Even if you’re already in your 30’s, 40’s or 50’s, have never saved, and want to reach a less extreme version of early retirement, then read on. The following discussion on building wealth quickly will be equally helpful for you.
Three Factors Determine Your Wealth
The Dough Roller Podcast 198, “The Three Ingredients to Building Lasting Wealth,” discussed three variables that determine how much wealth you will ultimately have:
- How much money you save;
- The rate of return on your investments; and,
- The amount of time the money is invested.
If you haven’t spent much time thinking about this topic, I highly recommend listening. It’s vital to understand the impact of each of these factors for any investor. But it’s especially important for long-term management of your assets that early retirement requires.
However, extreme early retirement doesn’t just require good management of your investments. It also requires rapid accumulation of wealth. Therefore, you can stop worrying about two of the factors and focus on the one that really matters for your goal.
The Simplicity of Rapid Wealth Building
For the investor who saves for retirement over four or five decades, time is a very powerful tool. When you want to build the wealth to support your living expenses in just a decade or two, you don’t have the luxury of time. This variable is essentially eliminated.
When beginning your wealth-building process, you have very little money invested to earn a return. By the time an aspiring early retiree accumulates enough money for investment returns to become significant, the remaining wealth-building phase will be very short. Investment returns will be vital to maintain your lifestyle in retirement, but will have only a small effect on building the initial wealth to allow you to retire early.
This makes the wealth-building equation extremely simple, if not easy. You can focus on the one variable that will ultimately determine your success or failure in building wealth quickly to allow for early retirement.
What Really Matters?
How much money your save will be the single factor determining whether or not you are able to achieve extreme early retirement. This fact first became apparent to me a few years ago when reading a blog post by the early retirement blogger Mr. Money Mustache, “The Shockingly Simple Math Behind Early Retirement.”
He points out that even more than knowing how much you save, you must pay attention to your savings rate. He defines this as the amount of money you save divided by your take home pay. Looking at savings as a percentage of your income is very important to see wealth building in relative terms.
Wealth is all relative. If you spend $30,000 per year, accumulating a million dollars would make you financially independent and therefore able to retire. You could continue living this lifestyle for the rest of your life with little to no worry of ever outliving your money. If you spend $300,000 per year, having a million dollars would make you financially independent to maintain this lifestyle for just a few years before your money runs out.
Savings Rate Determines Time to Financial Independence
In his post, Mr. Money Mustache made some conservative assumptions regarding rate of investment returns and retirement spending and turned his data into the chart below. It shows the approximate amount of time it takes to reach financial independence as a factor of your savings rate.
|Savings Rate (Percent)||Working Years Until Retirement|
Notice that if you want to retire in ten years, you will need to save approximately 65–70% of your income. To retire in 20 years or less, you need to save about 50% of your pay. Saving 10–20% of your pay is in line with conventional wisdom and equates to a conventional career of about 35–50 years. In the U.S., the average savings rate is about 5%, reflecting the sad reality that most people will never become financially independent.
The most important factor to being able to retire early is to be able to build a lifestyle that you are happy with that allows you to save a large percentage of your income. A person taking home only $30,000 who lives well on $15,000 will be financially independent in roughly the same amount of time as the person who takes home $3 million and lives on $1.5 million. Their lifestyles will look much different, but their math (tax considerations excluded) is the same.
Who Saves 50+% of Their Income?
Most people assume that you need to have millions of dollars to retire early and that you must make a massive salary to accumulate this much money. The reality is that there is only a low correlation between income and savings rate.
Intuitively one would think people who make more money would save more money. In absolute terms, this is true. People who make more money save a larger dollar amount. However, when looking at savings as a percentage of income, this is much less true. Even the top 10% of all earners have an average savings rate of only about 12%.
My experience is in line with the vast majority of others that I’ve read and heard in the FIRE (financially independent, retire early) community. We tend to make above average salaries working relatively normal jobs, and our salaries aren’t way above average. We then focus on a few key decisions to live a lifestyle of frugality relative to our incomes. By earning more than average and spending less than average, we develop a high savings rate.
A Closer Look at The Math
We’ve simplified the three-variable wealth-building equation down to only one variable: savings rate. As a math equation it looks like this:
Savings rate = Savings/Income
Therefore, to increase your savings rate you can only do two things, spend less or earn more. For the fastest path to financial independence, you could work on both at the same time. For those with below average incomes, this is a necessity unless you want to live a life of extreme frugality.
For those that already are making average incomes or above, it is interesting to consider the most efficient and easiest way to build the wealth to allow for extreme early retirement. It would seem that spending a dollar less or making a dollar more would have the same effect. Every extra dollar you don’t spend or every extra dollar you earn could be applied to your savings.
Mr. Money Mustache points out that spending less has a second major benefit. It is less intuitive but probably far more important. By building a more efficient, lower-cost lifestyle, you will need to save far less to become financially independent. Remember, wealth is relative.
I would add a third benefit to spending less. It’s far easier because you can leverage your savings with further tax savings. For every extra dollar saved, you simply must save a dollar. For every extra dollar earned, you may only keep $.60 or less after paying Uncle Sam all of his taxes. In our progressive tax system, the more you earn, the more your tax rate continues to increase. This makes increased earning progressively less efficient.
You can also drastically cut the greatest expense that we all have during our working years: taxes. Using a simple strategy of maximizing any available tax deferral allows you to save more by substantially lowering your tax bill during your working years.
These tax savings can then be further leveraged with a low-cost lifestyle once you reach early retirement. Early retiree Darrow Kirkpatrick of the blog “Can I Retire Yet?” outlines more about the favorable tax considerations for an early retiree in this excellent blog post. Early retiree Jeremy of the blog “Go Curry Cracker” shows how you can use a low-cost early retiree lifestyle to “Never Pay Taxes Again.”
Focus on Savings Rate
So there you have it. Building wealth rapidly to enable extreme early retirement can be reduced from a three-part wealth building equation to one single factor: savings rate.
If you want to further simplify and focus on the most efficient path to financial independence and early retirement, you can start focusing on increasing your savings rate by spending less. This allows you to save more money, build a lower cost lifestyle that is easier to maintain in retirement, and supercharge your wealth building through tax advantages.
This knowledge allows you to stop worrying about wealth in absolute numbers that can seem huge and overwhelming. Instead, you can start working on what matters to achieve extreme early retirement: building wealth relative to your expenses.