You may have heard that you can retire early when you have 25 times your annual expenses.
Say your yearly expenses are $40k. That means: $40,000 x 25 = $1 million i.e. hello retirement.
Unfortunately, this simple calculation is not realistic and doesn’t work for a variety of reasons:
- This formula doesn’t work because most of us have our wealth locked in different accounts.
- Our most common account is our pensions/401(k), which we cannot access before age 55.
- That’s why we invest in other account types (ISA/Roth IRA) that can be accessed at anytime.
- Therefore, we must calculate how much we need to invest into each account to retire early.
In this article, I talk about how to calculate how much you would actually need to retire early.
I also use the example of annual income of £40,000 and using UK investment accounts.
Finally, I share handy online calculators for you to be able to calculate this for yourself.
The Problem with the Standard FIRE Equation
So where does this ‘25 times your annual expenses’ come from? It comes from the 4% Rule.
4% is the amount you can withdraw with a 96% success rate of not running out of money.
This assumes you’re invested in index funds and your asset allocation is 50/50 stocks/bonds.
If we take £1 million x 4% = £40,000 you can safely withdraw from your investments per year.
Does this mean we need £1 million invested before we could retire early? The answer is no.
The reason is most of us will be funding our standard retirement using our pension accounts.
In other words, from age 55 onwards, our pensions will be funding us for the next 30+ years.
However, we can’t access our pensions before age 55, so then how can we retire early?
This is where Individual Savings Accounts (ISA) come into play, which we can access any time.
The key is to figure out how much you actually need in your ISA in order to retire early.
How much do you need Invested in your ISA?
Just like pensions, we use ISAs to invest in index funds in order to grow our money over time.
So, how much money would I need in my ISA to retire early: £1 million? Thankfully, you don’t.
I can see why you might think that: £40k x 25 (inverse of 4%) = £1 million, but fortunately no.
You see, a 4% withdrawal rate applies only if you want your investments to last 30+ years.
This is the case for pensions, but we just need our ISAs to last until we can access our pension.
So then what withdrawal rate do you use for your ISAs? This depends on a number of factors.
The first factor is your asset allocation i.e. 100% stocks, 50/50 stocks/bonds, 100% bonds etc.
The second factor is what kind of success rate are you comfortable with: 100%, 90%, 80% etc.
The 3rd factor is how long you want your ISA to last until pension access age: 20, 15, 10 years.
Is there a way to determine a suitable withdrawal rate using all these factors? Yes there is.
How to Choose a Suitable Withdrawal Rate for your ISA
Introducing Portfolio Success Rates, a study carried out on using different withdrawal rates.
The difference between table 1 and 2 is if you want to adjust your withdrawals for inflation.
Once you choose a table, you then go to the section corresponding to your asset allocation.
From there, you then choose a row for how long you want your ISA investments to last for.
You then choose a withdrawal rate based on a success rate you are most comfortable with.
Let’s go through an example: Let’s say that you are 30 years old and want to retire by age 40.
Therefore you need your ISA to last from age 40 to pension access age (55) which is 15 years.
As well as that, you’re 100% invested in stocks and comfortable with a 70-80% success rate.
If using table 1 you might go for a 10% annual withdrawal rate which has a 80% success rate.
If using table 2 (inflation adjusted), you might go for a 8% WR which has a 76% success rate.
How much do you actually need in your ISA to Retire Early?
Now that we have suitable withdrawal rates we can use, time to plug them into our formula.
The formula is: annual expenses x inverse of withdrawal rate = how much you need invested.
Using our initial figure: £40k x 1/10% (which is 10) = £400,000 – much less than £1 million.
Similarly, if we adjust for inflation: £40k x 1/8% (which is 12.5) = £500,000; which is not bad.
The question now is: how long would it actually take to get to £400k or £500k to retire early?
Let’s continue assuming you are 30 and want to retire by 40 and have £10k invested already.
Let’s also assume that you are investing £1000 a month with an average annual return of 10%
Using the MYB Early Retirement Calculator, it would take 14 years using 10% withdrawal rate.
With the MYB Realistic Retirement Calculator, it will take 16 years using 10% withdrawal rate.
In this example, you can’t retire completely by age 40, but that’s ok, you are not too far off.
That’s all I need to Retire Early?
Let’s recap: to retire early with an income of £40k a year, you do not need £1 million invested.
In fact, you would need much less than that: £400k-500k depending on your withdrawal rate.
This is great because it would take you much less time to reach £400k/£500k than £1 million.
How much less? Using the MYB retirement calculators, you’re saving yourself about 10 years.
Remember: this £400k-£500k is only meant to last you until you can access your pensions.
From that point onwards, it is your pensions that you will be living off for the next 30+ years.
If the stock market works in your favour, hopefully you won’t have depleted your ISA money.
If anything, it’s likely that you’ll have money left over to support your pension withdrawals.
This is good because withdrawing from pensions and ISA will reduce how much tax you pay.
In a future article, I’ll discuss how much you need in your pension by the time you retire early.
To find out more about early retirement, check out our articles on retirement and investing.
Do you know what your FIRE Score is? Take our FIRE Quiz to see how close you are to FIRE.
Are you on the path to early retirement? How is it going? Feel free share in the comments!
To get the latest tips early retirement, make sure to subscribe to the MYB Retirement Club.
