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Retiring early is like the utopia of financial success: You get to stop working sooner and spend the rest of your time doing what you love. What could be better than that?
The tricky part is knowing how to do it. Luckily, experts say there’s a strategy to help you get there.
“The 5% rule is a potent wealth-building strategy that can accelerate retirement plans,” said Abid Salahi, finance expert and co-founder of FinlyWealth.
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He noted that this approach involves structuring investments to generate a 5% annual return, which can be used as income without depleting the principal.
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There are other so-called 5% rules as well. One refers to the amount of income you devote to investing each year. Another refers to the amount you withdraw in retirement. Another refers to not putting more than 5% of your investing money into the same security.
Below, experts outline how the various 5% rules can benefit you. Also see seven classic investing rules you should know.
Earning passive income doesn’t need to be difficult. You can start this week.
Invest 5%: The Key Is To Start Early
“As a financial advisor for over 25 years, I have helped many clients use the 5% rule to build wealth and achieve early retirement,” said David L. Blain, CFA and chief executive officer at BlueSky Wealth Advisors.
He said saving and investing 5% of income each year in a low-cost, diversified portfolio has allowed his clients to take control of their financial futures.
“For example, one couple in their 30s contributed $5,000 a year to retirement accounts, increasing with pay raises,” he said. “Over 20 years, their nest egg grew to over $300,000, giving them the option to retire five years early at 55.
“Another client saved 5% of his salary and invested the proceeds in a balanced fund returning 7% annually. In 15 years, he accumulated $150,000, which he used to start a business. By reinvesting profits, he sold the business for over $2 million and retired at 45.”
The key, Blain said, is to start early, increase contributions over time and stay invested for the long run.
“Market downturns are buying opportunities if you keep the 5% rule,” Blain said. “Compounding returns and time do the hard work for you. Open an investment account today and set up automatic transfers of whatever amount you can. It will change your life.”
The 5% rule is simple but remarkably effective if you have patience and discipline.
Melanie Musson, finance expert with Insurance Providers, agreed that starting early is the best approach.
If you’re investing and saving for retirement expecting the rule of 5% growth, she said you can plan for your invested assets to double every 14 years.
“This rule can help inspire younger investors,” she said. “Even if you don’t have as much to invest as you would like, knowing that your investment could easily quadruple by the time you are 50 years old can keep you motivated.”
As you become more financially stable, you’ll also be able to invest more. So when you’re 30 and investing regularly, Musson explained, you can plan that everything you invest will be worth twice as much by the time you’re in your mid-40s.
“If you start investing with this strategy when you’re young,” she said, “you may be able to retire comfortably before the full retirement age.”
According to Musson, the key to making this rule work for you is to start as soon as possible.
“If you think waiting until you’re 60 years old to start getting serious about retirement investments is going to work, you’ll be surprised that you didn’t give yourself enough time for the 5% rule to give you the benefit that you may have hoped for.”
Maximize Savings and Diversify Your Portfolio
“In my experience working with clients, I’ve seen the 5% rule transform retirement timelines,” Salahi said. “One client, a 35-year-old software engineer, implemented this strategy and cut her expected retirement age from 65 to 52.”
By maximizing her savings rate and focusing on a diversified portfolio of dividend-paying stocks and bonds, he said, she’s on track to build a nest egg to sustain her desired lifestyle well before the traditional retirement age.
Salahi said, “The magic of the 5% rule lies in its balance between growth and sustainability.”
5% Returns Require Disciplined Saving and Investing
According to Salahi, a well-structured portfolio can yield 5% annually through a mix of capital appreciation and dividend income.
“This allows retirees to live off their investment returns without touching the principal, ensuring long-term financial security.”
However, he explained it’s crucial to understand that the 5% rule requires disciplined saving and investing. Individuals must save 25 times their desired annual income to make this strategy work, he said.
“For example, someone aiming for $50,000 in yearly retirement income would need to save 25 times their desired annual income, which translates to a $1.25 million portfolio.”
That said, he added that the 5% rule isn’t a one-size-fits-all solution.
“It works best with other financial planning strategies and regular portfolio rebalancing,” he said. “Investors should also be prepared for market fluctuations and adjust their withdrawal rates accordingly during economic downturns.”
5% Withdrawals: Maintain a Diversified Income Stream
Laura Adams, personal finance expert and finance author, referred to the 5% rule as “a rough guideline for how much a retiree can withdraw annually from their investments without running out of money.”
However, she warned that the appropriate withdrawal rate for a retiree’s investment portfolio depends on their total account balance, age, life expectancy and required minimum distributions.
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“For example, an early retiree may only be able to safely withdraw 3%, while 5% could be suitable for a typical retiree in their mid to late 60s,” Adams said.
Unless a retiree has a diversified income stream that includes guaranteed lifetime income, such as a pension, annuity or significant Social Security retirement benefits, she said, depleting their investments too quickly means they may have to return to the workforce for income.
“According to Finder’s Consumer Confidence Index, 75% of respondents feel stressed about their finances,” she said. “A significant sign that a retiree’s spending could require them to return to work is taking withdrawals from their investment portfolio that are too high.”
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Contributed By Cindy Lamothe
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