Financial independence in a nutshell is a pretty simple concept. If you regularly invest your money into income-producing assets, at some point in the future the income generated by those investments will grow larger than your living expenses. You are no longer required to show up at a job to earn money, since you can sustain your current lifestyle indefinitely by spending the income earned by your nest egg.
I believe that I can retire by age 40 with one million dollars, and it will cover my expenses for the rest of my life. Both of those claims may sound dubious to most people, but the math will prove them out. Rather than give some theoretical numbers I am going to share my actual monthly finances, using data averaged over the first 6 months of 2019. Check it out:
As you can see, I spent $3,161 per month on average. You can see a detailed breakdown of my expenses in my previous post, The Most Effective Way to Set a Budget. This comes out to $38,000 per year. I believe that I can actually spend much less than this in retirement by cutting in two key areas:
- Housing: By moving from our current high cost of living area to almost anywhere else in the US, we could drastically reduce our housing expenses. Housing represents roughly a third of my monthly average expenditure.
- Car: I won’t be commuting to work every day, which will save hundreds per month on gas and maintenance. I will also have to buy a new car less frequently due to reduced wear and tear.
However for a conservative estimate and to prove that I could really retire by 40 while changing absolutely nothing about my life, we’re going to move forward with $38,000 in annual expenses for our example.
What about taxes? While I pay a decent amount of them now, I don’t plan to pay too many taxes in early retirement. Did you know that for a single person with income under $39,375 in 2019 (or $78,750 for married couples) your long-term capital gains are taxed at zero percent?
If your expenses are low and you have a good mix of tax-advantaged accounts like a 401k and Roth IRA, in addition to a regular brokerage account you can optimize your strategy to avoid the early withdrawal penalties on those accounts, and pay almost no taxes in retirement. I’ll write much more on tax planning later. For now, I will go with an overestimate and say I will pay $2,000 in taxes to bring my annual withdrawals to an even $40,000.
How will I get passive income to cover my expenses in retirement?
Easy. I will click a few buttons to sell 4% of my million dollar stock/bond portfolio to get my required $40,000 in expenses. Every year I will slightly increase my withdrawals in line with inflation. There is a very high chance (remember, nothing in investing is guaranteed) that my portfolio will grow faster than my withdrawals, allowing it to sustain paying for my living expenses indefinitely. Don’t worry, I’m not just making this stuff up. Financial advisor Bill Bengen first prescribed a 4% portfolio withdrawal rate in 1994:
Assuming a minimum requirement of 30 years of portfolio longevity, a first- year withdrawal of 4 percent, followed by inflation-adjusted withdrawals in subsequent years, should be safe. In no past case has it caused a portfolio to be exhausted before 33 years, and in most cases it will lead to portfolio lives of 50 years or longer.
William P. Bengen, Determining Withdrawal Rates Using Historical Data (1994)
He laid the groundwork for further research into what has become colloquially known as “the 4% rule.” The data set he used for US stocks went all the way back to 1926, and included every financial catastrophe along the way starting with The Great Depression in 1929, where stocks lost nearly 90% of their value. Although I take a bit of issue with calling it a “rule” (in many historical cases, the flexibility to reduce withdrawals during bad years would have vastly increased portfolio survival rates) a 4% withdrawal rate is nevertheless a great guideline for financial independence. Expect much more on withdrawal rates in future posts.
So how will I get my million?
As of writing this post, I am 26 with $119,000 in investable assets. As you can see from my breakdown chart above, I save $3097 per month. We’re going to assume my portfolio generates a 5% annual real return over the next 14 years. After plugging all those variables into a compound interest calculation, it puts me at just over one million dollars by age 40:
Actually, I fully expect to hit that milestone before then. All of my assumptions for this calculation were fairly conservative. Let’s take a look at those assumptions:
- I assumed a 5% annual real return (i.e. accounting for inflation) on my invested assets. This is less than the historical return for a globally diversified equity portfolio, which has averaged out to a 5.2-6% real return annually, depending on the source of the data. I used the Credit Suisse Global Investment Returns Yearbook 2018 as well as the Portfolio Visualizer Backtest Asset Allocation tool to verify these returns.
- This assumes that my income will stay exactly the same over the remainder of my career, and that I will never again get a raise beyond the value of inflation. Since I am still early in my career, I’d like to think that this is unlikely.
- I also haven’t accounted for my quest to improve my frugality skills and decrease my expenses going forward. For example, in my previous budget review post I set specific goals that — if I am successful in implementing them — would immediately cut over $200 per month from my average monthly expenses. As the data I used for this post was backwards-looking, these cuts are not reflected yet. I’m definitely hopeful that I will be able to reduce my expenses even further to juice my savings rate.
I don’t think the math lies. Thanks to conservative planning, I am comfortable asserting that I will be financially independent and have the option to retire by age 40 as long as I keep on track with my plan.