Savings is the key to financial freedom. By the time you are 35, you should have at least 4X your annual expenses saved up. Alternatively, you should have at least 4X your annual expenses as your net worth.
From savings, comes investing. And from investing, comes asset growth that will set you up for a comfortable retirement.
Your expense coverage ratio is the most important ratio to determine how much you have saved because it is a function of your lifestyle. You must calculate ow many years (or months) of expenses can your savings cover in case your income goes to zero? Given nobody can work forever, we must increase our expense coverage ratio the older we get because we will have less ability to earn. At this point, it’s time to start drawing down our savings.
At age 35, if you spend $50,000 a year, you should have about $200,000 in savings or net worth to live a comfortable retirement decades into the future.
Savings can be defined as cash, pre-tax investments, post-tax investments, rental property, and anything of value. Ideally, you should be building passive income streams that allow you to live off and not draw down principal.
Your ultimate goal is to achieve a 20X or greater expense coverage ratio to be financially free. If you’re 35 now and aren’t close to having 4X of your annual expenses in savings or net worth, then I suggest putting your savings intensity into overdrive for the next 20 – 25 years to save all you can before Social Security and / or a pension kicks in to help supplement your lifestyle.
Remember, if the amount of money you are saving each paycheck doesn’t hurt, you are NOT saving enough!
Pre And Post Tax Savings Guide
I recommend everybody start off with 10% and raise their savings amount by 1% each month until it hurts. If you’ve ever had braces, you get the idea. Keep that savings rate constant until it no longer hurts, and start raising the rate by 1% a month again. If you make more than $200,000, certainly shoot to save more if you can. You can theoretically achieve a 35%+ savings rate in two short years with this method!
Please note that I am making 401K and IRA contributions a priority over post-tax savings. The reasons are: 1) we have a tendency to raid our post tax savings, 2) tax free growth, 3) untouchable assets in case of litigation or bankruptcy, and 4) company match. Obviously you need some post-tax savings to account for true emergencies. Ideally, my goal for everyone is to contribute as much in their pre-tax savings plans as possible and then save another 10-35% after tax.
The maximum 401k contribution for 2017 is $18,000. The maximum pre-tax contribution will probably increase by $500 every two years or so if history is any guidance.
Recommended Expense Coverage Ratio By Age
The below chart is an expense coverage ratio chart that follows someone along a normal path of post college graduation until the typical retirement age of 62-67. I assume a 20-35% consistent after tax savings rate for 40+ years with a 0-2% yearly increase in principal due to inflation.
The other assumption is that the saver never loses money given the FDIC insures singles for $250,000 and couples for $500,000. Once you breach those amounts, it’s only logical to open up another savings account to get another $250,000-$500,000 FDIC guarantee.
Expense Coverage Ratio = Savings / Annual Expenses
Note: Focus on the ratios, not the absolute dollar amount based on a $65,000 annual income. Take the expense coverage ratio and multiply by your current gross income to get an idea of how much you should have saved.
Your 20s: You’re in the accumulation phase of your life. You’re looking for a good job that will hopefully pay you a reasonable salary. Not everybody is going to find their dream job right away. In fact, most of you will likely switch jobs several times before settling on something more meaningful. Maybe you are in debt from student loans or a fancy car. Whatever the case, never forget to save at least 10-25% of your after tax income while working and paying off your debt. If you have the ability to save 10-25% after tax, after 401K and IRA contribution up to company match, even better.
Your 30s: You’re still in the accumulation phase, but hopefully you’ve found what you want to do for a living. Perhaps grad school took you out of the workforce for 1-2 years, or perhaps you got married and want to stay at home. Whatever the case may be, by the time you are 31, you need to have at least one years worth of living expenses covered, and 4X your expenses at age 35. It’s important to really focus on your finances at this age because life comes at you fast with homeownership expenses, baby expenses, student loans, and more. You must focus on doing well in your occupation and staying disciplined with your savings and investments. At the very least, max out your 401k.
Your 40s: You’re beginning to tire of doing the same old thing. Your soul is itching to take a leap of faith. But wait, you’ve got dependents counting on you to bring home the bacon! What are you going to do? The fact that you’ve accumulated 3-10X worth of living expenses in your 40’s means that you are coming ever close to being financially free. You’ve hopefully built up some passive income streams a long the way, and your capital accumulation of 3-10X your annual expenses is also spitting out some income. It’s important to stay on track with your savings habits and NOT let a mid-life crisis bog you down.
Your 50s: You’ve accumulated 7-13X your annual living expenses as you can see the light at the end of the traditional retirement tunnel! After going through your mid-life crisis of buying a Porsche 911 or 100 pairs of Manolo’s, you’re back on track to save more than ever before! You are 100% in tune with your spending habits, therefore, you raise your savings rate by another 10% to supercharge your final lap.
Your 60s: Congrats! You’ve accumulated 10-20X+ your annual living expenses and no longer have to work! Maybe your knees don’t work either, but that’s another matter! Your nut has grown large enough where it’s providing you hundreds, if not thousands of dollars of income from interest or dividends. Full Social Security benefits kick in at age 70 now (from 67), but that’s OK, since you never expected it to be there when you retired. You’re also living debt free since you no longer have a mortgage. Social Security is a bonus of an extra $1,500 a month. You’re budgeting a couple thousand a month for health care as you plan to live until 100.
Your 70s and beyond: Sure, you’ve been spending 65-80% of your annual income every year since you started working. But now it’s time to spend 90-100% of all your income to enjoy life! They say the median life expectancy is about 79 for men and 82 for women. Let’s just bake in living to 100 just to be safe by taking your nut, and dividing it by 30. For example, let’s say you live off $50,000 on average a year and have accumulated 20X that = $1,000,000. Take $1,000,000 divided by 30 = $33,300. You’re getting another $18,000 a year in Social Security, while the $1 million should be throwing off at least $10,000 a year in interest at 1%.
Important Note: If you find yourself unable to save as much, then you’ve got to make some sacrifices to reduce expenses. Everybody has somewhere to cut. You can also consider moving to a lower cost area of the country or the world. Many retirees have moved down south to Mexico, or South East Asia, where $1,000 – $2,000 per person is good living.
At Age 35, Keep Saving Aggressively
Although you should have 4X your annual expenses saved up by 35, you should keep on saving aggressively for as long as possible. The only way to reach financial independence is if you save and learn to live within your means.
For the money you are comfortable risking, actively invest the rest of your after-tax savings in real estate, the stock market, bonds, real estate, and basically anything else that matches your risk tolerance.
Given you’re inquiring about your savings at age 55, it’s probably best to stay CONSERVATIVE with your investments with a heavier weighting towards fixed income (bonds), and a lighter weighting in stocks.
You can now earn 1.15% in an online money market account with CIT Bank thanks to the Federal Reserve raising short term rates so often since the end of 2015. I’d take advantage of this higher rate, if you don’t want to risk any more money in the stock market. The 10-year bond yield is below 1%.
Although Social Security will likely be there for you since you’re close or at the minimum retirement age to receive Social Security benefits, try not to use Social Security as a crutch. Instead, save aggressively and depend on nobody but yourself!
Recommendation To Build Wealth
It’s important to then track your investments to make sure you’re comfortable with your positions. I highly recommend signing up for Personal Capital, a free online wealth management tool that let’s you easily monitor your finances.
Before Personal Capital, I had to log into eight different systems to track 28 different accounts (brokerage, multiple banks, 401K, etc) to manage my finances. Now, I can just log into one place to see how my stock accounts, how my net worth is progressing, and whether my spending is within budget.
One of their best features is their 401K Fee Analyzer which is now saving me more than $1,700 in portfolio fees I had no idea I was paying. They also have a fantastic Investment Checkup feature that screens your portfolios for risk.
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About the Author: Sam began investing his own money ever since he opened an online brokerage account in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at two of the leading financial service firms in the world. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate.
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