Where Will Our Model Family Be in 10 Years? 20 Years?


To quote AC/DC, it “ain’t no fun waiting ’round to be a millionaire.”  It seems that when you’re putting money away that you are getting nowhere for a long time.  It is similar to going into debt, where the interest payments seem miniscule at  first, but then you reach that tipping point where the interest just seems to grow and grow.  When saving and investing, it seems like you aren’t building wealth at all, but before you know it, the money you are making from your portfolio is far more than you make from your job.  The difference between building a portfolio and going into debt, however, is that you’re getting interest rather than paying it out.

In the last post I provided a cash flow plan for a model family making $60,000 per year after taxes.  The cash flow plan was as follows:

Mortgage: $15,000/year ($1250 per month)

Retirement: $9000 per year ($5000 in an IRA and $4000 in a 401K to get the employer match)

College: $3600 per year ($2000 in an educational IRA and the rest in mutual funds or a state college savings plan)

Large Purchase Fund: $6,000 per year ($500 per month into a broad index mutual fund)

Asset Building: $6,000 per year ($500 per month into index mutual funds with individual stocks added periodically)

Living expenses: $22,200 per year ($1700 per month for living, with $500 for groceries, $400 for clothing, $300 for utilities and gasoline, $300 for insurance and property taxes, $200 for entertainment each month and $1800 each year for vacations).

Today I thought I’d see where our model family was after 10, 20, and more years to show how things build up.  Now understand this is just a model and I’ve made a lot of simplifications.  In reality there would be a lot more twists and turns and different changes in income and expenses.  Understand that the point is just to show how wealth builds over time.  There will certainly be holes in the model, but then again you can model the drag on a brick falling through the air as a sphere and get results that are 90% of the way to accurate.

The Mortgage:

It is best to get a 15-year fixed mortgage.  This provides the lowest interest rate, will be paid off before the kids are ready to go to college and while you still have a lot of time before retirement, and will save you a lot in interest over the life of the loan.  The loan would therefore be paid in full between years 10 and 20.  Using the mortgage calculator from www.mortgagecalculator.org, assuming a $173,000 loan on a $220,000 home with an interest rate of 3.75% we get:

Mortgage Repayment Summary

$1,258.09

Monthly Payment

$226,457.07

Total of 180 Payments

$53,457.07

Total Interest Paid

After 15 years, our model family would have $1258 per month to add to the budget to either increase saving/investing or pay for things like college expenses.  That would be enough to pay for an apartment, clothing, and food for a college student with a bit left over to put a big dent in tuition.  After the kids were out of college that could be a very nice vacation each year (or two or three), catch-up payments for retirement, or a nice new car for cash every three years.  That’s a good reason to get a 15-year loan instead fo a traditional 30-year that your neighbor is getting.

Retirement Savings:

Our model family is saving $9000 each year.  Using the Dave Ramsey Investing Calculator, assuming a $750 monthly investment and a steady rate of return of 12%, we get:

Years Total Value Amount Invested Investment Return Yearly Investment Return
10 Years $177,000 $90,000 $87,000 $19,000
20 Years $726,000 $180,000 $546,000 $78,000
30 Years $2,400,000 $270,000 $2,160,000 $261,000

Here Total Value is the value of the portfolio, Amount Invested is how much cash our family contributed, Investment Return is how much the portfolio has returned total in interest and capital gains, and Yearly Investment Return is how much the portfolio would be generating, on average, each year.  Understand that this is treating the portfolio like a bank account, which would not be the case.  Some years the investment return would be a lot more.  Other years it would be less or even be negative.  If there are a few big events in the market, there might be barely more than the amount invested after ten years.  For this reason the 20 and 30 year numbers are likely to be closer to accurate than the 10 year numbers.

So after 10 years, the family would start getting about as much in investment return as they would have put into the portfolio, assuming a steady rate of return of about 12% during that period.  They would also be getting twice as much in investment return each year as they were investing.  In 20 years — about the time our couple is in their 40’s, they would have three-quarters of a million dollars invested.  Their yearly returns from the portfolio, on average, would exceed their yearly income from their employment.  In 30 years, they would have almost $2.5 M in their portfolio and be gaining a quarter of a million dollars in investment return each year on average.  Note that they would be getting as much back in investment return each year as they contributed during all those 30 years!  Assuming a 4% withdrawal rate, they could generate about $96,000 per year in income, which would be 50% more than the salary they were receiving.

(Again, this is a rough calculation.  The actual amounts could be significantly more or less, depending on when the big moves up in the market occurred, particularly when looking at the 10 year numbers.  For example, an individual who started working right before the year 2000 would have seen both the dot-com bubble burst and the mortgage meltdown and would have had difficulty even breaking even after 10 years.)

College Fund:

Using the same Dave Ramsey Investment Calculator, assuming a $300 investment in stock mutual funds for 18 years and getting a 12% annualized return, the family would have over $250,000 for college.  This would be enough to attend even the Ivy league schools for cash.  Of course, this might be a bit optimistic since it would require staying fully invested in stocks the entire time, which would be a big risk when the child was in high school since a stock market stumble could do some real damage.  After 13 years, which would be a good time to start pulling back on the risk a bit by diversifying into bonds and other less volatile assets, they would have more than $125,000 in the college fund.  This would not fully cover an Ivy League school, but would make a big dent in one.  It would definitely fund a state school.  An investment mix of stocks and bonds during the last few years would boost this some more, perhaps into the $150,000-$175,000 range by the time the child was heading to the dorm rooms.

Large Purchase Fund:

This is the fund to pay for the things that would need to be covered eventually such as a new roof, an air conditioning unit, replacement vehicles, and home repairs.  Again investing in stock mutual funds and assuming a 12% return (and again, assuming steady returns, which is a BIG IF for short periods of time), at $500 per month this fund would grow to more than $32,000 in four years if no withdrawals were made.  If a $8000 vehicle were then purchased, the fund would be still be worth over $71,000 by the eighth year.   Obviously returns would not be steady, but if the family had a few good years early on in the markets they would easily develop a fund that would allow cash to be paid for vehicles and home repairs, eliminating the need to go into debt and pay out lots of interest for these expenses one knows are coming at some point.

Asset Building:

Asset building would follow the same trajectory as the large purchase fund, except without the withdrawals to pay for things that break.  This money would be able to compound and grow unconstrained until it became large enough to start supplementing income.  The values after 10, 20, 30, and 40 years are as follows:

Year Account Value Yearly Market Return
10 years $119,000 $12,500
20 years $489,000 $52,000
30 years $1,640,000 $175,000
40 years $5,201,000 $550,000

So after 20 years – about the time the couple is in their 40’s – they will be able to generate about $50,000 per year on average from their investment account.  They could start to withdrawal some of this return (perhaps $5,000 per year) to supplement their incomes and let the rest roll over and continue to grow.  Before they reach the age of 50 they will have more than a million dollars in this account, allowing them to easily withdraw maybe $30,000 or more each year to add to their lifestyle and do some pretty phenominal things for cash.  They will have also gained financial independence since the income from their investments will exceed their income in many years.  The account becomes very substantial by the time they are ready to retire, becoming a large supplement to their retirement accounts.

So, as one can see, even with a modest $60,000 income (and no raises in 40 years), a family can save for retirement, save for college, and build up assets that can be tapped in their 40’s and 50’s to add to their lifestyle and provide financial freedom.    It is all just a matter of balancing priorities and allocating cash flow appropriately.

Follow on Twitter to get news about new articles. @SmallIvy_SI. Email me at VTSIOriginal@yahoo.com or leave a comment.

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Saving for Retirement, and Life Before That


 

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In the last post, Are You Saving Too Much for Retirement? How to Tell if You Are “Retirement Poor,” I discussed how to tell if you have saved up enough for retirement already and how to tell if you need to save more.  I also talked about the state of being “retirement poor,” where you are saving up so much for retirement that you don’t have cash for anything else.  Saving up enough for retirement is certainly important and a lot of people don’t do so and end up home-bound in their remaining years because they don’t have the money needed to do the things they thought they would in retirement.  Many also end up in nursing homes who could stay at home with nursing help if they had the money.

You can overdue saving for retirement, however.  There is a lot of life before retirement.  There is also the satisfaction of having enough saved in readily available assets to support yourself indefinitely without a job.  If you have $10 M in a retirement fund when you are fifty years old, but little saved outside of that fund, you still won’t be able to do things like pay cash to upgrade vehicles, pay tuition for your children without putting a strain on the budget, or break away from a job you don’t like and spend some time finding one you enjoy more.  You are very wealthy but the cash you have is locked away in the retirement fund.  You need to strike a good balance between saving and investing for retirement and building up resources that you can tap as needed before you retire.

Most retirement vehicles have maximum contribution limits and many people are tempted to put the maximums away.  They may put $5000 into an IRA and also max out a 401k plan because they get a tax break for doing so without really determining if they need to put so much away.  Certainly it is nice to keep a lot of the money you make rather than sending it off to the tax man, but there should be a limit.  The worse thing would be to save your whole life and never really do anything, waiting for that magical retirement day where you get to travel the world, only to get ill during your last year before retirement and never get to enjoy any of it.

There is also a chance a large retirement account could be taken in the future through taxes or direct confiscation.  With so many people not saving anything for retirement and many countries, including the US, eyeing Value Added Taxes and other taxes that would take more money from retirees, it is entirely possible that your fortune may be largely swallowed up by taxes.  With Social Security and other retirement programs facing underruns by the mid 2030’s and the government in general reaching unsustainable debt levels, we might also see a “fix” for Social Security that involves taking all of the money people have saved for retirement to shore up the public system or a big levy being placed on withdrawals to support government programs.  You might have saved diligently but may be living next door to a family that spent their whole lives living it up on credit and debt who therefore have nothing in retirement.  If you have $10M and they have nothing, there will certainly be people who will want to force you to give up a large share of your fortune because you have so much and they have nothing.  It doesn’t matter that you both had the opportunity to save and that the other family already got rewarded for their work while you delayed pleasure.  In the world of socialist politics, wealth is evil and poverty is saintly.

Instead of squirreling everything away for retirement, it therefore makes sense to just save enough for retirement and then start putting money into taxable assets that still allow wealth to grow tax deferred; in other words, stocks.  In this way you will have retirement covered but also be building up the wealth you need to supplement your income while you’re young.  By doing so you will: 1) have more financial security and be better able to deal with events that arise; 2) have more freedom in your career, primary school and college choices for children, access to medical care, and other facets of life; 3) eliminate the need for debt, thereby reducing the amount of interest you pay over your lifetime by having the cash needed to make big purchases, and 4) have another source of funds to support you in retirement that will not be encumbered should a tax on retirement distributions be enacted.

A more balanced cash flow plan includes allocations of money for current needs and wants,  for retirement, for other known future needs (like college and car replacements), and money to build security and lifestyle.  Such a plan might look like the following:

Primary residence mortgage: 25% of net income

Retirement: 15% of net income

College: 3% of net income per child

Large Purchase Fund: 10% of net income

Asset Building: 10% of net income

Living Expenses:  The remainder of net income

 

For example, a family that had a take-home pay of $60,000 per year from their jobs and one child might have the following cash flow plan:

Mortgage:  $15,000/year ($1250 per month)

Retirement: $9000 per year ($5000 in an IRA and $4000 in a 401K to get the employer match)

College:  $3600 per year ($2000 in an educational IRA and the rest in mutual funds or a state college savings plan)

Large Purchase Fund:  $6,000 per year ($500 per month into a broad index mutual fund)

Asset Building: $6,000 per year ($500 per month into index mutual funds with individual stocks added periodically)

Living expenses: $22,200 per year ($1700 per month for living, with $500 for groceries, $400 for clothing, $300 for utilities and gasoline, $300 for insurance and property taxes, $200 for entertainment each month and  $1800 each year for vacations).

Note that they are not maxing out retirement plans, but they are putting away plenty to ensure a comfortable retirement, especially if they get another 5% of gross pay or so each year as an employer match.  They are also probably not putting enough away for private colleges for their child, but they should be able to make a big dent in college costs for a state school and with increases in their work incomes and paying off their home they’ll be able to support some fo the cost directly.

Note also that this is just the starter cash flow plan.  With time the assets in the taxable account will build, increasing income and allowing more to be spent on things like entertainment and vacations.  They will also be able to reinvest a portion of the funds, causing their accounts to build even faster.  In the next post I’ll take this family and see where they are financially in 10 and 20 years.

Follow on Twitter to get news about new articles. @SmallIvy_SI. Email me at VTSIOriginal@yahoo.com or leave a comment.

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Are You Saving Too Much for Retirement? How to Tell if You Are “Retirement Poor.”


People who have a big home with an equally big mortgage, such that they have little left over each month after paying their mortgage payment are said to be “house poor.”  Being house poor makes it difficult to save up for things, such that any little thing that happens outside the norm for the month becomes an emergency.  There is also never enough money for investing, and credit card balances slowly grow as little extra expenses add up to big balances.  A good way to avoid being house poor is to save up enough of a down payment and purchase  a house inexpensive enough such that the payments don’t exceed 25% of your take-home pay.

I believe there is also such a thing as being retirement poor.  This is when you are putting so much away for retirement that you never build up the taxable portfolio — the one that you can tap while you’re still below retirement age — that will allow you to find financial freedom while you’re still relatively young.  This is the set of investments that allows you to not worry too much when there is a layoff at work because you can live off of your assets as needed until you find another job.  It is also the money that allows you to start doing things in your mid-career like go on cruises and other nice vacations every couple of years year without going into debt, upgrading your home (or buying a bigger one for cash after you pay off the first one), and pay cash for progressively better cars if that is what you want.  It also allows you to help out others around you since you have enough free cash to really give generously without a second thought.

Certainly saving for retirement is important and you don’t want to save up too little.  As I’ve shown in other posts, having a little extra in retirement makes life a lot better than having just enough.  If you have extra you can invest a portion more aggressively and increase your average return without jeopardizing the basics.  Not having enough to last through retirement will result in living out your last days in poverty, either with an adult child to support you or on the government dole.  Personally I think seniors should be the wealthy ones since they have had their whole lives to invest and save and new hires who are just starting out should be the ones getting the discounts.  Unfortunately, many people don’t save enough.

So how do you tell if you’re on track for retirement, and if you’ve been saving diligently since you first started working, how do you know if you can slack off a bit? On the flip side, if you have not been saving that much or are getting a late start, how do you know if you will have not have enough for retirement and maybe need to increase your savings a bit?

If you are fully invested in stocks, a simple way to estimate your worth at retirement is to subtract your current age from your retirement age and then divide by 7.  If you have a 50-50 bond mix, divide by 10.  (If your retirement is in a savings account, just keep saving unless you have a couple of million dollars already.  In other words, you need to start investing in stocks and bonds because savings accounts don’t provide the returns needed.)  This will give the number fo times your investments will double between now and the time you retire if you stopped putting away money today.  Then, raise 2 to that power and multiply by your current retirement savings to determine how much you’ll have at retirement based on your current investments.  (Note, there are also a lot of good savings calculators online that you can use, but this is just a quick way to make an estimation.)

For example, let’s say that you are 30 years old and have $50,000 in your 401k.  Let’s also say that you are mostly invested in stocks (which means you can expect a long-term return of 10% after inflation).  If you plan to retire at 65, you have 35 years before you retire.  35 years divided by 7 equals 5, which means that you can expect your balance to double 5 more times before you retire if you keep it all in stocks.  Two raised to the power of 5 is 32, so you can expect your retirement savings to be worth at least 32 times what it is today.  Multiplying 32 times $50,000 would give you about $1.6 M in retirement.

So is $1.6 M enough for retirement?  Well, divide that number by 20, and that will give you an estimate fo the annual income you can expect to get from that retirement portfolio if invested correctly.  $1.6 M divided by 20 is $80,000, so you would be able to generate an income of about $80,000 each year from your retirement funds in 2014 dollars.  (Note that I don’t include Social Security at all since it will not be there in 35 years, trust me!)   If you are currently living on an income (money that you actually spend each year, not including money you are putting into retirement and elsewhere) of $80,000 or less and are happy, that may be enough and you can reduce your retirement savings somewhat and concentrate more on building your taxable portfolio for near-term expenses.  If you want to up your lifestyle in retirement or just want to build in a bigger cushion, maybe keep savings as you currently are for a couple more years.

If your number is low, you might also want to see if you are putting enough away.  A good rule-of-thumb is to put 10-15% of your gross salary away into a 401k, IRA, another retirement account, or a combination.  You can also contribute to a pension plan if one is still available.  If you do have a pension plan, you can reduce your savings rate in other accounts down to between 7-12%.  The more you save, the more you will have at retirement.  It is also easier to have enough if you put away more when you are young than when you are older.  If you put away 12% when you are in your 20s and 30s you might be able to slack off to 8% when you are putting kids through college in your 40s and 50s.  Conversely, if you don’t put much away before you reach 40, or you dip into your 401k along the way, you would really want to put in at least 15% to make up for the time you’ve lost.  Note that this should be 10-15% before any company match because it is really difficult to find the money to make up for the loss of a company match if the company stops providing it.  It is easier to never have the money for lifestyle in the first place than to cut back your spending and put more away for retirement.

If you don’t have enough money for your retirement now and want to be sure you are investing enough to get there at some point, you can use an online savings calculator.  Simply plug-in your current balance and monthly or yearly contributions, along with a rate of return of 10% if you are going to be mainly in equities.  (This assumes a return of 12-15% before inflation, reduced down to account for a 2-5% inflation rate.)  You can then see what your account balance will be when you are ready to retire.  If it is not enough to provide the monthly income you’ll need when you divide that amount by 20, start saving up more or plan to work a few extra years.

If you do find that you are retirement poor and will have far more than you will need in retirement, it is probably time to cut back on your retirement savings rate.  This doesn’t mean that you should just stop contributing to retirement entirely.  You may be leaving money on the table in the form of tax breaks and employer matches if you do, plus it doesn’t hurt to have a bit of a cushion.  It also doesn’t mean that you should instantly increase your spending and blow all of the money you used to be putting towards retirement (although doing so to a point might be justified if you have been living on nothing for far too long).  Instead, start putting a portion of the money you are no longer putting into retirement into taxable investment accounts and investing.  Then, use a portion of the income you gain from these accounts to improve your life.  For example, if you have $10,000 invested and it grows to $13,000 on year, you may choose to sell a few shares and pull out $1000 to buy some new furniture, go on a small vacation, or  otherwise add to your life.  You would then be reinvesting $2000, allowing the account to grow and provide more income in the future.

You can even have different accounts or mutual funds for different things.  You could invest in one fund for vacations, one for home improvements, one for replacing vehicles, one to supplement your daily spending, and one for giving.  Add these to your budget each year and decide how much you will harvest from these funds and how much you will allow to roll over and get bigger.  With time these will become a major source of your income.

In the next post I’ll go into more details on controlling your cash flow and allocating to cuttent and future needs.

Follow on Twitter to get news about new articles. @SmallIvy_SI. Email me at VTSIOriginal@yahoo.com or leave a comment.

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.