How to Retire by 40

Many people wish to retire young. However, if an attitude of laziness causes that feeling, then it is likely to be difficult. However, if an attitude of determination is what causes the feeling, then it is possible, assuming that you're young enough.

Start young. This is obvious. If you're 39 years old and haven't started saving yet, then there is no chance. (Winning the lottery is not an option.) For the purposes of this article, I will assume you are 23 years old and a recent college graduate and have not yet started saving for retirement. Also for the purposes of this article, I will assume you are making $40,000/year and will be able to live off the same adjusted for inflation in retirement.
Get on a written monthly budget where you tell every dollar of income what it must do before it comes into the house. If you have a plan for your money, it will obey the plan.
Get out of any debt that you are in and avoid all further debt. That means pay off all credit cards, student loans and cars. (Better yet, sell the car.) Then you must always pay for everything you buy after you earn the money to buy it. That means no car payments for your whole life. If you own a house, create a five year plan to pay it off entirely. If you can't, get a smaller house.
Start putting 30% of your income towards retirement. Under the $40,000 assumption, that means $12,000 per year towards retirement. Feel free to use Roth IRA's and 401(k)'s, but remember that you cannot withdraw that money until you reach your 60's. That will be the plan for late retirement. However, since the tax advantages are so great, it's worth maxing out a Roth IRA.

I will assume here that you will contribute $5000/year to tax advantaged accounts and $7000/year to regular accounts. (The brokerage account will be accessible without penalty before retirement, but all earnings will be taxed as you receive them.)
Invest the money in good growth stock mutual funds. Be extremely aggressive inside your Roth IRA and 401(k), since those will be very long term investments and therefore time will balance out the risk. We will assume that the value grows at 11%/year adjusted for inflation (so about 14%/year not adjusted for inflation.)

Inside your brokerage account that has no tax advantage, invest in low turnover mutual funds. Low turnover means that the people running the fund will generally buy a stock and hold it for a very long time, rather than selling it regularly. This has the tax advantage that you are only taxed on gains once the stock is sold inside the mutual fund or you cash out. If the mutual fund doesn't sell many stocks, but only buys them, then you will not be taxed significantly as the mutual fund grows. An index fund (such as a fund that tracks the S&P 500) generally has excellent performance and low turnover. Assume that you can beat inflation by 9% per year in your brokerage account.
Calculate your estimated nest egg. If you put $5000/year in your Roth IRA and make 11% more than inflation, you will have $246,980 (in today's dollars) in your account when you turn 40. If you continue your aggressive growth strategy but stop making contributions, the account will grow to $3,990,332 by age 65. That will be able to sustain you through the remainder of retirement.

Under the above assumptions, your brokerage account will have a balance of $282,107 by the time you hit 40. Those with financial calculators are starting to worry at this point. If you plan to use up that money over 25 years, assuming you continue to earn 9% faster than inflation, you will only get $28,400/year, which is not quite the $40,000 you had hoped for. However, here's the kicker. You just spent the last 17 years living on $28,000 since you were contributing $12,000/year to retirement. By this point, $28,000 is what you are used to so you won't have any trouble with it. Remember that you have also paid off your house and have no other debt, so the money can be spent as you wish.

Once you hit 65, your Roth IRA will generate a yearly income of around $350,000/year, so you'll be fine.
Retire at age 40!

Copyright 2009 by Michael Nehring