recording all expenditures, from the $2.00 cup of coffee to the $1,000 mortgage payment. If it is early in the month you may begin this step retroactively, assuming you can account for expenditures up to this point. For now, don’t be overly concerned with the method of recording these figures, just record them. Some people like to set up elaborate Excel spreadsheets; others prefer a ledger pad and pencil. During this first month resist the urge to reduce your spending. Try to spend and save as you have been doing to get an accurate representation of your starting point.

Step 2: Tracking and Diversifying Income

This step will take much less time, unless you are already in the enviable position of receiving daily income from multiple income streams. Most of you are probably like me. My first month of tracking income had exactly three records. Two paychecks and about $0.16 in interest from a savings account. Some of you may have even less. That’s fine – as they say in the book that inspired this entire exercise, Your Money or Your Life, “No shame, no blame.”

If you really want to step off the corporate treadmill one day, you simply have to increase your passive income either by investing current earnings in high-yield accounts, or by developing multiple income streams from part-time or freelance work, or some combination of the two. As long as you rely on your current full-time paycheck to pay for your expenses you are trapped in the rat race.

Step 3: Creating a Freedom Chart

At the end of the first month you should now have a detailed cash flow statement listing all of your expenditures and your household income. You may need to sit down for this step. For most people this is the point where they realize they are spending more than they earn. This overage accounts for what I refer to as “lifestyle debt.” It is the two hundred dollars you charged at the grocery store to float until you got paid, or the insurance bill you paid with your credit card because there wasn’t enough in checking. Lifestyle debt is a killer when it comes to early retirement plans. It ties up your income from future investment, and the interest accrued cheapens your future earnings.

Step 4: Project the Intersection

At some point in the future, as your passive income increases and daily living expenses decrease, your monthly expenses will equal your passive income. It is at this point that you are technically free from the rat race. If you received a pink slip from your job tomorrow you could survive indefinitely assuming your expenses did not increase significantly due to health coverage, etc. From this point of intersection forward you are continuing to work, save and invest to improve the quality of life in your early retirement. The more you have invested in high-yield accounts the higher your passive income will be, allowing you a few more expenses each month. You may decide to continue working at your full time job to generate some capital to put into your own business, adding even more to your passive income stream. Whatever you decide, the choice is now yours. At this point of intersection you are officially free from the rat race.

photo by davidandnasha