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Do you want to retire comfortably? How can you start preparing for retirement early?
Retirement isn’t something that just magically happens. You have to be dedicated to creating a financially stable situation for yourself years down the line when you stop working. Thankfully, the steps to retirement aren’t that hard.
Let’s look at how to prepare for retirement in five steps.
Step 1: Start Saving
The first step to learning how to prepare for retirement is to start saving money so you have enough to live comfortably in the future. Many people can’t build a stable income for retirement because they live a high-consumption lifestyle relative to their income—they spend whatever they make and therefore have no money to save and invest.
According to The Simple Path to Wealth by JL Collins, high-income people have trouble making ends meet or they go broke by overspending. Many people think of money in terms of what it can buy. If your goal is achieving financial stability for retirement, you need to think of money in terms of what it can earn. With this mindset, even lower-income earners can retire comfortably by limiting their spending and investing whatever they don’t need for expenses.
Even if you overspent in the past, it’s never too late to start thinking differently about money and how to use it. Spend less than you make, invest the extra, and stay out of debt—and retirement won’t be hard to achieve.
Think About Opportunity Costs
Collins doesn’t argue that you should never spend money, just that you should understand all the implications when you do—including the opportunity cost, which is what you give up when you choose one thing over another.
For example, if you spend $20,000 cash for a car, your opportunity cost—what you give up by choosing to spend $20,000—is the interest or dividends the money could have earned had you invested it. If you invested $20,000 in the VTSAX index fund, it would earn $1,600 a year or about 8%. That’s your opportunity cost for the first year; over 10 years, because of compounding, you’d miss out on earnings of $16,000 (the amount would have been higher had you reinvested your earnings each year).
Similarly, if you take out a car loan and have to make payments for five years, the opportunity cost is not having that money available to invest monthly and build wealth. However, once you become financially independent, compounding keeps your nest egg growing while you withdraw 4% a year to spend—so spending has little opportunity cost.
Make a Budget
One of the best ways to save money and prepare for retirement is to make a budget each month to determine where your money will go. If you don’t, it will just disappear.
Here are the basic steps for creating a budget that The Total Money Makeover by Dave Ramsey recommends:
- Each month, draw up a budget for the next month. If you’re married, sit down with your spouse to do this.
- List next month’s bills, savings, and debts, then list and allocate every dollar of your income (think of this as spending the money on paper before the month starts). This process is referred to as zero-based budgeting: monthly income minus expenses equals zero.
- Once both partners agree on a budget, pledge not to do anything with your money that isn’t prescribed by the written plan. You can’t get control of your spending without working together. If something unexpected comes up—for instance, your car needs repairs—hold an emergency meeting and together reallocate and balance the categories so that the month’s income minus expenses still equals zero.
Step 2: Start Investing ASAP
The next step in learning how to prepare for retirement is deciding on your retirement plan, where you’ll benefit most from compound interest. The earlier you invest, the more your money will grow, and the better off you’ll be once you stop working.
In The Automatic Millionaire, David Bach argues that you need to contribute to your retirement account before you pay your taxes to make the most out of your income. This is because the government takes approximately 30 cents per dollar of your salary as tax before the money is even sent to your checking account. This means that if you intend to contribute 10% of your income towards your retirement, the amount you end up contributing after you pay your taxes is considerably lower than the amount you’d contribute before you pay your taxes.
You can legally bypass the government’s taxation to maximize the earning potential of your retirement fund and get the most out of your earned dollars by using a tax-deferred retirement plan—a plan that allows you to send money to your retirement account without having to pay tax on it.
Bach suggests various retirement plans depending on whether you’re employed by a company, or self-employed.
If Your Employer Offers Self-Directed Retirement Accounts
There are two types of self-directed retirement accounts your employer might offer: 401(k) and 403(b). According to Bach, one out of every four American workers doesn’t sign up for the retirement accounts their companies offer—he claims that most people just assume that they’re automatically signed up to benefit from their company’s retirement plan.
If You Need to Open an Individual Retirement Account
If your employer doesn’t offer self-directed retirement accounts, you’ll need to open an Individual Retirement Account (IRA). You can choose from one of three options: the Traditional IRA, the Roth IRA, or the Roth 401(k), which is similar to the Roth IRA but allows you to contribute more each year. The difference between the Traditional IRA and the Roth IRAs is when you pay tax on your retirement money: when you withdraw money in the case of the Traditional IRA, and when you contribute in the case of the Roth IRAs. This means that the Traditional IRA has the benefit of allowing you to contribute more money upfront, as it won’t be taxed. Meanwhile, the Roth IRAs provide tax-free income after you retire.
If You’re Self-Employed
Business owners can take advantage of many different types of retirement accounts and benefit from many tax breaks. Bach claims that the simplest options to choose from are: the Simplified Employee Pension (SEP-IRA) and the One-Person 401(k) Profit Sharing Account, otherwise known as the “Solo 401(k)”.
Step 3: Downsize Your Debt
You also need to get rid of your debt when learning how to prepare for retirement. The debt snowball method from The Total Money Makeover is the best way to pay off debt. It’s easy to understand, but it takes effort and commitment to pull it off. There are two steps:
1) Make a list of your debts, in order from the one with the smallest balance to the largest. Exclude only your mortgage, which will be addressed in another step. A form is available for downloading here.
2) Each month, apply every extra dollar you have to the smallest debt until it’s paid off. Make the minimum payment to stay current on all other debts.
After the smallest debt is paid, apply the payment you had been making on it, plus any additional money you have, toward paying off the next smallest debt. When the second debt is paid off, apply the payment amounts from the first two debts, plus any other money you can find, to the third debt on your list, and so on.
Each time you pay off a debt, you increase the amount you can pay on the next one—your payments continue to snowball until your debts are paid off.
Starting with the smallest debts gives you some quick wins to motivate you, and by the time you get to the largest payments, such as car payments and student loans, you’re in a position to pay over $1,000 a month. You’ll soon be debt-free.
Tips for Success
To make a debt snowball work, you need to create a monthly budget, be current on your loan payments before starting the process, and list your debts from smallest to largest. You need to make two mindset adjustments as well:
1) Focus intensely on becoming debt-free: If you’re half-hearted, the debt snowball won’t work. Tell yourself, “I’m getting out of debt, no matter what.” Fully focusing your mind on a goal is as powerful as focusing the sun’s rays with a magnifying glass and setting a piece of paper on fire.
Develop gazelle-like intensity: a gazelle keeps an intense eye on its surroundings to avoid being taken down by a cheetah. Similarly, your focused attention on your finances will save you from debt.
2) Stop using credit: While you’re working through your debt list, remember that your goal is to eliminate all debt—don’t replace any paid-off debts with new debt. Pledge that you’ll never borrow money again. Before long, you’ll face a test of your gazelle intensity level—you’ll need a major car repair or get the urge to make a big purchase using credit. To eliminate temptation, cut up your credit cards. You can’t get out of your debt hole by digging it deeper.
Step 4: Draw Social Security
Many people rely on their Social Security before or after retirement. When you should start collecting Social Security checks depends on your age and financial situation, according to The Simple Path to Wealth.
The Social Security system has been sustainable in the past, but as large numbers of Baby Boomers retire and live longer, the payroll taxes that support it will fall short of payouts if nothing is done to fix it.
Thus, depending on your current age, your experience with Social Security likely will vary. Collins argues that:
If you’re 55 or older, you’ll collect the full amount you’re entitled to because politicians won’t take anything away from such a large group of voters. That’s why the solutions proposed so far to shore up the system only affect those 55 and under.
If you’re under 55, you won’t get the same deal, but you’ll still receive benefits. You can expect that:
- You’ll get any benefits you’re promised, but they’ll be smaller than those older recipients are getting today.
- The benefits will cost you more. The income cap—the amount of income on which you pay Social Security taxes—will keep increasing.
- The full retirement age will continue to go up.
- Benefits may be determined by need rather than how much you paid.
- Congress will keep making changes but Social Security will survive.
Social Security is a good deal for most people over 55. Of course, if you invested the 6.2% of your income that goes to social security and the 6.2% your employers contribute, you’d be better off financially in later years. But many people don’t save or invest for retirement, so Social Security will keep them out of poverty in their last years.
Step 5: Test Out Mini-Retirements
Before diving into full-time retirement, it’s a good idea to test the waters first. The best way to do that is to have mini-retirements. A mini-retirement is a months-long hiatus from work during which you live one of your dreams. Unlike traditional retirement, you can have many periods of mini-retirement throughout your life.
In The 4-Hour Workweek, Tim Ferris said he spends most of his mini-retirements traveling, so from now on, the term “mini-retirement” will specifically refer to relocating to a new place for several months.
A mini-retirement is a better way to travel than a vacation or sabbatical because when you’re mini-retired you have enough time to truly experience a place. Vacations are so short they’re exhausting—to see a lot, you have to binge it. Sabbaticals are longer, but they only happen once or twice. Another advantage of mini-retirements is that they can be more affordable than a vacation. Hotels and hostels are a lot more expensive than renting an apartment, so spending a month living somewhere else may not be any more expensive than a week-long vacation.
How to Plan a Mini-Retirement
There are three steps to planning a mini-retirement:
- Assess your finances. Write a list of your assets and how much they’re worth, incoming cash, and expenses. What can you get rid of? Consider how much you use it or if it creates more stress than it’s worth.
- Fear-set. Fear-set one of your dreamlines or a one-year mini-retirement in Europe.
- Choose where you want to go on your first mini-retirement. You can stay in your own country, but it’s easier to get out of the working mindset somewhere with a different culture. To find a place:
- Pick a place to start and then wander until you find somewhere you like.
- Choose a place you know you like, and do some short trips in the area.
- The author recommends Argentina, Thailand, and Berlin if you’re looking for a low cost of living and somewhere easy to start.
Wrapping Up
Now that you’ve followed these steps, you’ll be able to ease into retirement without worrying about finances. Preparing for retirement may be years in the making, but it’s certainly worth it in the end.
Are there any other steps to understand how to prepare for retirement? Let us know in the comments below!
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