How to Get--and Keep--Financial Independence in Retirement
It used to be that when workers turned 65, they retired and started living out their golden years, but when baby boomers hit this birthday, many can’t afford to leave the work force.
Lack of savings, increased life expectancy, rising health-care costs and Social Security changes have put added pressure on boomers to reach a certain level of financial comfort before retiring and losing the steady paycheck.
John Vento, certified public accountant and author of Financial Independence Getting to Point X says the battle doesn’t end when boomers enter retirement, the focus then shifts to how to maintain financial independence throughout their golden years--what he refers to as “Point X.”
Here’s what Vento had to say about how to execute and maintain financial security leading up to and in retirement, and how boomers can navigate the new road to retirement.
Boomer: How would you define "Point X" and how can baby boomers best calculate for their own personal "Point X"?
Vento: To achieve financial independence, people need to be learn the distinction between want and need as well as how invested assets, personal use assets and liabilities differ.
Wealthy people focus on accumulating investment assets, while the middle class and the poor tend to focus on increasing their standard of living based on their cash inflow. If you are able to accumulate sufficient investment assets to maintain your desired standard of living, your money will be working for you instead of the other way around. This is point X: Financial Independence.
The best way to calculate your Point X is by using a financial calculator. The variables that go into calculating your personal point includes answering the following questions:
- What is your current age?
- What is your household current annual income?
- How much do you currently have set aside for retirement?
- What percentage annual raises do you expect?
- At what age do you expect to retire?
- How many years do you expect to spend retired?
- What percentage of your pre-retirement income do you expect to need during retirement?
- What after-tax return do you expect on your investments between now and retirement?
- What after-tax return do you expect on your investments during retirement?
- How much do you expect to collect from your company’s retirement plan and social security?
Boomer: Why do you find living within your means to be the most important step anyone can take towards financial independence?
Vento: The most basic principle that must be followed to achieve financial independence is to live responsibly and within your means. Without this, financial independence is not possible no matter how well you deal with all the other wealth management issues. During your working years, you must pay yourself first by setting aside 10% or more of your gross income--this needs to be treated as your most important expenditure (although it in fact is adding to your investable assets). Whatever is left after hitting the 10% rule and covering other basic life necessities should then determine your standard of living—the car you drive, size of house, vacation style, etc…
Boomer: What are some of the basic principles for managing debt?
Vento: You must know the difference between good debt and bad debt. Borrowing money in an attempt to make money is generally viewed as good debt. If you borrow money to purchase a house you cannot afford, this is bad debt. If you borrow money to purchase a house you can afford, this is good debt.
Credit card debt should be viewed as terminal cancer when it comes to your personal finances—this is really bad debt and is the best way to ruin your chances of ever achieving financial independence.
Boomer: What do boomers need to be warned about when it comes to delaying saving for retirement?
Vento: As can be seen when you go through the financial calculations of getting to Point X, you will find that the three most important variables in accumulating wealth are: 1) how many years you save 2) how much you save each year, and 3) your rate of return.
Of these three variables, the one you have the most control over and the one that has the most power is time, and understanding this is one of the most important keys to financial independence. Time allows for your money to compound, and here’s an example of how the rule of 72 works:
.Let us assume a rate of return of 10% per year and a starting point of $25,000. Based on the Rule of 72, here ’s how that amount will increase every 7.2 years:
- In 7.2 years, that $25,000 will double to $50,000
- In 14.4 years, it will double once again to $100,000
- In 21.6 years, it will double once again to $200,000.
- In 28.8 years, it will double once again to $400,000.
- In 36 years, it will double once again to $800,000.
- In 43.2 years, it will double once again to $1.6 million.
This really proves the point and shows how in this example if you saved $25,000 just 7.2 years sooner then you may be able to more than double your money by the time you are ready for retirement.
The earlier you start the more dramatic the results. It is quite amazing that $25,000 could potentially turn into $1.6 million during your lifetime.
Boomer: What is the importance of understanding the basics of our tax system in reaching financial goals?
Vento: If you are like most people, when you hear the word ‘taxes’ you either look the other way or turn a deaf ear. This is at the root of the problem and why most people have a difficult time answering the question ‘where has all my money gone?’ The answer to this question is often simple: taxes, taxes and more taxes.
Most people think there is nothing they can do to minimize their tax obligation and they simply ignore tax-planning opportunities. Taxes represent more than 50% of our expenditures and when you factor in the top federal income tax rate at 39.6%, Social Security at 15.3% and state and local taxes which can be as high as 13%, it’s easy to see where all your money goes. This is all without taking into account real estate taxes, sales tax, gift tax, estate tax, excise tax, transfer tax, capital gains tax and now the new 3.8 Medicare tax for high-income earners.
The easiest way to accumulate wealth without altering your standard of living is by minimizing your largest expenditure, taxes. The tax code only requires us to pay the amount of taxes we are legally obligated to pay so implementing strategic tax planning strategies can significantly lower your tax liability. To be clear, tax evasion is illegal, tax avoidance is perfectly legal and is simply another way of saying tax planning.