How to Retire By Age 25

I originally posted this to a different blog on February 9, 2015 when I was a sophomore in college. I’ve since shut down that other blog, and I’m re-posting this here.

According to a 2014 Gallup survey, the average U.S. retirement age is 62. But what if you could retire in half that time, by age 25?

There are two ways to retire early: make more or spend less. Most seem to make more, but you could also just spend less. Then you could travel the world, meet all kinds of interesting people, make music, create art, write books, whatever you want.

The working class doesn’t care much for creation and adventure, so I’ve prepared this investment plan to assure the taxpayers that those who retire early aren’t necessarily a waste of their dollars.

If three years after graduating (age 25) you have amassed a $220,000 bank account, then you can retire from the desk job and start working on what’s most important to you.

1. Power of Compound Investing

Einstein said, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”

Lucky for us, compounding isn’t as complex as quantum physics.

This table shows if you invest $220,000 when you’re 25 years old into an account returning an average of 10% per year, assuming all capital gains are reinvested, your investment will be worth almost $11 million when you turn 65.

Note: If full table isn’t showing on your mobile device or smartphone, try switching your screen orientation from portrait to landscape view. If full table is still not viewable, try reopening this webpage on a laptop or desktop with a bigger screen.

Footnotes:

10% Return based on average annual returns of Vanguard Total Stock Market Index Fund (VTSMX)

Account Value calculated using F = P(1 + k)^n

Account Value calculated as nominal amount for end of each year on December 31

3% Inflation based on conservative estimate one percent above the two percent target of the Federal Reserve

Inflation calculated using P = F(1 + k)^-n

Inflation-adjusted amounts calculated for December 31 of each year, in terms of dollars on January 1st of Year 1

2. Power of Distributions: Dividends

If I’m going to retire to work on my own stuff, I don’t want to worry about money, but I’ll still need an income stream to support my living expenses. Dividends, right?

This table shows the 10% annual return split into an 8% price appreciation and 2% dividend yield. My initial investment is now worth about $5.2 million when I turn 65. Less than in the table above, but that’s okay because I get money every year in the form of a dividend distribution.

Footnotes:

Split of 10% Return into 8% Price and 2% Dividend based on past performance of Vanguard Total Stock Market Index Fund (VTSMX)

Dividends technically paid out quarterly; for simplification, any resulting effects on account value are assumed in 8% annual price appreciation

Dividend-paying assets will have price fluctuations each quarter; for simplification, changes in dividends paid out quarterly as a result of asset price fluctuation assumed in 2% annual dividend yield

3. More Distributions: Capital Gains and Roth IRA

These distributions—Capital Gains and Roth IRA—are different than the Dividend distribution, because the Dividend distribution is automatically paid out from dividend-paying assets in the account, typically every quarter; hence, we split the 2% dividend yield from the 8% price appreciation.

The Capital Gains and Roth IRA distributions, on the other hand, are paid out from the account appreciating at 8% annually, so I’ll have to sell some assets each year.

What’s the purpose of these additional distributions?

The table above shows a “real” (inflation-adjusted) distribution of approximately $4,600 during the year of age 25. I’m confident in my ability to live minimally, but I’m not sure I would lead a very healthy lifestyle with less than five grand for a whole year.

A Capital Gains distribution allows more than just my Dividend distribution to be paid to me each year, but can also be adjusted to hold constant the total annual distribution that covers my living expenses at a “real” value of $10,000 per year.

The key to this plan is spending; specifically, less spending. I need money only to survive with spartan amenities without being a fiscal burden on society, while having enough left over after living expenses to fund experiences. For me, this amount is $10,000 per year.

But what about when I’m old and sick and need to be put in a home and pay my medical bills and $10,000 each year is not enough?

A Roth IRA will act as a tax shield for my money as I grow old, but the IRS limits annual contributions to $5,500. The amount will eventually increase, but for now we’ll just assume it’ll be $5,500 for a while.

This table shows account value each year before and after Capital Gains and Roth IRA distributions. At the end of each year, Capital Gains and Roth IRA distributions are subtracted from the account before the beginning of the next year when the account value starts to appreciate at the 8% annual rate. The Dividend distribution is not subtracted from the account because the Dividend is calculated by a 2% yield separate from the 8% appreciation of the account.

Inflation-adjusted amounts are not provided. The account will be worth $1,714,197.67 after Distributions when I’m 65 years old, which, adjusted for 3% inflation each year, equals $510,193.22 in terms of dollars on January 1st of Age 25 (Year 1).

Footnotes:

Capital Gains and Dividend sum to an inflation-adjusted $10,000 each year (Notice: this is the annual amount I claim to need for living expenses)

Capital Gains calculated as difference between amount of Dividend distribution and inflation-adjusted $10,000

4. Roth IRA: Avoiding Taxes

Where do all those Roth IRA distributions go? Into a Roth IRA, of course.

This table shows my Roth IRA account, accumulating annual contributions of $5,500, growing to about $2.4 million by the time I turn 65.

Footnotes:

Age begins at 26, not 25, because first Roth IRA distribution from account is paid out December 31 of year corresponding with age 25; therefore, first cash flow is essentially at beginning of age 26

Account Value = C{[(1 + k)^(n) – 1] / k}

10% Return based on average annual returns of Vanguard Total Stock Market Index Fund (VTSMX)

5. Conclusion

If you can make $220,000 in the next five years, then you can retire on $10,000 per year, with a $1.7 million mutual fund account and $2.4 million Roth IRA when you turn 65.

Final Footnotes:

According to current tax law, “Some or all net capital gain may be taxed at 0% if you are in the 10% or 15% ordinary income tax brackets.” In other words, I’ll be poor enough to pay no taxes on my distributions.

The IRS requires that you have “earned income” equal or greater to the contribution limit of $5,500 each year in order to make a maximum contribution. We can assume I’ll make $5,500 each year from my miscellaneous endeavors.

Initial investment of $220,000 calculated so as to allow for a $5,500 contribution to the Roth IRA each year beginning Age 25 until Age 65 (65 – 25 = 40 * 5,500 = 220,000).

As a general clarification, Capital Gains and Roth IRA distributions are subtracted from the account each year on December 31, after the account has earned the full 8% annual return for the present year, but before the account begins to earn a full 8% annual return for the next year, starting January 1.

Disclaimer: I am not a financial professional. The expected returns are non-guaranteed estimates. Also, many of these figures are based on current tax and financial laws that are subject to change. I am not liable for any losses, nor do I expect compensation for any gains.