Retiring early: is it a realistic option?

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Retiring early is the aim for many people - it could be accomplished with lots of planning, some hard saving and returns on your investments.

The earlier you can start your retirement saving, the sooner you may be able to jump off the work treadmill.

The idea of having years of life ahead of you with no work stress, fewer financial concerns and the freedom to do whatever you want is very appealing. But you need to carefully consider how this could be achieved.

Investing now to buy time later

The blissful part of retiring early is the freedom it gives you to do the things you couldn’t do before – in essence, you’re buying time. But this is a commodity that’s not cheap. So, you’ll need to put in the hard graft beforehand to ensure you have enough money to retire and achieve the lifestyle you want.

The earlier you start saving for your future, the easier it could be to meet your goals, but if you’re reading this and you’re already in your 30s or 40s, don’t despair – you can still make inroads to early retirement.

Early retirement questions you need to ask yourself

- Is early retirement a realistic goal for you?

A good way to test this is if you use the 50-30-20 rule of thumb. Basically, this is a guideline for how to split your income, after tax.

So 50% of your earnings should go on living expenses – essentials such as rent or a mortgage, food, utilities, insurance, paying off debt and so on. Then 30% to ‘flexible’ expenses such as holidays, your Netflix subscription, and hobbies – anything you might consider a ‘nice-to-have’. That leaves the final 20% for savings and investments.

Think about how you currently use your money. If you’re not already saving 20% every month, or could comfortably do so, then early retirement is probably not for you. The reality is that early retirement would require greater sacrifices than the 50-30-20 rule.

- When do you want to retire? And how much do you want to retire with? 

If you’re still considering early retirement, then the two most important factors to consider are: when do you want to retire and how much money do you want to retire with?

For example, if by retiring early you’re thinking you’d like to leave the working world in your early 50s, then a traditional pension is not going to cut it for you – with most pensions, the very earliest you can take the benefits (unless you’re in ill health) is at 55 years of age. Just be aware that it’s expected this will rise to age 57 by 2028. This information is based on our understanding of current, taxation law and HM Revenue & Customs (HMRC) practice, which may change.

So, you’ll need to consider alternatives. Individual Savings Accounts (ISAs) could be an option, as you can build a portfolio, have your investments grow tax free, and the money you take out at the end is also tax free. The value of an ISA will be directly linked to the performance of the funds selected and may fall as well as rise. You may get back less than you invested. An investment in a stocks and shares ISA will not provide the same security of capital associated with a cash ISA. The favourable tax treatment of ISAs may not be maintained in the future and is subject to changes in legislation.

Creating additional funds to bridge the age gap

ISA saving and pension saving work differently – both have their pros and cons. The most likely way you’ll be able to retire early is to have a combined strategy using pension and ISA savings to maximise the benefits of both.

Let’s say you decide you want to retire at 50, but with enough money to do all the amazing things on your bucket list. After all, 50 is the new 40, isn’t it?

So, once you know whether your pension savings will kick in when you hit 55, you’ll know how long you have to fund your lifestyle before you get a pension, which allows you to work out how much money you’ll need to put by to achieve your aims.

Then you can work towards building up ISA funds to bridge the gap between when you want to stop working and start getting your pension.

To achieve an early retirement, you’ll need to look at how you’ll create additional funds to bridge the gap between your retirement and when your pension is available at age 55.

For this, you really need to think about how much money you’d need to live on during these years, and that’ll depend on what financial and work freedom looks like to you.

The current ISA limit for 2019/20 is £20,000, so you can put as much as this into an ISA this year and shelter it from any tax. Building up this same amount of money over 10 years would mean that with a growth assumption of 5% a year, you’d end up with a pot worth £259,778.20 according to the Money Saving Expert ISA calculator. If you did this for 10 years from ages 40-50, that would give you a sizeable £25,977 a year to live on and the best part is that money would be paid to you tax-free from your ISA. Just remember that the value of an investment, and any income from it, can fall as well as rise and isn’t guaranteed, so you could get back less than you originally invested.

You also wouldn’t have any work-related expenses, meaning for most people they could afford to take a real-term pay cut when they leave work and still maintain the same standard of living.

So that’s the first part of the work done. Then you need to ensure you have enough money in your pension to live the life you want for your remaining years. The good thing about pension saving is that you get help to boost your pension pot from your employer and the Government. You just need to maximise that help.

Under the auto-enrolment rules, providing you’re earning more than £10,000 a year and you’re over the age of 22 (and under State Pension age), you’ll be automatically enrolled into your employer’s pension scheme. You can opt out of the scheme if you wish, but consider this carefully before you do so. You and your employer are required to make regular contributions of around 8% of earnings, depending on how the scheme is set up, with your employer paying a minimum of 3%. So use that saving to your advantage and consider investing any other monies you have to help make your plans come to life.

You’ll also need to consider, or at least try to compensate for, changes to the retirement age. State Pension age has been increasing for men and women in recent years, and will reach 67 by 2028.

It’ll be kept under review by the government, which means that it could change again in the future, depending on factors such as an increase in life expectancy.

Pension tax relief

If you’re paying in to a personal pension scheme, your contributions are boosted by basic rate tax relief that’s paid directly into your plan by HMRC. It means growing your pension pot should theoretically be easier, because the amount you’re investing is boosted.

If you pay £80 into a personal pension you’ll have £100 invested. This is because HMRC pay in £20, representing 20% basic rate tax relief on a gross payment of £100.  Add to that any amount put in by your employer, and you’ll see your pension grow. Depending on your tax rate, you may be able to claim additional tax relief via self-assessment. Tax relief isn’t available on an ISA.

While your pension savings won’t be accessible to you until you reach at least 55, you may think it is better to put any spare money aside in another investment product yourself. But with the employer’s contribution, the tax relief you’ll get and any investment growth - taking into account that the value of investments can fall as well as rise - it can be a good way to help fund your retirement freedom.

The figures

If a person who is 40 this year is earning £50,000 and paid £750 a month into a pension, it would give them a pension pot worth £141,294 according to the Money Advice Service Pension Calculator. They can take 25% of this as a tax-free lump sum – meaning £35,323 in their pocket when they reach age 55 – and then they’d have an annual income of £4,169. Not that impressive, perhaps. But when they reach 68 years of age, as long as they have a full National Insurance record of 35 years under the new State Pension system, they’d receive £11,767 in today’s money.

You’re likely to need more than this to maintain your lifestyle in retirement, so that would mean retiring later, putting more money aside if you can afford it, hoping for an inheritance or even making use of an equity release plan to generate some cash from a property you own. But putting the work in early to save money so you can enjoy the benefits of financial freedom as soon as possible will be worth it.

Whatever you can afford to save will help towards your retirement, and working with a financial adviser will help keep your plans on track. If you don’t have a financial adviser, you can find one at unbiased.co.uk

Happy saving.