The idea of stepping away from paid employment at a time where 10% (the real number is much higher, of course) of the population is unemployed, is fraught with risk. What if we blow through savings because of some emergency, and I can’t find another job? What if my side hustle crashes and burns and we no longer have any income. All legitimate concerns. However, there is another angle to this decision that is not often considered. Paid employment has considerable risk as well.

The Self-Employment Risk Myth

We tend to look at things in black and white:

Paid employment = 100% safety
Self employment = 100% risk

Real world experience tells us this is just simply not true. The truth lies somewhere in the middle. No job, industry or employer is 100% safe. And not all forms of self employment are as risky as others.

Personal situations differ as well. A two-income family with no kids is much more able to handle one spouse stepping away from the corporate world than a family of five living on one-income.

A family deep in debt with 22 years left on a huge mortgage would have a much harder time stepping off the corporate treadmill than a single person renting an apartment.

Seven Steps to Consider When Preparing to Downshift

#1  Cut recurring, monthly expenses. “The things you own end up owning you.” Tyler Durden was referring to all material possessions, but it could be said that the expenses we agree to each month wind up owning us. The Netflix subscription, Onstar, XM radio, lawn service, gym memberships, HD television service, and on and on conspire to eat away at our earnings. However, when we earn a regular paycheck, it seems easier to allow ourselves to be nickel and dimed by such services because we are relatively sure that next check will be there to pay for it.

When preparing to downshift, you must prepare your lifestyle well in advance. That means limiting things like dining out to once a month, vacationing to once a year (and done frugally), and similar niceties to infrequent “treats” rather than routine expenditures. After downshifting, chances are your income will be much lower, and perhaps much more infrequent, than you are accustomed to today. Eliminating these miscellaneous expenses now not only better prepares you for your new lifestyle, but it helps you succeed at Step #2.

#2  Get out of debt. Carrying debt while dreaming of downshifting is like loading a 150-pound pack when preparing to scale Mt. Everest. I suppose it is possible, but it will make your journey infinitely more difficult. The first step in preparing for freedom is to free yourself of the burden of monthly payments to banks, Sallie Mae, and the auto finance company.

If you are currently deep in debt, I’d encourage you to do a exercise that helped motivate me. Create a debt-free budget. Take a look at your most recent budget and simply remove all lines associated with credit cards, student loans and car payments. Now imagine this was your budget every month. Have a little more breathing room? Could you live on much less income without these payments?

#3  Pay off your mortgage early. I hesitated to include this one for fear it would be read as a prerequisite to downshifting. I know several people who have downshifted successfully with a mortgage. But this blog is about what I would do, so I’m including it in my list.

Before I can seriously consider stepping away from paid, full-time employment, I need to pay off my mortgage. With no credit cards, car loans or mortgage payment, our income requirements would be relatively small. We’d curtail our entertainment budget a bit, and save money in sinking funds throughout the year for large, annual expenses (property taxes, insurance premiums, etc.). With a low requirement for income, we would be free to pursue something we love, rather than be forced to pursue a big salary.

#4  Build a one-year cash reserve. Again, this is a personal requirement, but one I feel eliminates much of the risk of self-employment or downshifting to a smaller income. Once my basic expenses have been established, I would like for us to continue full time employment until we had one year of expenses saved – sort of a super emergency fund.

I would pay myself a “salary” covering our basic needs (and a couple small wants – remember, life is to be enjoyed) from this fund at the same interval I currently receive a paycheck. I would deposit earnings from my new passion into this account. On good months, the cash reserve balance would go up. On bad months, we would eat into savings a bit. But over the long term, this fund would smooth out the hills and valleys associated with infrequent income.

#5  Supplement your full-time income (for now) with a side hustle or two. Before stepping away from a full-time paycheck, it’s a good idea to get started on your second career. Beware of potential conflicts of interest if your new gig will be along the same lines as your current employment.

Three years ago I wanted to be a writer – I declared it my side hustle. Recognizing I probably wasn’t going to enter the world of writing as a first-time author and make mega bucks, I started small, writing for an article directory. I made about $3 per article. Because this had nothing to do with my full time job, I was able to moonlight in the evenings and early morning hours. After writing about 70 articles for someone else, I stumbled on a personal finance blog (TheSimpleDollar.com) and thought, hey, if I could figure out the technical stuff I could do that, too!

My idea was born, and for the last couple years I have continued to build my half-time job, writing at Frugal Dad as well as a couple small freelance opportunities, while maintaining my 8:00-5:00 full-time job. I’ll continue to do so until I’ve completed steps 1-4 above, and then decide if my earnings here are enough for us to live comfortably, debt free.

#6  Secure employee benefits as a non-employee. At this point in the process, you are ready to begin looking over your benefits plan at work and investigating the things you’ll need to continue when no longer employed. Here’s a sampling of the more important items:

• Health insurance. Affordable health insurance for self-employed individuals is a challenge to find. But it isn’t impossible. Consider getting a free quote at online site like ehealthinsurance.com. Check with any organizations you are a member of – such as trade organizations, warehouse clubs, etc. Many of their business services include health insurance options.
• Disability insurance. This is one you can’t afford to be without. Disability insurance provides income for you in the event you are unable to continue working. Most people are covered under their employer’s benefits package. You will no longer have that luxury, but should still cover yourself against the chance of disability.
• Life insurance. If your only life insurance policy is through an employer, you should probably shop around for an additional policy anyway. If you know you are leaving that employer, it’s even more important. Many horror stories exist of someone being terminated from employment and suffering a heart attack two months later (when they were no longer eligible for employee life insurance).
• Retirement savings. Fortunately, there are many self employed retirement plans out there. You’ll have to sift through the various types of plans to determine which one fits your goals and your business model. Depending on the route you take, you’ll likely find that you can contribute more to a self employed plan than you could as an employee (minus that sweet employer match you used to receive!).

#7  Step off the treadmill and enjoy. This may in fact be the hardest step. At this point in the planning process you are debt free; you’ve saved one year of cash reserves; you have cut back on your monthly expenses; and now you are ready to set off the treadmill.

Anyone who has ever done sprints on a real treadmill knows that the point where it is time to jump off is filled with anxiety. That belt is still moving pretty fast. What if one of my feet slips off the side of the treadmill? What if I land on the belt and my feet fly out from under me? It’s a real concern, and one that makes most people just stay on the treadmill a little longer, gradually decreasing the speed until it feels safer to step off.

If you’ve completed steps 1-7 above, you have effectively slowed that treadmill belt to a comfortable, walking pace. Stepping on and off the slow-moving belt is still a little tricky, but much less dangerous at 1.5mph than 10mph. A misstep here and you might stumble a bit, but you’ll survive.

Who knows what the future holds for any of us. All I know is that life is precious. We all have a finite amount of life energy to which we can devote to our passions. If you are not fulfilling that passion right now, I encourage you to begin planning to take the steps to make it happen. It will take sacrifice, but no greater than sacrificing your passion for a comfortable living and a steady paycheck.

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.

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%.

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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?

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