College Graduates: You Could Retire with $4,426,000 By Saving $111 per Paycheck
Investing Tips for Grads Who Want to Enjoy Financial Independence
Congratulations, you've graduated from college! With degree in hand, you're ready to go out and face the world. You no doubt want to do well in life, which includes making enough money during your career to retire comfortably without having to worry about paying the bills. Although this will be much easier if you have one of the highest paying college degrees as opposed to one of the worst paying college degrees, it is absolutely, mathematically, irrefutably possible for you to amass millions of dollars by the time you retire if you, like most college graduates, are in your early to mid-twenties and live a normal life expectancy.
Sure, it will require hard work, discipline, and an ability to stick to a budget but it can be done.
Using one of the time value of money formulas, I'm going to demonstrate how $111 per paycheck at average rates of return over a typical career could turn into $4,426,000 in wealth throwing off six-figures a year in passive income; a portfolio of stocks, bonds, mutual funds, real estate, and other assets that keep your family living comfortably during your lifetime and serve as an inheritance for your children and grandchildren (or, perhaps, your favorite charity).
When Starting Your Career, Time, a Good Tax Shelter, and a Decent 401(k) Match Can Combine to Make You Rich
Imagine you go to work for a company like Starbucks in a low-to-mid range job, in a low-to-mid range metropolitan market. You earn $40,000 a year in salary (which is considerably less than the average Starbucks manager is paid at $48,665). Depending upon the rate put in effect in any given year, the coffee giant matches 401(k) contributions dollar-for-dollar up to either the first 4 percent or 6 percent of your salary. Further, imagine your effective combined tax rate for Federal, state, local, and payroll taxes is 28 percent.
You decide you want to put aside 20% of your earnings each year, which is a rather ambitious target but certainly not extreme in the financial independence community. That's $8,000 per annum. However, most 401(k) plans are Traditional 401(k)'s rather than Roth 401(k)'s. That means you're going to get $2,240 taken off your aggregate tax bill; money that would have gone to various levels of the government but now stays in your own pocket as a reward for providing for your future. The effect is you actually only need to save a net $5,760 out of your pay each year, or less than $111 per weekly paycheck, as the government subsidizes your good behavior.
This means you've instantly leveraged your out-of-pocket savings by 38.89 percent as you get to keep the extra $2,240 to invest as a sort of interest-free loan from the government for the next 30, 40, or even 50+ years.
That's not all. With the varying 401(k) matching schedule, in some years, Starbucks is going to deposit $1,600 in tax-free matching contributions, while in others, it will kick in $2,400 in tax-free cash. This results in a total of $9,600 to $10,400 in fresh money being added to your account every 12 months, even though you've only parted with $5,760 out of your own pocket. At this point, you've leveraged your money by between 66.67 percent and 80.56 percent, even if you decide to forego investing entirely and park the greenbacks in something like a money market fund!
But, wait! There's more! As long as the money remains within the protective confines of your 401(k), under nearly all circumstances, the dividends, interest, rents, and capital gains you earn aren't subject to taxes! (Rather, you pay taxes on withdrawals, as if they were a paycheck when you enter retirement. If you attempt to tap the money early, you are subject to a 10 percent penalty rate on top of the regular tax hit although you can take a 401(k) loan or hardship withdrawal, which is almost always a terrible idea.
Under the present rules, the government will force you to begin taking structured withdrawals at the age of 70.5 to keep you from perpetually compounding the money within the tax-shelter.) Under the right circumstances, you can get nearly a half-century of tax-deferred growth.
The final cherry on top of this wealth-building sundae? If you were to experience financial catastrophe and find yourself in bankruptcy court, it's entirely possible several million dollars of your 401(k) balance could be protected from creditors as the courts have been hesitant to invade retirement principal. (This is one of the reasons you should never draw down your retirement account balances when your financial world is falling apart without talking to a qualified adviser, first! You might be better off taking the wipe-out protection bankruptcy affords and rebuilding with your nest egg already intact.
Every situation is unique. Do not exhaust all of your options before seeking counsel.)
Where does all of this put you? Let's review. In a typical year, your 401(k) would see $10,000 in fresh cash deposited into it ($9,600 some years, $10,400 others). Your net adjusted out-of-pocket savings rate is only $5,760; a much smaller chunk of your salary. That $10,000 is going to be invested in the securities or funds you select, compounding for you until retirement or you reach the age of 70.5 years old and the government forces you to begin drawing down the money so as not to take advantage of the tax benefits for too long, enriching your heirs beyond what society considers worth subsidizing.
Imagine you opt for a 100 percent low-cost equity index fund approach. We take the long-term historical equity returns earned by large, blue-chip stocks (which dominate index funds). You do this for 40 years, between the ages of 25 and 65, and never, in all that time, enjoy a meaningful raise. You fail to get promoted. You forget about adjusting your contributions for inflation.
How would you fare? Ignoring any other assets you accumulated in life—your home equity, savings accounts, cars, personal investments in a brokerage account, annuities, businesses you started; disregard all of it—your 401(k) balance alone would contain upward of $4,426,000. You'd statistically have another two decades or so in life expectancy to enjoy the money. Alternatively, if you had built other wealth along the way, you could attempt to hang onto the 401(k) cache by using a Rollover IRA for as long as possible so your children, grandchildren, or favorite charity ended up with triple or quadruple the amount as it continued to grow.
Then, they could extend the tax benefits upon your death using an Inherited IRA.
All from only $5,760 net out-of-pocket savings per year. That was less than $111 out of each weekly paycheck. Do not despise the day of small beginning. I know you probably feel like you're in a rush being a new college graduate and all but some things take time. This is one of them. Be patient.
The Reason Some Investors Fail to Build Wealth This Way
As the United States has moved from a pension based system where every worker largely ended up with roughly the same benefits in retirement as his or her similarly situated peers to a do-it-yourself system where the mathematically gifted, and emotionally disciplined, can amass exponentially more money due to the way compound interest works (good decisions, no matter how tiny, can result in huge outcome differentials over many decades), those who don't understand the basics of the investment process can make a lot of foolish mistakes.
One of these mistakes is panicking when the stock market declines. I'm going to be blunt with you: It will happen. The stock market is merely an auction mechanism through which people buy and sell ownership in businesses. People are not always rational. Sometimes, economic conditions force them to sell when they don't want to sell. (Look at 2008-2009 when some companies collapsed as the owners of the shares were trying to avoid bankruptcy! Many of those people and institutions knew they were giving away their ownership but they didn't have a choice if they wanted to avoid having the furniture repossessed.)
Legendary investor Warren Buffett and his business partner, Charlie Munger, often talk about how they've watched the quoted value of their Berkshire Hathaway shares fall, with seemingly no reason, peak-to-trough, by 50 percent or more at least three times in their lives; half of their liquid net worth wiped out in a short period of time despite the fact the underlying businesses they owned were still churning out more money than ever. I've written about this phenomenon on my personal blog quite a few times.
For example, there was one weekend in the 1980s when an owner of one of the best long-term investments in history, PepsiCo, saw 35 percent of his investment disappear in a matter of hours. Likewise, there was a four-year period between 2005 and 2009 when owners of The Hershey Company saw their investment decline on paper by more than 50 percent even though chocolate sales were increasing, on average, and dividends were growing. If you are unable to think about stocks or the index funds that hold those stocks rationally—and understand that just because the market declined, say, 25 percent, does not mean you have lost 25 percent of your underlying earnings power, you stand virtually no chance of enjoying this sort of outcome.
You'll do something stupid.
My suggestion? Throw in the towel and pick another asset class that suits your emotional shortcomings. There is no shame in being honest with yourself. I am telling you this because I want you to be successful. I don't want you to lose sleep or have your blood pressure increase. If you're the type of person who is constitutionally not equipped to own equities, then don't own equities. Accept the fact you don't deserve the higher returns they generate over longer periods of time and be content with that.
This should be perfectly obvious but it never seems to occur to some folks. What is your alternative? Guzzle antacid and lose your hair from worry? Why live that way? Life is too short to put yourself through that kind of misery.
Other Things You Can Do to Build Wealth After College
Self-made millionaires (which means practically all millionaires in the United States, as by most estimates, first-generation rich who built their fortunes represent 80 to 90 out of every 100 in the seven-figure club) have several traits in common. While everyone's path is different, it can be useful to know how others do it.
- The typical millionaire household in the United States is far more likely to be married, and stay married, than the average household. It is not an exaggeration to say that wedding rings are the new class status symbol. Divorce rates are extremely low among millionaires compared to the general population. You get all of these wonderful economies of scale (one house payment, lower per unit costs when shopping for groceries, etc.) that add up to higher levels of free cash flow relative to every dollar of income. You can also even out economic disasters as there are two people capable of joining the workforce or taking on extra jobs. If you had a spouse of a similar educational background who also worked a job like the fictional one we've given you in the scenario, your combined income would put you in the top 1/5th of families and you'd easily become multi-millionaires as long as you were, in the words of the earlier mentioned Charlie Munger, "consistently not stupid". Time does the heavy lifting. And recall we underestimated your salary relative to other managers in similar positions by 20 percent for the sake of conservatism!
- Remove detrimental habits and conditions that drain your money and threaten your health. Millionaires are far less likely than the general public to smoke. Millionaires are far less likely than the general public to be overweight. All of these things that cause you to die younger (less time to compound your wealth) and cost more money along the way ("cheap" food that is bad for you or consuming too many calories ends up costing far more in medical expenses than any savings you thought you enjoyed at the time) are to avoided at all costs. This is directly relevant to your investment portfolio. There's a joke in the money management industry that the key to getting rich is to live a long time. It's not really a joke.
- Learn the tax code. It can pay for itself in ways you never imagined. Picture leaving your children and grandchildren millions of dollars in stocks and having all of the unrealized capital gains forgiven upon your death. It can happen if you harness the stepped-up basis loophole. Imagine getting what amounts to an interest-free loan from the U.S. Treasury. It can happen if you know how to factor deferred tax liabilities into your models. Sam Walton, founder of Wal-Mart Stores, ended up avoiding tens of billions of dollars in inheritance tax using a family holding company he set up when he was practically broke. He understood the way the rules were written and decades down the line, it paid off in one of the biggest tax savings experienced by any single family in history. If you play by the rules, a few changes here and there can mean incredible amounts of sur wealth in your, and your family's, hands. It is worth your time.
- Recognize that life is a set of opportunity cost trade-offs. Things get so much easier when you accept that you are entitled to nothing and that self-pity will never improve a situation. For example, if you can't afford to live in a certain city while meeting your savings goals at the same time, improve your personal happiness and make an informed choice. It might not be what you want to hear. It might not make you happy. It's better than the alternative. It's part of adulthood; accepting consequences and arranging your life based on what you value most. Sometimes, you can't have your cake and eat it, too. Deal with it.
- Think of ways to grow the pie. If you were raised in a lower or lower middle-class household, you might have been given the mistaken impression that the only way to generate income is to sell your time for money. Interestingly, that is not how the top 1 percent of households behave. As a matter of fact, the top 1 percent of households only generate about half of their income from selling their time. A quarter comes from businesses they own. Another quarter comes from personal investments, such as real estate, stocks, mutual funds, and other securities. It's entirely possible that heart surgeon in your city is collecting income from shares of Johnson & Johnson he collected over the years, as well as from an apartment building he acquired, renovated, and paid off decades ago. In my own hometown, one of the most successful lawyers happens to also own one of the most successful ice cream chains, generating more cash for his family on top of what he brings home from billing clients.
- A super-majority practice something known as "stealth wealth", which involves keeping the resources they have amassed a secret from even their own children, leading to a misconception that inherited wealth is more common than it is. Paradoxically, the failure to prepare heirs for handling money responsibly could explain why in nearly 9 out of 10 cases, all of the money will be gone by the third generation.
- If you don't know what you're doing, always and forever consider sticking with a low-cost index fund. I'll repeat it until the cows come home.
Resources to Help You Get Started Investing in Your Post-College Career
To learn more about some of the topics we've discussed, you might want to read these articles:
- Introduction to Your 401(k) Plan
- Why the Roth IRA is the Perfect Tax Shelter (and You Should Probably Open One Today)
- Using the Roth 401(k) as a Self-Employed Tax Shelter
- 3 Ways to Super Charge Your Retirement Savings
- Six Steps to Retire Rich
- Surviving and Thriving in the New American Retirement System
- All About Dividends
You can also check out my personal blog, where I have detailed my own experiences over the years and try to respond to as many questions as I can. If there's only one lesson you remember from my financial writings, it's this: Get your name on as many cash-generating assets as you can; assets that throw off cash, preferably in increasing amounts with each passing year; cash that comes in while you sleep, while you vacation with your family, while you read a book or play a video game. That, in a nutshell, is the key to financial independence.
You may also want to read the letter I wrote to a college student about how to be successful, happy, and fulfilled in life.