Few of us go through our entire careers without at least thinking about the prospects of retiring early. Perhaps it is after a difficult period at work. Perhaps after a special vacation.

Many people have no choice but to retire early. It can become harder to keep up with work as we age. Especially if it involves physical labour. Even in non-physical vocations it can become more challenging to gain new skills over time. Workers also may face age discrimination later in life.

There are steps that can be taken to prepare for early retirement. Like any financial challenge all it takes is a plan and some foresight to prepare for whatever life has in store for us.

At a high level the planning process for early retirement doesn’t differ too much from retirement planning. Estimate how much it is going to cost, set a goal and design an investment strategy to meet that goal. However, there are nuances that need to be considered. Below are three things to think about

  1. Taking care of retirement first
  2. Build a financial bridge to retirement
  3. Reduce future expenses

Taking care of retirement first

Retirement is the universal goal shared by all investors. Retiring early does not change the need to build up retirement savings. However, it does present a challenge as there are less years of earnings to plough into superannuation.

Retiring early also requires savings outside of super which will be covered in the next section. Investors striving to retire early may be tempted to focus early on building investments outside of superannuation. We tend to concentrate on our most immediate goals and procrastinate about events further in the future.

In the case of retirement savings this is a mistake. The tax advantages in the superannuation system can make a profound difference in outcomes. We often think of returns as the key to compounding. And that is partially true. The thing that investors often don’t consider is that what really matters is after-tax returns.

After-tax returns are higher in superannuation because taxes are lower. Applying those higher returns over longer time periods results in more wealth generation. Making extra concessional and non-concessional contributions to boost super should be the priority. The tax savings will compound over time.

Start by estimating how much is needed for retirement and come up with a savings plan to reach those goals. This plan can inform when extra savings can be shifted into non-super accounts to support a bridge to superannuation.

The bridge to superannuation

The Australian retirement system is designed for retiring at what is known as the preservation age. The preservation age is the date that assets built up in super can be accessed. The following chart outlines the preservation age based on date birth. Retiring prior to this age denotes an early retirement.

Preservation age

Retiring prior to the preservation age requires two things. As previously mentioned, the first is enough assets in super to grow to an amount that will support a retiree at preservation age. The second is that assets have been saved and invested outside of super to pay for expenses until preservation age. This is the bridge to super for early retirees.

Philosophically we can approach this bridge in two ways. Assets that will be exhausted prior to preservation age or a sustainable stream of portfolio withdrawals that will last into and through retirement.

Building up savings to be spent prior to preservation age is easier to do. If your goal is to retire 5 years prior to preservation age and spending needs total $50,000 a year then savings of $250,000 are needed. This can be converted or saved in cash to prevent short-term market swings from derailing early retirement plans.

Building a sustainable stream of portfolio withdrawals is more difficult but has the benefit of contributing to living expenses post-preservation age. This means less savings are required in super as there is another source of funds for living expenses.

Creating a sustainable stream of withdrawals means either picking a sustainable withdrawal rate or using portfolio income to fund life expenses. We have covered both topics previously and you can read more on sustainable withdrawal rates here and retiring on dividends here.

In early retirement there are additional factors to consider. A withdrawal rate is typically focused on the sustainability of a portfolio for 30 years. That timeline is supposed to cover all but the longest lifespans. It also assumes a traditional retirement age. Early retirement stretches this retirement timeline and investors should consider a lower withdrawal rate to provide more safety.

The second consideration is tax. Super has many tax advantages. One of the biggest is that at preservation age a pension account of up to $1.9m will face no taxes on withdrawals, capital gains and dividends. A portfolio outside of super will face taxes on any capital gains on assets sales to fund withdrawals and on any income earned.

The tax rate to focus on when you retire early is the effective tax rate. Normally we care about the marginal tax rate when considering taxes on non-super investment income and capital gains. However, that assumes a salary is being earned. An effective tax rate accounts for the graduated nature of taxes where higher rates are paid as earnings surpass each threshold.

The following chart shows the effective tax rate on different levels of investment income or capital gains generated in a year. This accounts for the tax cuts due to go into effect on July 1st 2024.

Effective tax rate

Simply put, more pre-tax income or capital gains in non-super accounts is required to support a given level of spending. That means more savings. Taking tax into account and working on minimising tax is a critical part of early retirement and should be included in your plan.

Reduce expenses

I’m constantly amazed that most budgeting advice focuses on small expenses. We are told the secret to the good life is making coffee at home and meal prepping. Budgeting gurus endlessly extol the virtues of continual forensic reviews of each expenditure. If you want to run your personal finances in excruciating detail go for it. If you want to retire early focus on the biggest expense faced by most Australians—housing.

Building wealth is a series of small sacrifices for the future. It takes consistency, self-discipline, and patience. It also means avoiding mistakes with the few truly big purchases in life. If you want to put yourself on solid footing financially buy a house you can afford. If you want to retire early paying off your mortgage will go a long way to achieving your goal.

The average monthly mortgage payment in Australia was $3,428 in 2023 according to estimates provided by the Australian Bureau of Statistics (“ABS”). Supporting this monthly expense requires a significant amount of assets in retirement – especially an early retirement.

There are multiple ways we can estimate what assets are needed to support an expense. As previously stated, one issue with retiring early is that investors will need to use taxable assets prior reaching preservation age. If we use a withdrawal rate of 4% on those assets and assume an effective tax rate of 24.32% a portfolio of $1,358,939 would be needed to just pay the mortgage. If we assume a 4.50% yield grossed up for franking credits the portfolio would still need to total $1,207,946 at the same effective tax rate. Either way it is a significant sum.

Eliminating this expense by paying off a mortgage is a tax effective way to reach the goal of early retirement. Given tax considerations it is always better to eliminate expenses than increase assets. The following chart shows the impact of cutting $1000 in annual expenses on the size of a portfolio at a 4% withdrawal and 4.50% of implied yield grossed up with franking. 

Expense replacement

At a 24.32% effective tax rate this chart shows that if $1000 of annual expenses are cut from a pre-retirement budget the size of a portfolio can be $33,025 and $29,364 smaller at a 4% withdrawal rate and 4.5% yield.

Final thoughts

Saving and investing provides options later in life. Creating a strong financial foundation may enable an early retirement. It may provide the ability for a career change later in life or the switch to part-time work. No matter what life has in store or the decisions we make in the future flexibility is the key. That is financial freedom.

For any questions or comments please email mark.lamonica1@morningstar.com