Time to Read: 14 mins
Read at Normal Speed
Read at 1.5x Speed
*Press play for a read-along*
So you’re going to be a millionaire in a little bit anyway, you’re an entrepreneur going down the Second Chute as it is, but you still want to have a million dollar backup plan — just in case.
I feel the same way, I’m going to be a millionaire whether I like it or not, but it wouldn’t hurt to still play the long millionaire game and invest.
That’s what this article is about. Retirement investing. The long game of becoming a millionaire.
- Making the Case
- The Factors
- Final Words
Making the Case
Wait, you don’t need to make the case for why I would want to invest in a retirement account — of course I want to be a millionaire when I retire.
Sure — I know that. I don’t need to make the case to get you to want to be a millionaire, but if your native language is English, then there is some convincing of sorts that will probably be helpful.
See, I remember hearing about a study from one of the podcasts that I listen to. They compared English speakers to other language speakers regarding their investing or smoking – something where you would need to invest in the now for the good of your future. It turned out that if you speak English, the language frames your past self, your future self and your present self as 3 separate entities. They break ‘You’ apart. With the other languages, there was no framing that separated themselves from their future selves – so they considered the investment as helping themselves instead of having it be helping out a different entity, such as themselves in the future.
So if English is your native tongue, the cards are already stacked against you. The only way to make up for this disadvantage is to actually start the investing, right away. There’s no better time than now.
So whether I’ve just convinced you or you’ve been convinced the whole time and you’ve just been looking for some direction, it’s time to get into it!
Before we get into strategy, there are some factors that we should consider, that will influence your strategy:
- Savings (percent)
- Quality of Life
Time – How much time do you have until retirement? Whether you plan on retiring at age 60 or age 30, what is the length of time that you have until you reach your goal age for retirement.
Savings – How much of your income, as a percentage of your total take-home, are you willing to save towards your future.
Quality of Life – What quality of life are you looking to have now and into retirement? This helps determine the amount of your income that you are willing to save.
Goal – Do you have a goal amount that you would like to save?
You either have a quality of life to maintain (expenses) or a goal amount to reach (goal).
Return – What kind of average return do you need to reach your goal or meet your quality of life requirements.
Risk – Are you willing to be risky to accomplish your goal or do you have to change your variables to reach a more feasible goal?
After putting it all together we can use some math to see what course you should take or whether there is no course available, i.e. if your risk tolerance can’t handle it.
So to put it all together let’s use some examples.
using Time, Savings and a Goal to find the required rate of Return
Say you want to retire at 40 and you’re 25, giving you a time of 15 years. You’re willing to save 40% of your income, $40,000 a year, take-home, which is $16,000. You have a goal amount of $1M for your retirement and you’ll risk whatever you need to to hit your goal.
When you have a goal focus like this, as opposed to a quality of life focus, it has some easier math involved.
So you’ve got 15 years to make $16,000 added yearly, compounded annually into $1M. After playing around with a compounding calculator, you find that you will need a 16-17% return each year to reach that goal. Since the stock market on average goes up by 7% each year you will need to be very aggressive and risky if you really want to reach that goal.
I’d direct you to my intro to the stock market series here, where you can learn more about what kinds of vehicles that are available for that kind of potential growth.
using Time, Savings and a Quality of Life to find the required rate of Return
Now let’s use an example of someone with a quality of life focus. Say we use the same example but instead of a goal amount for retirement, we’re shooting for a quality of life in retirement. Let’s just forget about the goal age for a minute here to make this easier and we’ll get back to it in a minute.
So you can decide the quality of life that you want in retirement it three different ways:
- You can use your current quality of life and current savings
- Use your minimum viable quality of life and highest possible savings, anticipating the earliest possible retirement
- You can aim high and pick a quality of life that you want to reach and live in at retirement
There’s another factor to consider called the 4% rule. After saving and investing up until your retirement you will have a “final” sum of money in your investment account. When you retire, you will withdraw from it what you need each year, in place of working for that money. The stock market grows on average 7% and inflation goes up on average by 3%. So, taking the difference, if you withdraw 4% each year, from your investments, you can sustain your nest egg without biting into it, typically. Statistics say that the 4% rule works 96% of the time.
Okay, so to put all of that together. Say that you make your $40,000, from above, and you can save that 40%/$16,000 each year. That gives you a quality of life, in financial terms, of $24,000. So to bring in the 4% rule, $24,000 has to be 4% of what you have when you retire, so that when you retire, you can theoretically withdraw this amount each year without biting into your nest egg.
After doing the math, (dividing 100% by 4%, which is 25 and then multiplying your quality of life number by that 25, you get 600,000) that shows that you need to have $600,000 by the time you retire, in order to live with this quality of life, without working.
So to bring back the time element, the when that we want to be retired by, and we keep it at the same 15 years, you’re 25 and you want to retire at 40. You have 15 years to turn $16,000 into $600,000, by adding and compounding annually. So after using the compounding calculator, we figure out that need a 10-11% return each year for 15 years to reach this goal. Which is also high compared to the market, but certainly more attainable than 17%.
using Time, Savings and Quality of Life to find a required rate of Return, again
Now let’s go into one more quality of life example, one that may be a little more reasonable. Say you’re 32 and you want to retire at 65, so you have 33 years to invest. You take home $40,000 a year. You aspire to live at $60,000 a year in retirement. This is a case where you are aiming for a higher quality of life in retirement. You can save 25% each year, so $10,000. Let’s see what kind of compounded annual return you will need to reach your quality of life goal.
Backtracking from the 4% rule, $60,000 needs to be 4% of our total nest egg, i.e. what we will need to have accumulated from investing after the 33 years, which turns out to be $1,500,000. So playing with the compounding calculator using $10,000, 33 years and different % return rates we find that we need between a 7-8% yearly return to hit our goal, which is totally reasonable.
using Quality of Life, Savings and a rate of Return to find Time
Now, so far we’ve been figuring out what rate of return we need to reach our constrained goals. In this example we will assume a rate of return and give ourselves a quality of life to solve for a time element. So this time we’ll use a low quality of life example and see how early we can retire.
Back to the 25 year old. $40,000 take-home, and assuming a 5% compounding return from investments (which is being conservative since it’s 2% below the average). If we can live off of $10,000 a year, that means we can save 75% of our income. If we plan to live off of $10,000 dollars a year when we retire, our current quality of life, then using the 4% rule backtrack, when we accumulate $250,000 in our investments, we can retire.
Putting away $30,000 a year, compounding at our assumed 5% annually, when is the earliest that we will reach $250,000 so that we can retire and live a quality of life of $10,000 per year?
Seven years. This person could retire at 32 with a nest egg of $250,000 and a quality of life of $10,000 per year if they got a conservative 5% return on 30,000, 75% of their income, added and compounded annually.
There are all sorts of examples you can use. You can choose a time and a quality of life and solve for a rate of return. You can choose a time and a goal and solve for a rate of return. Pick a quality of life or a goal, assume an average rate of return and then solve for a time. You could pick a goal, a time and an average return rate and then solve to figure out what percent savings you need to save.
I love this stuff. I could do examples for days, but I’ll get on with it.
So when figuring this stuff out for yourself, just pick which factors matter to you and put them through the examples above to figure out what you need to do to reach your goals.
P.S. If you find you need a certain return rate to make it work for you, whether you want to try to beat the market by going down your own ETF, REIT or Index fund path — or you would rather forget it all and just match the market with an easy old Standard and Poor’s Index fund — or you have no idea what I’m talking about — check out my stock market investing series here for an in-depth stock market investing tutorial.
Dog years make it kinda hard to retire
The situation that I’m in is like a quagmire
See I got until I’m 60, right now I’m 4.
According to my doctor that’s only seven years.
Right now I guess that I gotta step my game up
Sit back and watch the richest dog who ever came up
I did the math and it left me feeling discontent…
I’m gonna have to compound at sixty four percent…
Millionaire Retiree Pooch, a Rhyme Scheme by Doug
End of Intermission.
Back to business.
So it turns out, there are a few more layers to this process.
There are taxes, there’s inflation and there’s a limit to how much you can put into tax-deferred accounts. So there are still a few things to address before you write on your resume that you are the world’s greatest retirement investing guru.
Factoring inflation into your equations makes things just a little more complicated and takes away from your expected returns. Inflation compounds as well, and at an average rate of 3%, if you really want to know how much you are getting on your return, you have to subtract that 3%. So a 10% return is really a 7% return after inflation. And your $60,000 after 15 years is the same amount, but has the buying power of $40,000.
One dollar, thirty years from now, at an inflation rate of 3%, will be worth $0.41.
So that $1.5M from one of the examples above has less buying power than you may have expected, when you actually reach it. If it took you 30 years, at an inflation rate of 3%, $1.5M 30 years from now would actually have the buying power of $620,000 (at the current time).
So you may want to factor inflation into your equations if you want a more realistic look at your results.
If you want to do some inflation math…
Here’s an inflation calculator (same as a compounding calculator).
Some math in these parenthesis below.
(To figure out the buying power of something after a particular time-span, see what you get after the 3% inflation of one dollar throughout that time-span. Take the result and get the inverse. Then multiply your inverse result with the number that you want to see the buying power of to get the actual value and buying power. That’s what I did above for the 30 year buying power of $1.5M. One dollar at 3% interest for 30 years is $2.43. The inverse of $2.43 is $0.41. 0.41 multiplied with $1.5M is $620,000, after some rounding.)
Then you will have to factor in taxes. You are going to pay taxes on dividends, interest earned (annually) and capital gains. For a better understanding of the taxes click here for a quick summary by Investopedia.
There are types of accounts you can use to defer or offset taxes though, to an extent.
These accounts were made for retirement investing.
The two main types you will run into are the IRA and the 401(k).
The 401(k) is an employer sponsored account that your company can offer where you can make deposits tax deferred and your company will either match a percent or portion or give you a share of the company profits. Click here for more on 401(k) plans.
The IRA is the individual retirement account. You are completely in charge of this one. This one functions like a normal account except for a couple of differences. These accounts are tax-deferred and have a limit to how much you can invest in them.
There are two types of IRAs, a Roth IRA and a Traditional IRA. To learn more about IRAs, click here.
There is also an annual limit to how much you can contribute to your tax deferred accounts. Depending on your age, for an IRA you can contribute up to either $5,500 or $6,500 per year. For a 401(k) you can contribute up to $18,000 or $24,000, minus whatever other constraints that apply through the company.
So if your yearly goal requires $10,000 invested yearly and you are using an IRA, after you hit your max you are going to have to put the rest of what you’ve got into regular-taxed accounts.
No problem. So you lose some money to inflation and taxes.
There is still no better way to diversify and grow your money than the stock market. Using retirement accounts to offset some of your taxes and using different vehicles to get the most return is the best you can do to set yourself up for a work-obligation-free environment after you’ve retired.
So it turns out that investing for your retirement is really easy!
Out of a few factors; Time, Savings, Quality of Life or a Goal and your Return Rate, figure out what matters most to you and plug and chug.
After you find out what strategy most matches your goals, pick your tax-deductible retirement account.
After you’ve got your account set up, make some investments and have a monthly contribution plan that you can sustain until retirement.
Keep putting the money in and watching it grow and compound until you’ve reached your goal.
Finally, simply retire without ever having to work for money again!
So, as mentioned in the beginning, you would be wise to begin investing now. Not only because you are potentially less-inclined to invest because of your language but also because of the implications of compounding. Let me explain.
If you were to invest $10,000 for 40 years at a 6% return rate, by the end of the 40 years you would have $102,857.18, without ever adding anything.
Between the first year and the second year you would gain $600. But between the second to last year and the last year you would gain $5822. The great thing about compounding is that it just keeps increasing. The longer you do it, the better it is for you.
What if you added 10 more years? The gain between the 49th year and the 50th year would be $10,426. This is all without ever adding to it (to your principle that is). So starting earlier is just as important as compounding longer, because it’s all about the time that you have allocated to compounding.
The difference between starting now and starting tomorrow could be an extra $10,000 in your account by the end.
So… Do it now!
Subscribe for more and tell me what you think in the comments! Thank you for reading!