If you are planning on retiring much earlier than the typical person, who retires at around 60-70 years old, one thing that you have to do is plan exactly how you will access my money in retirement. My plan is to split up savings into two “buckets” – Old Money and Young Money. The idea is that my retirement accounts will be funded exactly to the point where they will provide me with enough traditional retirement income. In order to take advantage of the time value of money, these contributions only occur at the absolute start of my career, between 20-26 years of age.
Luckily, I will be in a position where I will be able to max out both my 401k and my Roth IRA when I start working. Right now the IRA contribution limit it $5,500 and the 401k limit is $17,500+Match (which I estimate to be around $3,000). Maxing out both of these accounts would come to a total contribution of $26,000.
Assuming 3.5% inflation, and a 6.5% after-inflation rate of return (this is the 100 year annualized market return and inflation value), after 6 years of contributions I should have approximately $227,000 in the accounts ($180,000 after inflation). Assuming that I stop making any contributions at age 27, and the accounts can grow at the same rate of return until I reach traditional retirement at age 60, the accounts would be worth nearly $5 million nominally. In today’s dollars, it would be worth nearly $1,400,000 and it would produce about $56,000 in annual income.
That seems like a great deal doesn’t it? All you would have to do is max out the accounts for just 6 years, allow compounding to do the rest, and be able to enjoy the median household income every year once you reach 60.
In practice, however, the opportunity cost of taking money out of these tax advantaged accounts is relatively high, and you might be inclined to not take withdrawals until age 65 or even later. In our scenario, those extra 5 years of compounding could create nearly $500,000 in real extra wealth, which would allow someone to spend $75,000 annually in traditional retirement.
The Other Way Around
In reality, what one should do is work backwards using some initial targets in order to determine what their savings level needs to be. For example, if your goal was to have $100,000 in annual passive income from your retirement accounts by the age of 65, you would do the following calculations:
$100,000 in Annual Passive Income
/ 4% = $2,500,000 in today’s $ needed
* (1.035^45) = $11,800,000 in 2058 dollars needed (inflation)
/ (1.1^35) = $420,000 needed by age 30
pmt(10%, 10, 0, $420,000) = $26,000 needs to be saved annually for 10 years.