Many people are hesitant to think about retirement because it all seems so complex. Also, it seems so far away that you might think you can push it off until later. As a result, most people get lazy and complacent and don't start thinking about it until their 30s and 40s. The unfortunate truth of retirement planning is that the best time to get started is with your first paycheck, at the tender age of 22 or 23. The earlier you start, the easier retirement planning gets (exponentially).
Because people find retirement planning and investing so complex (and it can be if you've never been exposed to these topics before), I've provided 3 simple guidelines to buy you time. Lots of time. If you do just these 3 things outlined below, you will have 10-15 years to truly figure out retirement planning, the stock market, and investing in general. You could even get away without any further planning. The idea is to put into action the basics and have it all work on auto-pilot while you're out having fun in your 20s.
Here are the only 3 guidelines you need to follow. You then get to procrastinate this stuff for 10-15 years!
- Only spend 50% of your after-tax paycheck
- Max out your 401(k), then max out your IRA
- Invest the rest of your money with Wealthfront
Let's get into some very basic details of why these steps are important, and how to go about achieving them.
1. Only spend 50% of your after-tax paycheck
People who do this will get so much ahead in life in just 10 years. It is so much easier to get into this habit when you're first getting started with your career. Once you accustom yourself to using up 80-90% of your after-tax paycheck, it is extremely hard to scale back later, even if you think it will be easy. Most people are unable to scale back, and so the best time to configure your lifestyle is when you've just graduated from college and are already used to living frugally like a student.
But why 50%? Take a look at the graph below:
How quickly you reach financial independence (FI) is directly related to your savings rate. Assumptions: Starting at net worth of $0, 5% after-inflation returns, 4% withdrawal rate, only gains/appreciation used for income, principal is untouched, no after-inflation increases in spending or income over the years, cost of living is same both before and after retirement
It shows how many years you will be required to work at various savings rates. At 50%, you only have to plan to work for 18 years. So if you start working at the age of 22, you can stop working, i.e. retire (if you want) by your 40th birthday. That's an entire 25 years ahead of when most people retire (age 65). If you want to keep working after then, that's entirely up to you. But you don't have to. At age 40, the interest and dividends paid by your investments will continue to feed you, without touching your principal. So you can remain retired for the rest of your life, if you choose. At age 40, you will have reached the epic destination of financial independence, and not have to work for money anymore.
The lower your savings rate, the longer you have to work to build up your nest egg. The higher your savings rate, the sooner you retire. The relationship isn't linear as you can see in the graph above. It's exponential! This year, 2017, we are on track to saving 70% of our after-tax income. This comes out to a whopping $140k in savings every single year. Any job-based bonuses or raises would be extra. 70% is an insane rate of savings for most people, but with a few frugal hacks, you too can dramatically increase your savings rate, often up to 50%. At a 50% savings rate, you can start to call yourself frugal.
Learn how to maximize your savings rate by following the same frugal tips we do on a daily basis.
2. Max out your 401(k), then max out your IRA
After you've configured your lifestyle properly to spend only 50% of your after-tax paycheck or lower, you will setup automatic 401(k) payroll deductions with your company's 401(k) provider like Fidelity or Vanguard. This should only take 10-15 minutes max.
The goal would be to reach the maximum 401(k) contributions, which in 2017 is $18,000. This means you need to be contributing at least $1500 each month ($18,000/12). To figure this out as a percentage of your paycheck, you need to be contributing $18,000/<your_salary> each pay period. So if you make $95,000 per year, you will be setting aside $18,000/$95,000 = 19% of your paycheck every pay period. This is the only number you need to key into your 401(k) provider's website.
Once you're done this, your provider (Fidelity, for example) will ask you to choose your investments. Since you're still young, you will simply choose the cheapest stock index fund. It is a simple, painless decision, and nobody ever regretted putting their money in cheap, low-cost index funds. An index fund basically buys slices of the entire country's economy, and so if America's economy does well, so will you. In other words, you profit whenever science, technology, innovation, and research improves all aspects of the country's productivity. It has been doing this to America's economy for more than 200 years now, so we have good reason to believe it will continue to do so for at least another 100+ years, unless we get embroiled in war or conflict for an extended period of time, or if we get hit by a meteor.
To figure out the cheapest index fund, you will take all the options provided by your 401(k) provider and sort them in decreasing order of expense ratio (i.e. fees). Then you will look at the bottom of the list for something that says "index" under the asset class of "Stocks". The expense ratio should be less than 0.10%. In my case below, I picked the FID 500 Index PR (FUSVX) fund which is the cheapest index fund available for 0.05% fees. This fund buy slices of America's biggest and strongest 500 public companies.
If you're really curious to learn everything there is to know about the 401(k) program, you can do so here. But you don't actually need to unless you really want to.
This is what my 401(k) account looks like. I've blurred out my company names but the numbers are all real. My balance should be a lot higher, but I went many years without contributing, which was a big mistake.
Once you've maxed out your 401(k), you will then open up a free IRA account with Vanguard and put in another $5,500 every year. This money is tax deductible as well which means you don't pay any taxes on the $5,500 you earned until you take it out. You can either put the $5,500 in one lump sum, or split it up into monthly installments of $460/month.
If you've got access to a HSA account, you can also elect to contribute another $3,400 of tax-free money every year. More details about hacking the HSA at the Mad Fientist.
3. Invest the rest of your money with Wealthfront
Hopefully you still have more money left-over to invest in taxable accounts such as Wealthfront or Vanguard. If you only spend 50% of your after-tax money, you'll have plenty of money left over even after $23,500 invested in your 401(k) + IRA. I personally use Wealthfront and highly recommend them. Here's why:
We care about two things when deciding how to invest our money. #1 is automatic investments, #2 is low cost index funds. Wealthfront takes care of us in both of these frontiers for a minmal management fee of just 0.25%, compared to the industry average of 1-2%. If you're busy with 10,000 other things going on in your life, take 30 minutes today and sign up for a Wealthfront account. It's a "set and forget" strategy, and we currently have ~$180,000 of our portfolio invested with Wealthfront.
Wealthfront does a lot of the routine "maintenance" work for you automatically. This maintenance work (known as "rebalancing") is absolutely important, but you don't have to worry about it. All you have to do is setup twice-monthly automatic debits from your checking account and that's it. You can literally watch your money grow year over year without you having to do anything.
Wealthfront also has a neat free tool called Path that shows when you'll be ready to retire. For us, that's when I turn 34 and Mrs. Frugal Hacker turns 31. This is just 4 years down the road for us, giving us 40 years to do as we please, without the burden of a 9-5 job on us. This is what Path looks like for us:
Conclusion
That's it! These are the 3 easy steps to kickstart your retirement planning. Do this, and you'll be covered for at least 10-15 years with zero regret. To re-cap:
- Only spend 50% of your after-tax paycheck
- Max out your 401(k), then max out your IRA
- Invest the rest of your money with Wealthfront
Then once you have some time and space in your life, perhaps in your mid 30s, you can do some more reading and research into other investment strategies. But until then, you can stay assured that you're already doing 95% of what you should be doing all through your 20s and 30s to have a successful retirement. Don't be surprised if you're able to retire at the ripe age of 40 with these basic 3 strategies, a whole 25 years earlier than everyone else.
