I want to retire early. I am currently 28 years old and want to retire by the end of my 40s. The thought of working for yourself and not worrying about money is invigorating and quite fantastic. This is definitely not an easy task. For this we first need to come up with a plan. In this article I will discuss the basics of coming up with a rough size of the portfolio you will need to survive taxes and inflation and make your money outrun you. There are online calculators which will do this for you but understanding the math behind it will make you appreciate how the different factors come together.
Portfolio
First we need to project how much money we will need to live comfortably. If I want to retire now, I can live comfortably on $25,000 per year after taxes. For you the figure might be different. For now let me run an example calculation on my own portfolio and then I will give you a formula which you can use for your own set of variables. To calculate it you will need to be aware of the following
The calculation
How much of a portfolio will you need to get a return of $25,000 after taxes and still not run out of your funds? Let's go step by step.
Let's suppose that your portfolio is of $X. With this portfolio you want to get $25,000 after taxes in the first year, $25,000*(1.02) in the second year, $25,000*(1.02)^2 in the third year and so on. The amount of money you need increases every year because of the 2% inflation. You need to adjust accordingly if the inflation is higher or lower.
How much do you need before taxes? Assuming 20% taxes you will need the following:
So, now we have the money we need before taxes every year for the next three years. You can repeat similar calculations to get how much you will need from your investment after a particular number of years.
Let us now assume a 5% return from the portfolio to be safe. To generate $31,250 in the first year you will need a portfolio of 31,250*100/5=$625,000. But as you see that the next year it will generate the same amount of return, i.e., $31,250 and not $31,875 that you need. Let us look at the size of portfolio according to the year that we need to generate the returns.
As we see, we need larger portfolios every year! How do we take care of this in our calculations? Theoretically, we will need a larger portfolio which will generate more than $25,000. We will add the remaining sum to increase our portfolio size so that it can generate larger returns next year. But how do we actually come up with this magical portfolio size?
An easier way to look at the calculations is as follows. Every year we get a 5% return on our portfolio. The government takes out 20% of this in taxes. So, we are left with (5-5*20/100=) 4% return after taxes. But 2% of this is eaten away by inflation. Hence, we need a portfolio whose 2% is 25,000. This is $1,250,000. Let us run the calculations on this portfolio and see if it returns what we want.
As we see from the table above, we need to generate double what we need. We add half to the portfolio and use the other half to live by. Magically, it all adds up and you will have enough money to last forever, assuming that the market, taxes and inflation perform as you assumed. Isn't mathematics fantastic!
But you might have different requirements. How do we run the calculation assuming a different set of values? Let us use a different set of variables. Assume that inflation is f%, taxes are t% and the market return is m%. Also, assume that you need inflation adjusted $y every year to spend. For this you will need a portfolio of y*100/(m*(1-t/100)-f). Assuming y=$25,000 m=5% t=20% and f=2% will give you 25000*100/(5*(1-20/100)-2)=$1.25 million. If instead you can get by with $20,000 you will only need $1 million.
Bottom line
This seems like a large portfolio and one will need a good amount of time to get to a portfolio of that size. But consider moving to a different country. In India for example you can live quite comfortably with an inflation-adjusted $15,000. The great part is that if you invest in the U.S. you will only need to beat the $-inflation and not the rupee inflation. For generating inflation-adjusted $15,000 you will only need $750,000, a significantly smaller sum.
Keep your eyes peeled for the next article which will discuss a saving and investing plan to retire.
Portfolio
First we need to project how much money we will need to live comfortably. If I want to retire now, I can live comfortably on $25,000 per year after taxes. For you the figure might be different. For now let me run an example calculation on my own portfolio and then I will give you a formula which you can use for your own set of variables. To calculate it you will need to be aware of the following
- Tax considerations. Make sure you know what you will be taxed on dividends and capital gains taxes in your country. Let us suppose that you pay 20% taxes on your investment earnings.
- Inflation. Make sure that you know the inflation figures. You need to adjust accordingly. For example, in India the inflation is around 9% these days. This is a huge number and ignoring it is a sure way to end up with a disaster. The long-term inflation rate has been around 2% in the U.S.
- Market return. The market returns are not the same year after year. You will need to keep an appropriate margin of safety. The S&P 500 has returned around 10% in the last 70-80 years. This means that investing in the SPY will earn you 8% per year (after discounting inflation).
The calculation
How much of a portfolio will you need to get a return of $25,000 after taxes and still not run out of your funds? Let's go step by step.
Let's suppose that your portfolio is of $X. With this portfolio you want to get $25,000 after taxes in the first year, $25,000*(1.02) in the second year, $25,000*(1.02)^2 in the third year and so on. The amount of money you need increases every year because of the 2% inflation. You need to adjust accordingly if the inflation is higher or lower.
How much do you need before taxes? Assuming 20% taxes you will need the following:
| After tax | Before tax | ||
| year 1 | 25,000 | 25,000/0.8 | =31,250 |
| year 2 | 25,000*(1.02) | 25,000*(1.02)/0.8 | =31,875 |
| year 3 | 25,000*(1.02)^2 | 25,000*(1.02)^2/0.8 | =32,512 |
So, now we have the money we need before taxes every year for the next three years. You can repeat similar calculations to get how much you will need from your investment after a particular number of years.
Let us now assume a 5% return from the portfolio to be safe. To generate $31,250 in the first year you will need a portfolio of 31,250*100/5=$625,000. But as you see that the next year it will generate the same amount of return, i.e., $31,250 and not $31,875 that you need. Let us look at the size of portfolio according to the year that we need to generate the returns.
| Year | Income | Portfolio size at 5% return |
| year 1 | 31,250 | 625,000 |
| year 2 | 31,875 | 637,500 |
| year 3 | 32,512 | 650,240 |
As we see, we need larger portfolios every year! How do we take care of this in our calculations? Theoretically, we will need a larger portfolio which will generate more than $25,000. We will add the remaining sum to increase our portfolio size so that it can generate larger returns next year. But how do we actually come up with this magical portfolio size?
An easier way to look at the calculations is as follows. Every year we get a 5% return on our portfolio. The government takes out 20% of this in taxes. So, we are left with (5-5*20/100=) 4% return after taxes. But 2% of this is eaten away by inflation. Hence, we need a portfolio whose 2% is 25,000. This is $1,250,000. Let us run the calculations on this portfolio and see if it returns what we want.
| Year | Portfolio | 5% return | Tax (20%) | Spent | Left to add in portfolio |
| year 1 | 1 250 000 | 62 500 | 12 500 | 25 000 | 25 000 |
| year 2 | 1 275 000 | 63 750 | 12 750 | 25 000*(1.02)=25 500 | 25 500 |
| year 3 | 1 300 500 | 65 025 | 13 005 | 25 000*(1.02)^2=26 010 | 26 010 |
As we see from the table above, we need to generate double what we need. We add half to the portfolio and use the other half to live by. Magically, it all adds up and you will have enough money to last forever, assuming that the market, taxes and inflation perform as you assumed. Isn't mathematics fantastic!
But you might have different requirements. How do we run the calculation assuming a different set of values? Let us use a different set of variables. Assume that inflation is f%, taxes are t% and the market return is m%. Also, assume that you need inflation adjusted $y every year to spend. For this you will need a portfolio of y*100/(m*(1-t/100)-f). Assuming y=$25,000 m=5% t=20% and f=2% will give you 25000*100/(5*(1-20/100)-2)=$1.25 million. If instead you can get by with $20,000 you will only need $1 million.
Bottom line
This seems like a large portfolio and one will need a good amount of time to get to a portfolio of that size. But consider moving to a different country. In India for example you can live quite comfortably with an inflation-adjusted $15,000. The great part is that if you invest in the U.S. you will only need to beat the $-inflation and not the rupee inflation. For generating inflation-adjusted $15,000 you will only need $750,000, a significantly smaller sum.
Keep your eyes peeled for the next article which will discuss a saving and investing plan to retire.
