Show Me The Money
The key to early retirement comes down to one thing; your savings rate.
And I don’t mean early retirement like retiring at 62 or anything like that. I mean extreme; like retiring in your 30s or 40s. Now, if aren’t interested in retiring extremely early and would prefer to retire in your 60s then you can get by saving an average percent. This means something between 5 and 10% of your income. But if your goal is something a bit more aggressive, like retiring 20 to 30 years earlier than everyone else, you have to take it to a completely different level.
I’m talking a savings rate of 50% at a minimum with a goal to get to 75 to 80% over time. Think of it this way; If you can get to a savings rate of 75% the simple math says that for every year you are working you are earning 4 years of spending. That’s actually fairly conservative since if you invest that savings you end up with compounding on your side. So it actually equals out to more than 4 years of spending.
Setting an average goal of saving 5 to 10% will yield average results. If you want to kick average in the face, you need to target way above average savings.
So first off, do you know your current savings rate? Or better yet, your potential savings rate?
The best way to calculate it is to track ALL household spending. EVERYTHING. This sounds like a hassle but it really isn’t because we already live in the future. There are free apps like Mint that will do most of the heavy lifting for you. Combining that with a rewards card (that you pay off EVERY month in full), you now have a perfect way to determine your savings rate.
So we have been using Mint for a while. We went a little nuts and hooked up every bank, investment and credit card to it. We use our rewards cards for every purchase or do electronic bill pays directly out of our checking accounts. Cash is rarely used. The only time we may use cash is on tips. That means that we know our exact annual spending.
Looking at our numbers it looks like Sorcerer Spendy did some damage on us last year. We spent nearly $40,000 dollars in just the last 12 months. I know that if we put in a real effort we could probably get this down to $30,000 even though we live in a very high cost area. (FI Girl cringing) But there is one major benefit to living in a high cost area, income levels are higher. (also tracked by Mint)
Since your savings rate is the key to early retirement (or Financial Freedom) we should focus on how to calculate your savings rate. To do that we also need to consider the amount we are putting in to pre-tax retirement accounts like 401ks and HSAs per year.
The maximum amount you could contribute to your 401k per person in 2016 and 2017 was $18,000. Which means the correct amount to contribute for us as a couple was $36,000; unfortunately FI girl’s company has a restriction that only allows her to contribute $15,000 under a law that would need its own article to explain. So that means we have saved $33,000 in our 401Ks. On top of that, we have an HSA which has an annual limit of $6,750. So you probably already guessed it; the correct amount to save is $6,750, which is how much we saved.
So calculating the savings rate is easy at this point:
Savings Rate = 1-(Annual Spending / (Annual after tax income + Pre tax savings))
Which means your Spend Rate is calculated as:
Spend Rate = (1 – Savings Rate)
Now another fun formula; if you take 100 and divide it by your spend rate you get a number. This number is the amount of years you save for every year you work:
Years Saved = 100/ Spend Rate
As an example, let’s assume we have an 18% spend rate. (100 / 18 = 5.55 years.) Using this assumption, the calculation shows that every year worked allows us to live in that current year + a minimum of 4.5 more years without working. That’s a pretty phenomenal trade; in my opinion.
Now remember what I said about our potential savings rate? If I could get FI girl to buckle down with me a bit more, we could lower our spending and get a few years back. So we need to ask ourselves is spending that extra money really worth giving up on years of living without having to work?
Run the math for yourselves. Your mindset completely changes when you start working with your own numbers. If you aren’t tracking your spending I guarantee you are wasting money and therefore spending extra years working. If you don’t have numbers, start tracking now! That alone will set you on an amazing journey!
Once you start tracking your spending you’ll likely be surprised at how much money you are wasting. If you are anything like us, you’ll awaken your hidden Optimization powers and you will start cutting out tons of wasteful nonsense that gives you little to no net happiness. Give it a try and see for yourself.