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Albert Einstein’s Formula for Retirement

It would make sense to listen to the person who discovered the theory of relativity, and who, in 1921, won the Nobel Prize for his discovery of the law of the photoelectric effect. This discovery led to the development of modern electronics, including radio and television. There are many reasons to thank Albert Einstein for his contributions. But what would this brilliant scientist and mathematician know about retirement? We can sum this up in one simple sentence uttered by the genius. Einstein once said,

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

The question is, which side of the interest equation are you on? Are you earning it, or paying it? Most consumers are paying interest, and in large amounts. But this article is about making money on your money, and we are going to use Einstein’s formula to do it.
A compounded return is when you earn interest on your principle, and5 interest on the interest.  Example:  You have $50 and it earns 10% or $5.  Now you have $55. During the next cycle, it earns 10%, but the gain is now $5.50 because of compounding.  You made 10% on the initial investment of $50 and 10% on the interest it earned. This is the difference between simple and compound interest. If our scenario focused on simple interest, you would only gain interest on the initial amount invested, and not on any future gains. If you borrow money, be sure you are paying simple interest on the debt. If you are saving for retirement, compound interest should be your goal.

Hopefully, you are putting back some money each month for retirement. The frequently asked question is, how much should a person save out of each paycheck? The answer depends on who is going to do the most work; you or your money. Burn this statement into your brain: It’s not how much you save, that determines your retirement affluence, but when you save that does.

3For example. Let’s say a worker decides to put back $100 a month for retirement. He is twenty years old, and his plan is to retire at age 70. The average return will be eight percent per year.

As you can see, at the end of 50 years, he will have accumulated a respectable amount of cash: $798,460. Notice the total deposit amount of $60,000. This contribution came out of his paycheck month after month, year after year, for 50 years, or 600 months, in order for him to arrive at this number. Another way to put it is that it cost our young investor $60,000, to make $798,460. This is one example of how compound interest can work for you. However, the investor is doing a large share of the work. It took him 50 years of constant contributions to arrive at this amount. Remember, it’s not how much you put back, but when you do it, that makes the difference.

Which side of the interest equation are you on?

 Now let’s recalculate the same example above, but with a slight variance. Instead of paying in over a 50-year period, let’s assume our young worker elects to invest a larger amount into her retirement account, but only for the first year! If our protégé sacrificed for just one year, perhaps by working three jobs, shopping at Goodwill, and living on Ramen Noodles, so that she was able to put back $1,200 a month for twelve months, how would she make out? Keep in mind, this is a one-time event. After surviving such a grueling year of saving and sacrifice, she decides she will never put back another dime toward retirement. Where will she be 49 years later?

To begin with, 2her contribution total equaling $14,400, ($1,200 per month for 12 months), is less than 1/4th of the $60,000 invested by our first example. At the end of the same time period, she would end up with almost $100,000 more in her bank account, and at a fraction of the cost of the first investor. After that initial year, she could spend the next five decades spending her money anyway she wanted to, without any need to worry about her senior years.

The general belief is, the more time you have to let your money grow, the smaller your contribution can be toward retirement. No! No! No! The more time you have, the more money you should put back. This is how you make your money work for you 24/7. The larger the amount you invest when you’re younger, the sooner you can stop contributing altogether. This could also hasten your actual retirement date.

Triple Compounding

Before we leave this subject, let me say a word about triple compounding. What is triple compounding?

  1. Interest on your principle
  2. Interest on your interest
  3. Interest on deferred taxes

When you put money into a tax-deferred investment, such as a 401(k), or an IRA, you receive triple compounding. You don’t have to pay income tax on your gains until you pull the money out of the tax-deferred investment. The money that belongs to the IRS remains in the account, earning interest for you. Below is a chart showing what $100,000 can grow to, utilizing the triple compounding method, versus paying taxes in an individual account.

4As you can see with triple compounding, you can almost double your investment return in a tax-deferred environment. If you are in the 39% tax bracket, and you pull out the entire lump sum at retirement, you would still be far ahead of the other figure. (Keep in mind that the tax table is based on a graduating system).

$684,848 – $171,212 (39% tax on a tier system) = $513,636

Conclusion

  1. Save as much as you can, as early as you can
  2. Deferring taxes on your gains as long as you can, is a great way to grow and sustain your investment dollars.
  3. If you want to keep ALL of your gains, put your contributions in a Roth IRA. There is no tax deduction for the initial contributions, but all of your gains are forever tax free.
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3 Dangerous Pitfalls to Avoid Before Retiring

Tennessee Williams once said, “You can be young without money, but you can’t be old without it.” Of course, in our nation of welfare, you can survive without money when you are old, but you can forget the iconic picture of you sitting by a pool, holding a fruity drink with the little umbrella in it. Those kind of dreams take money. Money may not buy happiness, but it sure offers more choices.

Everyone has a different perspective of what a comfortable retirement is, but all scenarios have one common denominator-money! Any level of a quality retirement depends on your financial success. The rest is influenced by your perception of what that success can buy. As the date of your departure from the workforce approaches, one way to  greatly enhance your experience, is by taking an early inventory of your priorities. While this exercise is particularly important to consider, as you draw near to retirement, this dynamic should actually start well before you’re ready to retire. It helps you engage in critical thinking about what kind of lifestyle you think you need.

As incomes increase, people naturally tend to raise their lifestyles to match. There is nothing wrong with driving a late model car as opposed to a clunker, but if you’re not careful, you can damage both your perception and the reality of your financial future. To understand this, look at the skew that household income tends to take over time.

Three essential dynamics to consider:

  • The Dynamic of Age Verses Earnings

According to the latest numbers by the US Census Bureau, the median household income, for workers between the age of 25 and 34 is $54,243. This figure rises almost twenty-three percent, to $66,693, when the primary earner is between 35 and 44, and steps up another six percent to $70,832, when the primary earner is between 45 and 54. It should come as no surprise that income increases, as individuals spend more time in the workforce. No problems yet.


But here is 3 dangerous pitfalls before retiringwhere many unsuspecting wage earners experience an unpleasant surprise. At the age of 55 (on average), the gradual incline
of rising income comes to an abrupt halt, and makes a nasty downturn. When the primary earner reaches an age between 55 and 64, overall household income shrinks to $60,580, according to the Census Bureau, but the plunge isn’t over. Households whose primary earner is between 65 and 74, see a drop in income to levels below that of a 25-year-old worker, to $45,227. Once the primary earner reaches 75 years of age, he can expect an income of just $28,535. This last figure represents a decline in household income of over $42,200, or 60 percent from the prime earning years of ages 45 to 54.

While most soon-to-be retirees expect to see some degree of decrease in their earnings, as they approach job liberation, few if any are prepared for such a radical drop as this. Add to this already stressful news, the shock that this immense shrinkage begins as early as 55 years old, and you have the makings of a very unsettled outlook on your upcoming retirement. Remember, I said a comfortable retirement is part perception, and part reality. This is why I stress that you should take a personal inventory of your priorities, before you begin to feel the pressure of income reduction. This continued inverse of wages after reaching the age of 75, suggests that resources become more limited as you traverse through your golden years. Such a decline is partly due to the inability of individuals to remain in the workforce, but it can also be an indicator that your retirement savings is beginning to run out.

  • The Dynamic of Age Verses Expenses

A somewhat fallacious assumption perpetrated by novice brokers and financial planners, is that retirees will need less income in retirement, than people who are still in the workforce, because their expenses will be lower. While this might be true to a degree, it can set a dangerous president, when you are trying to figure just how much will be needed to live on. Some costs that should decrease, include support for children, (unless you like to support your adult children), house payments, and general expenses related to employment, such as gas, wardrobe, meals, and so on. However, figures from the Bureau of Labor Statistics show, that the reduction in expenses do not keep pace with the sharp decline of income.

Interestingly, income and annual expenses both peak at roughly the same time, for people between the age of 45 and 54, at a national average of $60,524. However, as I stated above, while household incomes drop by about $42,200, when the primary earner is 75 or older, his expenditures only decrease by $28,333. This creates a shortfall of $13, 867 per year. Therefore, when planning for retirement, it is imperative to remember that expenses don’t typically fall as fast or as low as income. One key factor to this disparity, is the rising cost of healthcare, especially in later years.

  • The Dynamic of Present and Future Lifestyle

Question One: Do you have any idea what it costs you today, to sustain your current lifestyle? This figure is an essential part of your inventory profile, and you should not let the sun go down until you have calculated it.

Question Two: Do you wish to remain at this lifestyle level in and through retirement? If you answer yes, then you have some serious work to do. Now that you are aware of the impact age has on household income, and of the shortfall created by expenses, it is important to consider how closely to tie your lifestyle to your current income. Unless you are prepared to cope with a substantial decline in your lifestyle, do not link your spending closely to your income, especially when you enter those peak earning years between the ages of 45 to 54.

To their chagrin, many people not only raise their lifestyles to match their incomes, they exceed their limits by acquiring non-deductable debt. (Non-deductable debt is simply debt that cannot be added to the schedule A of a tax return, thereby deducting it from taxable income). An example of non-deductable debt is having a credit card balance.  Seeing their incomes rise steadily as they move through their 20s, 30s, and 40s, can lead to the erroneous impression that they will continue to improve financially in the future. As a result, they think they can afford to take on debt now, and pay it off in the future, when they are earning more.

The Fix

Living above your means today, could result in a shock to both your perception and reality, when your retirement date comes knocking on your door. Take an inventory, learn what really makes you happy, and adjust your current plan to match what you discover. For example: Let’s take the two extreme examples of the chart. $70,832 and $28,535. Add these two together and divide by two. This gives you an average of $49,684. If you can think long-term, use this number for your current lifestyle, and save the rest. Repeat this formula every year. This will give you two advantages. First, it will help you save more for retirement, and second, it will help you become accustomed to a more frugal lifestyle gradually.  This can offer you years of satisfaction during your retirement.