Early retirement is not exclusive to the wealthy. Many people, especially followers of the FIRE movement – shorthand for financial independence/retiring early – use a few key calculations to determine how much money they need to sustain an extended stay in retirement that will last years or can even start decades earlier than the standard pension. age.
In this article, we explain how to calculate your FIRE number, along with other considerations, including how to estimate your annual expenses in retirement and the best ways to invest your money so it grows over time.
Here’s what you need to know.
How to Calculate Your FIRE Number
The FIRE movement has become popular as a goal for people looking to escape the traditional retirement age. The standard retirement age is 67 for people born after 1960, but FIRE supporters hope to leave the workforce well ahead of schedule by increasing incomes and aggressively cutting spending.
The first step in achieving FIRE is determining your FIRE number, or the amount you need to save to support your desired lifestyle without relying on traditional work.
At the heart of FIRE calculations is the rule of 25. It states that you must multiply your expected annual expenses in retirement by 25 to reach your intended savings goal.
FIRE number = Annual expenses at retirement X 25
For example, if you expect to need $40,000 per year to cover your living expenses in retirement, your FIRE number is $1 million ($40,000 x 25).
The Rule of 25 is based on the assumption that you can safely withdraw 4 percent of your savings each year in retirement without depleting your savings too quickly. This is known as the 4 percent rule.
The 4 percent rule was popularized in a landmark 1998 research report known as the “Trinity Study,” which analyzed past market performance to determine a safe withdrawal rate in retirement.
The study found that in 99 percent of cases, retirees could withdraw 4 percent per year, adjusted for inflation, from a portfolio of stocks and bonds without depleting their savings.
The Rule of 25 and the 4 Percent Rule complement each other: While the 4 Percent Rule focuses on a safe rate to withdraw money, the Rule of 25 provides a quick estimate of how much you need to accumulate before leaving the job market .
Planning your retirement budget
Before you use the Rule of 25 to calculate your FIRE number, it’s critical that you have a clear understanding of your expected retirement expenses.
While some expenses may decrease in retirement, others may increase. And for early retirees, especially those who retire in their 40s or even 30s, there are countless other costs to consider, such as paying for health insurance or financing a child’s future college expenses.
Here’s a broad overview of what to consider when mapping out your annual estimated expenses in retirement.
- Housing: Do you still have a mortgage after your retirement? Mortgage payments may decrease if you downsize, move to an area with a lower cost of living, or make additional mortgage payments before you reach financial independence.
- healthcare: Healthcare costs generally increase with age, so learning to manage health care costs in retirement is essential. Finding affordable health insurance as an early retiree is particularly challenging. You can enroll in an insurance plan on the federal health care marketplace, be added to your spouse’s workplace plan, or pay the costs yourself by withdrawing money from a well-funded health savings account (HSA).
- Transport: Costs for work-related commuting may decrease, but costs for leisure travel may increase.
- Food: The cost of eating out and grocery shopping depends on your lifestyle choices.
- Leisure activities: Many early retirees dream of indulging in travel, entertainment and hobbies, but you need to factor these costs into your estimated budget.
Your expenses during retirement are the most important variable when calculating your FIRE number. If you have Ferrari tastes, living on a Ford budget is probably not realistic. Here’s how much you should save to afford different lifestyles:
- $30,000 per year: $750,000
- $40,000 per year: $1 million
- $50,000 per year: $1.25 million
- $60,000 per year: $1.5 million
- $70,000 per year: $1.75 million
- $80,000 per year: $2 million
- $90,000 per year: $2.25 million
Choose the right savings interest rate
Once you’ve calculated your FIRE number, the next step is figuring out what age you want to achieve financial independence. You can then determine how much you need to save and invest each year to achieve that goal.
Here’s an example.
Marcos is 25 years old. He wants to retire at the age of 45. His estimated expenses during his retirement are $50,000. Applying the rule of 25, his FIRE number is $1.25 million.
To amass $1.25 million in 20 years, Marcos will need to invest about $2,255 per month, assuming an 8% return, to reach his goal.
The road to financial independence may seem difficult, especially if your FIRE number is large. However, with strategic planning, high revenues and disciplined savings, this is achievable.
Invest so your money grows
Investing is crucial to achieving FIRE. Although savings accounts offer minimal interest rates, investments have the potential to generate significant returns over time. You need that extra money if you want to live off your nest egg for decades.
Investing can grow your money exponentially as you earn returns not only on your initial investment, but also on the returns and dividends these investments generate. In contrast, relying solely on savings will not keep pace with inflation, and will erode your purchasing power over time.
Choosing the right type of investment account is also important. While traditional 401(k)s and IRAs are preferable for saving for a standard retirement, they impose early withdrawal penalties if you want to access your money before age 59 ½.
Here are some options to consider:
- Roth IRA: A Roth IRA offers tax-free growth and contributions can be withdrawn at any time without penalty. Earnings may be withdrawn without penalty after age 59½.
- Taxable brokerage account: There are no income restrictions or contribution limits for taxable investment accounts, making them ideal for high-income earners who have maxed out other tax-advantaged accounts. There are also no penalties for early withdrawal, although you will have to pay taxes on the capital gains. Yet this flexibility can be attractive for early retirees.
- Traditional 401(k) and IRA: You could use a Roth conversion ladder to gradually convert traditional IRA funds into a Roth account, paying taxes in the process. After five years you can withdraw your premiums without penalty.
As for what to invest in, the S&P 500 index has historically produced an annual return of 10 percent, so low-cost index funds or exchange-traded funds that track the S&P 500 may be a good option.
Ultimately, your personal risk tolerance will determine your investment strategy. Speaking to a fee-only financial advisor can help you flush out your plan and choose an appropriate mix of investments for your portfolio.
In short
Calculating your FIRE number and achieving financial independence is a journey that requires adequate planning, discipline, and commitment to long-term goals. Keep in mind that preparing for life outside of work requires more nuanced planning than a simple calculation can yield.
By understanding the power of investing and taking practical steps to increase your income and decrease your expenses, you can turn a seemingly unrealistic number into an achievable reality. For FIRE followers, the reward is unparalleled: working from choice, not necessity.
