Crafting an early retirement plan involves the harmonic interweaving of multiple components. During pre-retirement, we have a long period of asset buildup, which basically involves living frugally and socking as much cash into investments as we can while still drawing a salary. We examined this phase in Part I.
Once that salary ends, a new phase begins. My projected life in early retirement involves an elaborate dance between satisfying necessary expenses while still living a frugal lifestyle and building a few different streams of extra income. In an ideal situation we can continue to earn more than we spend each month, thus continuing to add to our investment war-chest, thus increasing our dividend income, thus reducing any anxiety we might feel at first about major expenses, such as a roof replacement on the house.
We spent time in Part II examining just how little we might need to spend each month in retirement. In that article, I determined that our little family would require roughly $1,375 monthly at a minimum, though there’s still some nice-to-haves in that amount, such as two cell phone plans. If we needed to trim the fat some more, we certainly could, though it would make life a little less comfortable.
Possible Income Streams
Now that we’ve estimated our retirement expenses, we need to find income streams to meet (and exceed) them. The way I see it, there are three overall categories available:
- Passive Income – Dividends from stocks & bonds, plus interest on savings & CDs
- Semi-active Income – Rent from one or more investment properties
- Active Income – Self-employment ventures and part-time work, if necessary
Let’s look at each of these in turn. Of the three, passive income is potentially the most powerful, but also takes the longest to develop. I view income as passive if it takes virtually none of my time to accrue, which is why investment property income is not passive in my book.
For me, passive income basically involves an investment portfolio that throws off dividends and capital gains. In a perfect world, we could meet 100% of our monthly expenses through passive income, but that’s just not realistic for those of us who do not earn a six-figure salary. My monthly requirement of $1,375 in expenses would require approximately $550,000 in an investment portfolio throwing off a 3% yield. Lovely as this sounds, with my mid-five-figure salary, it might take me a full working career to build up to that amount. If I want to retire early, I’ll need other streams of income, and my current aim is to generate at least $500 monthly in passive income as my threshold for early retirement. To generate $500 monthly, I would only need $200,000 yielding 3%, or even $150,000 yielding 4%. This is a more-realistic goal.
For the record, I’m still considering possible investments for my passive portfolio, which I will share here when I make my decisions. My current inclinations learn toward a total-stock mutual fund, a dividend-equity fund, a bond fund, and perhaps a REIT fund. My passive portfolio will become the subject of a future article. (Update: View my taxable portfolio.)
In my book, semi-active income means income that shifts between long bouts of passivity and short bursts of activity. Owning an investment property fits this definition nicely. I’ve owned an investment property in the Midwest since 2009 (see A Tale of Two Mortgages). Most months, the rent check rolls in like clockwork without any effort on my part. On occasion, though, something requires my attention, such as a repair, or a late payment, or the need to advertise and find a new tenant.
When my wife and I retire, we expect to move back to that rental house in the Midwest. The house is a little smaller, the property taxes are significantly lower, and the city is more accessible by bicycle/walking. By moving back, we can also avoid taxes on depreciation recapture by living there for at least two years (according to my vague understanding of the tax code – someone please correct me if I’m wrong!).
Part of our retirement plan is to rent our current house in Texas. It’s a new home in a decent neighborhood, and the current Zillow estimate is that we could rent it for $1,150 a month. In another 5-10 years, I would hope that we could get at least $1,300 or so. Even after property management fees, the house should generate at least $1,100 every month for us. Put another way, if we only require $1,375 monthly in retirement, then our rental property could generate 80%* or more of our required income by itself. Even if we consider the occasional repair or a few months of vacancy, it’s easy to see how having an investment property is an integral component of our early retirement plan, and there’s no easier way to acquire an investment property than to convert an existing primary residence.
* Those of you paying attention will certainly object to my percentage above, as having an investment property will also increase our required monthly expenses due to additional property taxes and insurance. Quite correct, but we can also count on the rent we charge rising by 2% or more each year. My figure of $1,375 also included such conveniences as two cell phone plans – some of these conveniences would be easy to purge if necessary, thus raising the percentage of our expenses that the investment property income would cover.
And this brings us to our final category – active income. This kind of income has a direct correlation to how much time is put into it. When my wife and I retire, we fully expect to keep working. But that’s not what retirement means, you might object. While the philosophy behind early retirement is the subject of another post, allow me to just say that I plan to stay productive throughout all stages of my life. To me, retirement does not mean sitting by the beach day after day, or lounging in my garage for countless hours at a time (as some of my neighbors are prone to do already). To me, retirement means the financial freedom to pursue my own endeavors on my own schedule, without being beholden to anyone but myself.
As such, active income entails several possibilities:
- Book writing – I’ve already published a couple of technology manuals, and would like to do more of this in retirement.
- Blog writing – I have no plans to cease writing InterestingMoney or a couple other sites that I run, even though the small amounts of income that I earn are certainly not my motivation for writing.
- E-commerce – I run a small e-commerce website directly related to my primary line of work. Retirement would allow me to continue building this business.
- Part-time work – If necessary, both my wife and I could seek part-time employment at any number of businesses in the community. Such work would be the opposite of drudgery, as it would be done partly to interact with our fellow citizens and we could quit whenever we desired.
- Other – We would keep our eyes and ears open for side-income opportunities. I might get interested in something like bicycle or computer repair, my wife could teach Yoga, or any other number of opportunities might come our way.
Even if our only active income came from part-time work at minimum wage, we could still earn over $1,000 a month before taxes ($7.25 * 20 * 4 * 2 people). Provided my initial estimate of $1,375 in monthly expenses proves accurate, part-time work alone could cover 80% of it.
Combining the three types of income streams, let’s make a rough estimate of how much we can earn in retirement. I’ll even low-ball a couple of the estimates.
|Part-time employment (1 person)||$500|
|Royalties & Online Commerce||$500|
At a total of $2,500 monthly income, this obliterates the requirement of $1,375 in expenses that I estimated previously. With such an income, we could continue adding to our investments, further increasing the amount of dividends earned each month and lowering the need for income elsewhere (especially part-time employment). That’s a key component of our plan: continue contributing to our investment portfolio so that as we age, the passive income stream begins to dwarf the active and semi-active streams, leading one day to a true retirement.
Just the words early retirement elicit simultaneous feelings of excitement and anxiety in me. Running the numbers like we’ve done helps to quell the anxiety and makes the plan look that much more feasible.
If you’re also planning to retire early, or have already retired, how do your income numbers look compared to the ones I’ve projected?