Although we want to get to more subjects, we are going to pause for a second to look at the magic of a 401K plan, and the common misconceptions about how to use it. I am then going to suggest that the American Dream of owning a house is the wrong vision for most people. The right dream is filling up your 401K plan.
Let’s start off with the base chart from our last three posts. The core of our future money comes from dividends because they never go away, and this guarantees the base money making machine, your S&P 500 stock fund, is never touched.
Here is the chart of how dividends have grown over the last 100 years, adjusted for inflation. You should expect that if you can live off of the dividends, things are only going to get better over time.
Everything other than dividend is subject to massive losses that can go on for a decade. The glory of dividends is that they will never remove the economic base of your investment, which is the stock. Any time you removed a stock, you lower your dividend yield.
How do you retire with the maximum dividend yield if you are banking on the S&P 500?
I’m going to take you through an example. I am assuming that you make $100,000 or more. I know that this is above the national average, but it is easy to use for an example, and its not that much above. (If you are extremely poor, I am going to assume that you are not reading this post, and God’s blessing on you, and I hope you find the opportunity to get out of a hole, so you can read this post.)
The tax man is a massive drain on your investments, and you truly need to do everything you possible can to get around him. Fortunately, the government encourages you to not pay taxes, but in very limited ways.
Now, let’s go back to our $100K salary, assuming the S&P 500 with a 2% dividend yield.
The way that our tax code is set up is that you get taxed at a lower rate on your income up to a certain level. On a $100K salary, your 25% tax rate starts at~ $90K. Up to that dollar amount, you average a 14% tax rate. On that last $10K of income, the government is going to take $2,500, or 25% of the last $10,000 you make.
The magic of the 401K is that if you divert your money into a 401K, the government does not tax it at all!
In our case, if you place $10K into 401K, you save yourself $2,500 in taxes. On top of this, virtually every company that has a 401K, will match at least 50% of what you put in. (You always want to check on employers plan before you join them.) So, if you are at a decent place, the company puts in another $5000 to raise your savings to $15,000.
Now you really need to absorb this. First off, you save 25% from the government on your taxes, which is $2,500. Then on top of this, you get another $5,000. If you took out the money, you would have only of had $7,500 ($10,000 less the 25% tax rate). The effective difference is that you sacrificed $7,500 today to have $15,000 for tomorrow.
I want to emphasize that getting free money from your employer is absolutely amazing, and you should always contribute up to the maximum match. However, I work with very highly paid people, and I often hear that they are contributing just up to the “free money.” Many people I work with make enough money to be in a higher tax bracket than 25%, but somehow they don’t understand that not being taxed is an incredible help in their wealth.
So, let’s compare investing in and out of a 401K plan. Without a 401K plan, you would only have $7,500 to invest. An easy way of investing in the S&P 500 is to buy SPY, which is an ETF proxy for the S&P 500, which is another blog posts, and it pays you your dividend once a quarter. You then say to yourself, “well I might as well reinvest the dividend because this is my retirement fund.
This reinvestment of the dividend turns out to be incredibly important for your wealth building.
Remember than the stock market goes up and down but pays 2% dividend every year? If you reinvest your dividend, you can use it to buy more stock. This in turn, increases your shares, so you get a bigger dividend check that you reinvest the next years. This is true regardless of the stock price.
- Year 1: 100 shares of SPY & you get a 2% dividend, which you use to buy more SPY
- Year 2: 102 shares of SPY & you get s 2% dividend, which you use to buy more SPY
- Year 3: 104.4 shares of SPY & you get a 2% dividend, which you use to buy more SPY
This is the power of compounding. No matter what happens, you are getting more shares for the day that you retire. Because you know the base will grow at least the same as inflation over a long time, you are growing your eventual dividend payout at least 2% per year.
What is nice, is that this is so well know that there are two ticker that you can use on Yahoo finance to see the difference between S&P 500 with reinvested dividends versus S&P 500 without reinvested dividends.
^GSPC is the tracker for just the price of the S&P 500
^SP500TR is the tracker for S&P total return, with reinvested dividends.
If you have 1 share of SPY 20 years ago, and you were retiring today, here is the difference between reinvested and not reinvested.
Reinvesting the dividends almost doubles your income at the end.
2.9x return over 20 year
1.7x return if you don’t reinvest your dividends
70% higher payout by reinvesting.
The example above is in the theoretical world without taxes. In the real world, the government says, “You made money, so I’m going to take 16% of that dividend that you made.” This means that you’re compounding effect goes down 16%. In short, this means that your dividend payments in the future will be 16% lower. It is truly a killer. (SPY is both qualified and unqualified dividends, which is another post so I’ve pushed up from the 15% that you might see on a tax website.)
But remember you have a 401K for your dividends! Not only does your money go into a 401K tax free, but it also grows tax free. Remember, that you also start off with a lot more money (25%) because you don’t get tax on the amount that goes in initially.
Between these two factors, if you decided that you “didn’t want to use the 401K,” at the end of 20 years, your payout would be approximately 25% less than by using the 401K plan. Or, if you want to look at it from the base of “how much more do I get by using a 401K?”, it means your payouts will go up 33%. This is a lot of money.
So, lets say you have $1M in your 401K plan.
What! How realistic is this type of a number? Can we really get $1M in our account? You can, and let me show you how.
This things first, we don’t want to say “$1M” in the future because we know that inflation will cause $1M to look a lot smaller in the future. Therefore, we want to adjust for inflation. There are a variety of calculators that can help you figure 401K growth. The way to “bake in” the inflation factor is to say, “I’m just going to calculate a growth rate of 2%, which I know if going to come from my dividends.” We know the base on dividends will stay up with inflation, therefore, just lowering the growth rate to 2%, bakes in the effect of inflation. In reality, the number will be much, much bigger, but don’t worry about this.
I’m also going to assume that you have a good employer that matches your 401K 50% to the first 6%, which is pretty standard.
The math is pretty simple. You assume you average $100K per year, you invest 10% of your salary, and you assume the dividend increase your base by 2%. At 60, you will have $800K. Although I don’t show it, if you wait until you are 65, you will have $1M.
Then remember this was down adjusted so that this is $1M in today’s dollars. Does the evidence say this is happening? It turns out that 3% of Fidelity 401K held by people that are 50-59 years old have $1M. So, is it hard? Sure.
Is it possible? Sure. It is very possible. There is a subset of people called “Financial Indepent/Retire Early” or F.I.R.E. This culture is sacrificing today to be able to retire early or be completely independent. It is amazing to me how these people, often not making big salaries, are well on their way of doing the above.
Also, from my experience is that most people have no idea of the benefits, and they are too lazy to do the work to enroll. This is not just conjecture. The research shows that only 56% of employees 25-34 will enroll in a 401K program, if they have to do work. Thank goodness people are lazy the other way also. So, company’s have been auto enrolling their employees of late, and it turns out that if people need to do work to get out of a 401K plan, the 56% will jump to 92% because only 8% will do the work to unenroll from a 401K program. Now I used the word lazy, but in reality, most people just go on auto pilot and don’t want to think that hard about their future, and once they are enrolled, they just adjust their spending to what they have.
The bad thing about auto-enrollment is that it normally enrolls at a low rate of contribution. In reality, you should jump in as hard as you can, even if it means sacrificing many other things.
As I wrote before, my goal is to live off of my dividends, so I can pass my wealth to my kids, who I am hoping will train all the following generations. Most of the FIRE community are not looking at it this way, so they plan on being able to withdraw 4% or so, which is higher than the 2% dividend rate I keep talking about.
On $1M, 4% is $40,000 per year, which is very healthy.
Now, you get to add social security to this number. In our example, we picked somebody making $100K per year, which is higher than the average household income of $75K, for everybody with a college degree. However, lets just use the average social security payment of $17,000 per year, because if you made $100K, you’d even have a higher retirement. (By the way, even if social security goes “bankrupt” the SS payments should only drop 25%, or down to roughly $13K.)
So, now you are living on $57K per year, and where do you want to live?
If it were me, I would move to either Port Orchard or Gig Harbor Washington, because the golf is cheap, and it is close to Seattle if I want to go to the city with my wife. These are medium cost areas, because you would need to sped something like $2K per month for a 3 bedroom house with a nice view. But remember that
Now, you have $2,750 to do everything else, which turns out to be $900 dollars per day. I don’t see any problems on living on $900 per day. In reality, I should be able to not only live on this with my wife, but then even be able to put money away for a rainy day, travel or anything else I need to pay.
Rent, you say, why would I want to rent? Why wouldn’t I want to own a house, and have even more money?
I plan to show this in a future post, but let me give you an example right here. I just looked up a rental on Zillow, and they want $2K per month for a charming house close in downtown Gig Harbor, a tourist spot. Let’s say that I wanted to buy the house “because I don’t want to pay the rent.”
Zillow says the house could be bought for around $840K. Most people don’t think about the tax man. In this case, property tax is going to be about $500 per month. Put insurance on top of this, and you are paying $650 per month to live in a “free” bought for home. Now, lets say the roof goes. Do you want to pay for this? The water heater goes. Do you want to pay for this?
This idea that things break down is very common, and landlord have something they call the 1% rule. You put 1% of the purchase price of the home every year because you know something is going to be replaced. So, let’s put the additional 1% or $8,400 per year for things that break. This is an astounding $700 per month. Add this to your other costs, and owning a house will cost you $1350 per month.
You always need to say “what is the difference” between two scenarios. Yes, you are paying more by renting, but it is only $650 more, adding all the possible expenses including eventual repairs. The point is that instead of buying a house, you could have been putting all this money into your 401K plan.
As we just pointed out, owning the house saves you $650/month or $8K per year. If you have the 401K account, you can pull out $34K per year at a 4% withdrawal. You are net positive $26K per year, or you have over $2000 more to spend per month by favoring the 401K plan.
This should make sense if you think about it.
It actually turns out that in most areas, the cost of renting a house goes up the same as inflation. On the other hand, even thought we’ve talked about withdrawing between 2% to 4% on your 401K plan, the base stock go up faster than inflation. By renting and saving the difference, you end up having a ton more money in the future in most circumstances.
Let me be clear, and I know this is so counter to what you’ve been taught and feel.
Unless extraordinary circumstances exist, you should NEVER buy a house if it means you are taking away money from your 401K plan. Now, if you have fully paid up your 401K plan, and now you have money left over, be my guest. It’s not that owning a house is bad, but if it causes you to miss out on filling up your 401K, it would be horrible.
By the way, the government is not stupid, and the taxman or taxwoman is going to get their due. They don’t want you hiding all of your money in your 401K plan, and generating tax free income. They actually want to force you to pull the money out of this fund, so they can get at it. Therefore, they have a requirement that once you get to 70 years of age, you need to start pulling out around 4% of your money. If the dividends are only 2%, and the government forces you to pull out 4%, they are going to get to an additional 2% of your capital.
A way of working this, and I’m assuming that you are an experience investor, is that you may want to raise your percentage of higher paying dividend stocks in your portfolio. Let’s say you are getting to 70 years of age, and you know they are going to start to force you to empty out your 401K. You may elect to move your portfolio to a set of stocks that produce 4% on the dividend. This means that you’ll continue to only pull out dividend income, and the principle will stay untouched.
However, to do this you need to make sure that your funds are in a place where you can manipulate them. Most companies have 401K plans that are set up so that the employees cannot hurt themselves. However, it also removes a ton of control. If you want to really be able to dial in your investments, then you will want to move from a 401K at a T Rowe Price or Fidelity to something like an eTrade self guided IRA.
The only thing you need to remember is that the easiest time to do this is when you either switch employers, quit or retire.
We have a bunch of subjects to cover. I want to emphasize that as down as I am on buying a house, there are a couple of unique situations that you should know about. We will get to these in future posts, and what started off as a simply series, is turning into a lot of work. However, I hope that you enjoy our journey.