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This is part two of a two part series on achieving retirement. As we already know from part one, there are two universal equations that govern our retirement progress. The savings equation and the nest egg equation.
Universal Retirement Equations
1) Income – Spending = Savings
2) Savings x Growth X Effective After Tax Rate = Nest Egg
We covered the first two steps which make up the savings equation in part one. Now, we turn our attention to the nest egg equation and the final two steps to retirement: investing your money and doing battle with the Tax Man.
Step 3: Find Good Places To Grow Your Money
You have successfully whipped your spending into shape and oversee multiple streams of income. Now you are looking at your money pile and thinking to yourself, “not bad.”
At some point, your money pile grows to a size where focusing on growing your nest egg will have a much more material impact to your net wealth than further reductions on your spending.
Say you make $70k a year and have steadily put away good money for a few years. Now you’re looking at maybe $120-$150k of savings. If you are able to get a better yield on your savings by 2%, that’s $2.4-$3k a year.
If you are able to get a total 10% yield on your money, you will be adding $12k-$15k a year to your stash while you sleep.
Try using savings jiu jutsu to have that level of impact. It makes shopping for $0.75 vs $0.90 toilet paper rolls seem less worthwhile, or camping out with a convoluted coupon plan to save $5 on soap seem silly.
There is a whole magical word to learn about in this phase. While initially vast and scary-seeming, fortunately you will read a lot of it and decide it is not right for you, and then you will read a lot and decide it is frankly horseshit. You will then be left with a manageable amount of stuff to think about.
Once you’ve sorted the wheat from the chaff, your ongoing management will be much easier. This appeals to us burst-of-energy folks. It’s not quite one and done, but there’s a bulk investment of time and then it gets pretty good from there on.
So when should you start actively working on this step?
My rule of thumb is to start thinking about these topics seriously once you have 2x your income in savings.
The reason you need to start early is that it takes time for you to build up a knowledge base and framework for thinking about investment. You want there to be that vague memory of an article you read about backdoor Roth IRA’s planted in your head by the time you hit the tax bracket that eliminates roth IRA eligibility. You want to already know a little about how you feel about real estate and what the returns look like before you have enough money to put a down payment on a rental house.
Step 4: Minimize Your Tax Exposure
As your nest egg gets bigger, your focus usually switches to tax efficiency.
Say you have $150k in savings. If you are able to avoid taxes on all your gains by contributing to tax advantaged accounts vs taxable accounts and they’re growing 10%, that can be a difference of $15k*Tax bracket = approximately $4k a year.
This is when you start to hear about people parking their money in trusts in a no state income tax state or buying municipal bonds which are tax-exempt rather than just investing in an index fund with all their money. This is also when you start thinking hard about what sort of investments go in your taxable accounts vs tax advantaged accounts like 401k’s and IRAs. Ideally the investments that must actually realize gains and income (for example, selling options, getting dividends that aren’t tax exempt) should go in the tax advantaged accounts.
Chart from Bogleheads
Your Own Personal Army
Growth and tax minimization together produce the output of equation 2. Once you reach the point where you are focused on these two things, you should be jumping for joy.
Working on income and spending is like commanding a single unit: yourself. Every time you go to the store, you’re thinking should I buy this? How is the side hustle I’m working on? When should I respond to that email?
When you are working on growth and tax minimization, you have vast armies at your disposal. Every decision you make has huge impact simply because you are leveraging more dollar workers. You are thinking “What should my dollars be working on? Where should they be deployed?” rather than what work you need to be doing.
The infantry and the and king of an army are both necessary and important roles. But one comes with a throne, so enjoy it.
Most folks can recognize the benefits of having money go out and work for you. But it’s not all sunshine and rainbows. Whereas the the components of equation 1 elicit emotional reactions (too depriving! Too hard!), equation 2 generally tends to elicit a sense of confusion and vague dread. It can sometimes feel overwhelming to wade through articles on complex investing topics. And to be honest, a lot of these are written poorly, which adds to the confusion.
Fear not, I say.
Equation 2 is actually the realm of the lazy. With 10 hours of work here or there, you can set it and forget it if that’s the strategy you choose. Equation 2 is relative paradise once you reach it.
My one piece of advice as you tackle steps 3 and 4 is the following.
You are smart enough.
Don’t invest in anything you don’t understand. Don’t nod your head along to some douchebag who is spouting a bunch of acronyms. You are smart enough to manage your money.
If something doesn’t make sense, assume the other person isn’t explaining it well and put the burden of proof on them rather than on yourself.
This will help you get rid of the vague feeling of dread and you will end up replacing it with piles and piles of money from your smart, well-thought-out strategies. Recognize that your hesitation around this is around the belief that it’s too hard or that it makes you feel to out of control and confused. We can solve that easily. Because you are smart enough, and all you need to do is stop whoever you’re learning from and challenge them to explain it in as many ways as needed for you to understand the concept backwards and forwards.
You now have a the full four step blueprint to achieving retirement. These steps are straightforward even if they aren’t necessarily easy. The important part is that they are all achievable when you break them down and focus your attention on the right one at the right time. What got you here won’t get you there, and we constantly need to build skills for the next opportunity that presents itself.