You are on part 7/9 in the Level 1 – The Basics Series. Next up: Withdrawal Stage
1. Why Retire Early?
2. The Basics – Overview
8. Withdrawal Stage
9. Your Life In Retirement
When it comes to financial independence, you absolutely must master income, savings, spending, and debt. Mastering investing actually isn’t required to become financially independent, but boy, it sure does help! Level 2 will go into much more detail on how to invest, while this article really emphasizes why you should invest.
Investing, in its simplest form, is using money, to make more money. You trade your valued money today for an expected return, or greater sum of money, in the future. As you raise your income, increase your savings, take control of your spending, and pay down your debt, you’ll have extra cash on hand.
You have a choice to invest, or stash under your mattress…
Both will eventually get you to financial independence and early retirement, but the mattress approach will take FOREVER. You have to ensure that your money is working for you by making more money, and to do that, we need to get comfortable with investing.
My background with investing.
As mentioned on the About page, I didn’t learn much about money growing up. My parents made average incomes and did an excellent job of controlling their spend. Both retired in their early 50’s. However, they never invested and never really talked about investing. They never considered investing…at least not with any potential for significant returns. They would occasionally put some money into a CD (certificate deposit – basically a long-term, low interest saving account where you can’t access the money). Other than that, all cash sat in a savings account at the local bank. They viewed the stock market as scary and completely uncontrollable. They were right on both accounts.
They mastered their spending and saved as much as possible. This approach along with their pensions, eventually got them to a comfortable financial position. Social security benefits has been gravy on top.
However, had they invested along the way, they would likely have several million dollars more to their name today.
So, I grew up with no knowledge of investing. Towards the tail end of undergrad, I became interested and started doing a bit more research. In grad school, I became even more interested and continued learning everything I could about investing. Within a month of graduating and starting a full-time job, I opened an online personal brokerage account (allows people to buy shares of stock in companies). I started buying stocks and felt good that I was finally “investing”.
Unfortunately, my definition of investing at that time was just plain wrong.
I viewed an investment as purchasing some company shares that I felt were a good pick, or bought shares of companies people at work called a “can’t miss.” It took me a while before I realized it, but this was not investing, this was speculating.
Speculating is when you expend money in hopes of making more money. Investing is when you expend money and have a high confidence in the return you will receive.
In those early years, I was just hoping for things to work out. Most times it did not. Several of the early companies I “invested” in either went bankrupt or went down by 50%, or more. Several doubled or tripled in value. It was all over the place.
After I made the realization that many folks smarter than me pick stocks full-time for a job and still fail, I understood that I should stop picking individual stocks and find another way to invest.
Around this time, my job afforded me the opportunity to work several years with various components of financial planning and even spent several years working a job that focused every minute of my day watching the stock market. I gained great insight into what investing really is and saw firsthand how many stock market “professionals” just waste money on complete speculation. More on this in the future.
In short, I stopped buying individual stocks, and started buying total market index funds (an investment that essentially mimics the total market return or loss). I knew, with confidence, that as long as the world economy continues to grow in the future years and decades, that my investments would make money. I also stopped trying to time the market.
No one can do this, it is a game you are destined to lose.
I set up bi-weekly automatic investments. At this point, I was finally a legit investor. I was consistently putting my money towards things that would, over time, provide a strong return, with high confidence.
That’s a bit on my background and relationship with investing. It is still scary, and something I have no control over, but I do have strong confidence in my approach. Over the long haul, it will absolutely work out, and great wealth will be amassed.
So, why should we invest? Very simple, when we make money, we have an opportunity to put our money to work for us. By investing, we are doing just that. Through investing, our money makes more money, and more money, and more money, and so on. This is called compounding, and it is one of the most powerful and awe inspiring forces you will encounter.
Let’s look at a Bob example to help illustrate.
Take Home Pay: $80,000
Savings per year: $30,000
Spending / THP Ratio: 38%
Current Savings: $100,000
Let’s assume that Bob (age 25) is petrified of investing, knows nothing about the market, and stuffs all of his money under the mattress. Well, let’s at least put it in the bank. He puts all money after bills and other spending into his an FDIC savings account (federal deposit insurance corporation – basically assures that your money is safe, up to $250,000 per account) that yields 0.25% interest. After 36 more years of work, he is finally free as he has amassed 25x his annual spending of $50,000 per year.
This is a sad scenario, as things could have been much better.
However, at least he saved a large sum each year, and managed to retire around 60, which is better than most people!
Now, let’s take a look at another scenario for Bob using the same numbers as above, but this time, Bob is a reader of Retirement Made Easy and is very comfortable and confident in his approach to investing. He puts his savings into a total market index fund that will provide him with a solid return over time. Sure, there will still be volatility, but over time, his money will grow. Let’s assume he receives an annual 9% return. When can the market investing Bob retire?
After just 14.5 more years of work, he is free! Wow!
This example really illustrates just how powerful compounding interest can be. The slow growth of his money in the savings account scenario required him to work 36 more years, whereas compounding market gains grew his money so quickly, he only had to work 14.5 more years, a difference of 21.5 years.
Please, do yourself a favor, commit to learning about investing, get comfortable with an approach that suits you, put a plan in motion and start your journey towards financial independence. In Levels 2 and 3 I’ll go into much more detail around investing. However, Jim Collins does a spectacular job discussing investments, stocks in particular. I’ve thoroughly enjoyed following him over the years and have gained a great bit of perspective by reading his posts. Have a look here at his blog (http://jlcollinsnh.com/stock-series/).
Now that you have a good appreciation for why you need to invest, and the benefits of investing, let’s discuss what sort of investments are available to you.
Let’s start with two buckets:
• Tax Advantaged
Tax Advantaged. This refers to investments that you can grow today, but also gain some sort of tax benefit.
In general, these are some, if not the most, powerful wealth building tools.
These investments help make sure as much of your money as possible is put towards investments, and not paying the tax man. You typically only pay taxes on these investments when you withdraw dollars from this account, presumably when you reach retirement and no longer have an income to cover your spending. Be sure that you are fully funding all tax advantaged accounts today! These accounts are the best way to accelerate your journey towards financial independence!
Taxable. With these investments, you pay tax first, then invest as desired. These are less desirable, mainly because you are giving your valueable income away in the form of tax payments, instead of putting it towards investment growth.
With these investments, you pay tax today, and then potentially pay additional tax when you withdraw dollars in the future. However, these investments can be less complex as they typically don’t have as many government regulations around them.
Common Tax Advantaged Investments:
401K, 457 & 403b: Varying forms of employer sponsored retirement plans. All contributors, or investments made by you, are pre-tax, meaning that no income tax is paid on these dollars today. You will pay tax on this money when you withdraw later down the line.
IRA: Individual Retirement Account. Funds invested here do have taxes taken out, but the amount you invest, up to a certain limit, can be claimed as a deduction on your year-end tax filing.
Roth IRA: Roth Individual Retirement Account. Funds invested here do have taxes taken out, and cannot be claimed as a deduction on your year end tax filing. However, when you withdraw funds at a future date, the withdrawal will be tax-free.
HSA: Health Savings Account. If enrolled in a high-deductible health insurance plan, you might qualify for an HSA. Funds invested in an HSA are pre-tax (no tax is paid today), grow tax free (you don’t pay any tax as the investment grows in value), and when you withdraw funds, no taxes are paid! This is a very powerful wealth building tool.
In all the accounts above, you can invest in various funds and in some cases, can invest in specific stocks or bonds if desired.
Common Taxable Investments:
Personal Brokerage: You can open up a personal brokerage that allows you to invest in stocks and bonds. All money in a personal brokerage account is post-tax, meaning you pay taxes today, and pay taxes along the way on any dividends or distributions, and pay tax on any gains when you sell the stock or a portion of your holdings.
Real Estate: Either buying or flipping properties or renting properties. You will pay tax on any money earned.
Small Business: If you start a small business and make money, you will pay taxes.
Blogs: If this website makes money one day, I will pay taxes.
Other: This bucket is very large. There are nearly endless investments and ways to make money. Unfortunately, most of them require us to pay taxes.
The above list accounts for just a few investment options in the tax advantaged and tax deferred buckets. I’ll go into each in much more detail in Level 2 and Level 3. In fact, much of Level 2 and Level 3 will be focused around investing. For most people, it is the most complicated and difficult part of reaching financial independence. I struggled through it for years, and I want to help eliminate that struggle for you.
- Through investing you can greatly accelerate your journey to financial independence and early retirement
- You can choose to invest in either tax-advantaged accounts or taxable accounts
- Maximizing your investments into your tax-advantaged accounts first will be your best route
Your Next Steps:
- What investments do you have today? Are they tax-advantaged or taxable?
- Are you fully funding your tax-advantaged accounts? If yes, great! If no, start working a plan to fully fund these accounts ASAP!
- Start thinking about your future investments. Do you prefer higher risk individual stocks or do you prefer lower risk and higher certainty index funds? Get comfortable now with your risk level.
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