Pursuing passive income is important.
It’s a matter of life and death!
Passive Income – a Matter of Life and Death
Let’s do a quick refresher of what passive income is exactly.
It’s NOT a shady internet marketing concept.
It’s NOT a get-rich-quick scheme.
And it’s NOT even a new concept.
People around the world have achieved financial independence through passive income in the markets for hundreds of years.
So what is passive income?
Passive income is where the money you earn isn’t a direct exchange for the time you spend to earn it.
In other words, you don’t trade time for money.
Earning passive income is a matter of life and death because, as Warren Buffett, the greatest investor of all time, says:
If you don’t find a way to make money in your sleep you will work until you die.
Making money in your sleep (aka passive income) is the only way to take care of yourself in your old age.
Even at current levels, social security doesn’t provide enough for most people to survive above the poverty line.
So what do you do?
You invest in the greatest passive income generator in existence – the financial markets.
Financial markets may sound scary or intimidating.
But they shouldn’t be.
In fact, the path to true financial independence, or true retirement is simple (though not easy) with the help of the markets.
The Simple Math of Retirement Investing
Knowing how much money you need for retirement is really just a math problem with assumptions.
First, there’s the question of what to invest in and what returns you can expect.
Thankfully, this part is easy.
Again, the greatest investor of all time, Warren Buffett, recommends passively investing in an S&P500 index fund.
The S&P500 is a collection of the 500 most valuable publicly traded companies.
If you invest in the S&P500, you don’t need to worry about stock picking at all.
You simply buy the index and let it appreciate in value.
Next, you want to know how much it will it appreciate or what sort of returns can you expect?
For the past 60+ years, the S&P500 has historically returned 7% with dividends reinvested and adjusted for inflation.
The absolutely critical part of achieving that return is that you NEVER sell.
If the market goes down (or up) and you sell your index shares, then it’s most likely that you won’t achieve that 7% annualized return.
Lastly, you need to determine a safe withdrawal rate.
The safe withdrawal rate answers the question:
“How much money can I regularly withdraw from my retirement account without touching the principal.”
Why is not touching the principal important?
If you remove any part of the principal from your retirement account, you reduce the amount of money that can earn returns for you.
This creates a snowball effect where each year you have less money to earn returns until you run out entirely.
People are living longer than ever before.
Likewise, they need money for longer than anticipated.
The safest way to address this reality is by not touching the principal in your investment account.
This way, you can withdraw money from you account for as long as you live.
So what is a safe withdrawal rate?
Again, experts have done the math for us.
Analysts have run countless theoretical scenarios showing that you can withdraw 4% annually and never touch your principal.
Calculating How Much You Want or Need in Retirement
Now we know what to invest in to earn passive income (an S&P 500 index fund),
How much it might return based on the past and as long as we’re long-term investors (7% annually)
And what percentage we can withdraw in retirement without touching the principal (4% annually).
Now, you can ask yourself how much you want to live on in retirement and discover what you need to save to get there.
The good news is that most people need less than they think for retirement.
In retirement, you typically don’t have children to take care of, a significant mortgage payment, and you don’t have to save for retirement 🙂
And depending on the sort of brokerage account you have, you may not have to pay taxes (more on this in the next section).
So keep this in mind when you try to come up with an annual figure.
Running The Numbers
Say you’d like to retire with $40,000 a year to spend (don’t worry about inflation – we’ve taken that into account in our figures).
That means you need $1,000,000 before you can retire.
How does that math work?
Just use some basic algebra:
$40,000 is 4% (our safe withdrawal rate) of what?
40000 = .04X
Divide both sides by .04 and…
X (our retirement amount) = $1,000,000
A shortcut to figuring this out is that you need 25X your annual expenses invested in the S&P500 before retirement.
So if you want to spend $50,000 annually in retirement, you need $50,000 X 25 or $1,250,000.
But for this example, let’s stick with $40,000 as your goal retirement income.
You can use a time value of money (TVM) calculator to see that you will need to save about $5010 per year assuming you can save this for 40 years and you’re starting with no savings.
How to Actually Meet Your Financial Independence Goals
$5010 a year or $417.50 a month might sound like an impossibly high amount.
Incidentally, I wrote an article about how you can save $430 or more per month here!
And if you need help earning and saving this amount outside of your current income and spending, check out these articles:
But remember: saving money is particularly powerful in the retirement equation for a couple of reasons.
First, if you manage to reduce your expenses in a sustainable way, this reduces the amount you need in retirement.
Also, for every extra dollar you make you take home that dollar minus taxes.
For every extra dollar you save, you keep that whole dollar!
When you have cash flow systems and savings tactics in place, use Ramit Sethi’s advice and automate that savings.
You can auto-deposit $417.50 per month into your Roth IRA so that you don’t need to rely on will-power to do it.
And I recommend making the auto-debit occur immediately after you receive your paycheck.
This is so that you don’t give yourself an opportunity to spend that cash.
What about Taxes in Retirement!?
Maybe you’re thinking:
“This all sounds fine, but what if future tax rates are 50%!”
We can’t know what tax rates will be like in the future.
And that’s why I’m such a big fan of the Roth IRA account.
A Roth IRA (Individual Retirement Account) is a type of retirement account that allows you to withdraw money tax free in retirement!
So in our above example, you would literally be taking home $40,000 a year!
Roth IRAs differ from traditional IRAs in that you must pay taxes on the money you deposit in them.
In other words, Roth IRAs contributions are taxed when contributed, and tax-free when withdrawn in retirement.
And traditional IRA contributions are tax-free when contributed and withdrawals are taxed in retirement.
Other Reasons I Like Roth IRAs
Because traditional IRA contributions aren’t taxed when contributed, you must withdraw from them in retirement and pay taxes on the distribution.
(Uncle Sam has to get paid somehow).
But, since you’ve already paid taxes on Roth IRA contributions, you don’t have to take Roth IRA distributions in retirement.
So if you make millions through other entrepreneurial endeavors and your Roth IRA isn’t critical to survival in old age, you can gift it to your children or otherwise give it away.
Though this scenario is unlikely, I prefer to be able to do whatever I want with retirement funds.
And Roth IRAs provide that flexibility.
The idleness often associated with retirement is a fool’s errand.
(Idleness won’t make you happy).
But the financial indepedence associated with retirement is a worthy pursuit.
And there’s every reason to make it your life pursuit.
I hope this article has given you some of the tools necessary to think about your own financial independence and how to make it happen.
I hope you head to Vanguard, open a Roth IRA account, and invest in the S&P500 today.