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This is a guest post from Pauline of InvestmentZen.com, a site that helps you grow your net worth with simple, actionable steps. Pauline escaped the rat race at 29 to live life on her own terms, and is now a location independent blogger and entrepreneur with a home base in sunny Guatemala.
To anyone slightly interested in money, the end goal is always financial independence. The moment when your investments take over, and generate enough passive income for you to kick back and relax for the rest of your life. In order to do so, and make sure your nest egg lasts forever, investment gurus recommend you withdraw no more than a safe 4% out of your portfolio every year.
Meaning if you need $5,000 a month, or $60,000 a year to live comfortably in retirement, you must create a $1,500,000 portfolio. That is equivalent to 25 years worth of living expenses.
Investing To Reach Financial Independence
With interest rates near zero on savings accounts, your best bet is to invest. Markets have yielded over 8% historically, and while savings accounts are safer, they will barely allow you to keep up with inflation. When investing, stick to easy and simple. Low fee index funds will do it. You don’t need to understand much, just to invest money every month for as long as you work. One thing you need to understand though, is that there is a hierarchy on how you should prioritize your investments. You always want to favor the ones that will give you the best returns first. And that is done via a mix of tax advantages and employer matches.
- The first step to maximizing your investments is getting your company match and filling up your 401k. The company match instantly duplicates the money you invested, and no other investment will give you a 100% immediate return. Furthermore, the money invested is taken off your gross income, so you enjoy an additional tax saving.
- Then, I would recommend you leave your 401k at the company match limit, and max out your IRA. The contribution limit was set at $5,500 for 2016, and $6,500 if you are over 50. They are tax deductible as well.
- Third, max out your 401k. The 2016 limit is set at $18,000.
- Now you can move on and fund other account with tax deferment or benefits, such as 529 plans to save for your kids’ college or Health Savings Accounts for medical bills.
- Once you have finished taking advantage of tax breaks, find a high yield savings account for the rest of your money.
If you are only able to max out your 401k and IRA, investing $23,500 a year, you will cross the $1,500,000 mark after 23 years. That is assuming an 8% average return on the markets. Since this is pre-tax money you are investing, depending on your tax bracket, and taking into account your company match, the actual amount taken off your paycheck will be much lower.
Running The Numbers
If you make $50,000 per year, and your employer matches 100% of contributions up to 3% of your salary, that is a free $1,500 right there, if you contribute $1,500 yourself. $3,000 worth of savings, or a sixth of the $18,000 you need to max out your 401k, was taken care of with $1,500 before tax. At that salary level, you should be on the 25% tax bracket, so you will be saving an additional $375 in taxes. Your paycheck will be reduced by $1,250 and you will have $3,000 in your 401k.
Saving $1,958 a month ($23,500 a year) is no small feat. But it can be done if you are truly dedicated. Saving a regular amount every month since your early years will allow you to learn to live on less. You were a student not so long ago, living with roommates and eating ramen twice a day. Now that you make five or six figures, can you live like that a year longer? Because time and compound interest are on your side, the effect will be incredible. It is just one year. 12 months fighting lifestyle inflation isn’t much, compared to one more year of work when you’re 70, because you didn’t save enough money.
All your 401k contributions will be taken off your paycheck, and you will get used to spending only what you receive. Since it will probably be more money than you’ve ever seen while in college, you should be able to make do. The following year, you can try living on last year’s paycheck, and save your raise and bonuses. This is a necessary evil, if you think about your future. For now, you are alone, healthy, and young. Once you have a family to take care of, every last penny will go into your mortgage, day care, supporting your spouse if they don’t work, etc. You should be able to make ends meet and then some if you live alone on one salary.
23 years of sacrifices, if you started before age 27, will set you up for a comfortable retirement in your late 40s or early 50s. If you think that is way more money than you are able to save, simply try to live on less, so the nest egg required to retire early is smaller. Reducing your annual expenses from $60,000 to $40,000 means you can retire after you cross the $1,000,000 mark. You can do it in 24 years if you save $1,200 per month, almost 40% less than our example.
But the main takeaway is that if you are going to save any amount for your retirement, make sure you get your money’s worth by taking advantage of your company match and the tax breaks for an instant boost.
[Photo Credit: Alexas_Fotos]
I have over 15 years experience in the financial services industry and 20 years investing in the stock market. I have both my undergrad and graduate degrees in Finance, and am FINRA Series 65 licensed and have a Certificate in Financial Planning.
Visit my About Me page to learn more about me and why I am your trusted personal finance expert.