While completing last week’s post about building a budget, I decided to review the budget that Nicole (my wife) and I had revamped about six months ago. In doing so, I noticed I’m not entirely practicing what I’m preaching. In particular, there was one budgeting blunder that stuck out. While our budget is built around our goals (as it should be), we didn’t accurately calculate how much we need to be saving to accomplish one of our most daunting goals of all: making sure our retirement savings can provide us with a sustainable source of income as we turn old and gray.
Frugal to a Fault
For as long as I’ve understood what a dollar is, I have been frugal (often to a fault). One story about my frugality occurred between my sophomore and junior year of college. It was summertime and I lived with two close friends in an apartment. When I moved in, I had the grand idea to hand-wash our dishes to save on utility costs. I naively thought it would be more efficient than using the dishwasher. Little did I know, any cost savings (if there actually were any) would be nowhere near worth the time and effort it took to hand-wash our dishware.
I’m sharing this anecdote because it reflects how poor planning and a lack of thoughtfulness can be detrimental. By choosing to hand-wash the dishes, my roommates and I spent hours in front of the sink each week. Instead of watching our hands turn into prunes, that was time we could have spent playing basketball, tossing around a football, or slaying zombies in Call of Duty. I realized a similar lapse in judgement when Nicole and I recently reviewed the retirement savings portion of our budget.
Ever since my initial interest in personal finance, I have been intrigued by tax-advantaged accounts. Individual Retirement Accounts (IRAs) and employer-sponsored retirement accounts (the most popular being the 401(k)) fall into the tax-advantaged category. The idea of being able to shelter a portion of my money from taxes has always been appealing to me. I opened my first tax-advantaged account after my freshman year of college and began making contributions to it immediately. Coincidentally, Nicole has been contributing to her Roth IRA (an alternative form of the traditional IRA) since she was in high school. She likes to remind me of that fact often. Since opening these accounts, we’ve contributed to them annually.
Nicole and I have debated whether we would feel comfortable sharing our personal financial information on this blog. We aren’t trying to be boisterous. Most importantly, we don’t want to ostracize anyone in the audience. The last thing we want is to push away those that have different goals or those in different situations. Ultimately, we decided that sharing this type of information would allow me to best serve those reading this blog. Using personal examples can show progress and be motivating. It can also help reinforce the effectiveness of a plan or strategy. In addition, the goals Nicole and I have might be similar to your goals. Sharing our strategy and receiving feedback from readers could lead to great conversations and learning opportunities for all parties.
After several lengthy discussions, Nicole and I have determined that one of our goals is to accumulate a total of $2,000,000 between all of our tax-advantaged accounts by the time we are 60 years old. When accounting for dividends and option trading, the annual income provided by a portfolio of that size should cover a substantial portion of our living expenses in our later years. Better yet, with most of the assets being held in Roth IRAs or Roth 401(k)s (I’ll cover Roth accounts in a future post), a sizable portion of the income received will be tax-free (assuming the current tax legislation doesn’t change).
With this goal in mind, we’ve been diligently contributing to our tax-advantaged accounts. However, when recently evaluating our progress, I realized that we are contributing too aggressively to these accounts. It might seem counter-intuitive, but having too much money tied up in these accounts has some negative aspects. The most obvious downfall is accessibility. Generally, you can’t access the funds in tax-advantaged accounts without being subject to penalty until you reach the age of 59 1/2 (there are, of course, exceptions). By continuing to make contributions to our tax-advantaged accounts at our current pace, we would end up over-funding these accounts and depriving ourselves of opportunities and experiences in our younger years.
By following the same calculation process described in last week’s post, we can identify exactly how much we should be contributing to our tax-advantaged accounts on an annual basis. Nicole and I have set a goal to have the option to stop working by the time we reach the age of 40. That means that we have about 15 years left to make contributions to our tax-advantaged accounts (typically, you can only contribute to these types of accounts in the years you have earnings). Based on this information, we can calculate the necessary annual contributions to our tax-advantaged accounts by splitting our scenario into two distinct time periods.
- Age 25 to age 40
- Age 40 to age 60
25 to 40
As was the case previously, we’ll begin at the end. If we desire to accumulate $2,000,000 in our tax-advantaged accounts by age 60 without making annual contributions after age 40, how much money do we need to have in those accounts at age 40? If we assume an average annual investment return of 7%, we find that we would need to have a combined balance of about $516,838 between all of our tax-advantaged accounts at age 40 (this was solved using the Financial Calculators application [this app can be downloaded to your Android or iPhone]).
40 to 60
Now that we know how much we need to have saved when we are 40, the second calculation helps us figure out how to get there. If we need to have $516,838 saved 15 years from now, and we currently have a nest egg of about $96,500 between all of our tax-advantaged accounts, how much do we need to contribute per year? If we again assume an average annual investment return of 7%, we find that we would need to contribute about $9,972 annually for the next 15 years to be on track toward our goal.
Making a Change
To provide some perspective, Nicole had been contributing about $13,000 a year to her Roth 401(k) on her own. By working through the calculations, we found that continuing on the same path would lead us astray. We would encounter the same pitfall that appeared in the dishwasher example. We would be focusing too many resources on a task that can be accomplished with less. By over-funding our tax-advantaged accounts, we would be sacrificing flexibility and opportunities in our younger years.
By arming ourselves with this updated information, Nicole and I now have a defined path to accomplish our goal. We know we can reduce our annual contributions to our tax-advantaged accounts and shift that money to other areas of our budget. After discussing it with Nicole, we intend to allocate a bit more to our education savings and increase the amount we save in our taxable investment account, which should give us more flexibility in the near-term. As a reward for monitoring our budget and making a change, we are also boosting the amount we allocate to travel (I’m sure you can guess which one of us lobbied for that). Completing this exercise illustrated that we can live more in the present and still accomplish our long-term goal.
Please let me know if you have any questions about the calculations. Are you still struggling to figure out what you need to do to reach your goals? Send me an email, leave a comment, or reach out to me on social media. I’m here to help.
Your thoughts are worth more than a penny.