By “Financially Independent” I mean having enough money to live soley off the interests of ones investments (not the principal) in perpetuity.
By “investments” I mean relatively safe investments.
I define “enough to live off of” as making the median annual income in the United States.
Median income: $42,228
“Relatively safe” investments: 4% (Lots of room to argue about this one)
.04 * X = $42228
X = $1,055,700
Check in the sofa.
Hal
Does this adequutely account for inflation?
If you check the cite for the 4% number, that’s based off of the Inflation Indexed securities issued by the US government. So, yes, that number does account for inflation.
As I said though, there’s a lot of room to argue. That number is based off of US securities, so there’s very little risk. I think the larger error term for you will be “relatively safe,” not inflation.
Well, if you can live relatively comfortably as a pseudo-Buddhist monk like I do, you don’t need that much money.
It’s all about input and output. I used to working in the city, I made over $100K a year, lived in a nice high rise apartment, drove a BMW, etc. It took a LOT of input to match my output.
Now, I live in a somewhat smaller town with reasonable rent, drive an older car, don’t go out partying every night, but I am happy. My output is MUCH less now, so I need very little input to survive.
So, I guess if you want to “Keep up with the Jones”, then keep your nose to the grind wheel. Otherwise, kick back, re-evaluate your priorities and keep a perpetual smile on your face.
Lots of variables here.
If you you want to live solely off interest, then the after tax interest must not only provide the median income level, but also enough to add to the capital each year to account for inflation. So, with 2% inflation and, say, 20% tax overall, then 80% of the interest must provide 2% inflation plus the median income.
The median income in 1999 was about $35k (based on googling). Let us say it is now $38k.
As you want a relatively safe investment, let us say you achieve 4.66% as the current rate for Government I bonds. So, allowing for tax, 80% of 4.66% is 3.73% You need to save 2% to counter inflation, so 1.73% of your capital must equal the median income. If median income is $38k, then your capital needs to be $38000/.0173, which is a fraction under $2.2m. Scary, huh?
While I was preparing this, I see on preview that Winsling came up with a number about half of mine, and says that it does cater for inflation. Winsling only says that the interest rate allows for inflation - s/he does not allow for the fact that you have to add to the capital to allow for inflation and therefore you cannot count that portion in the income. Also, I do not see any allowance for tax in Winsling’s calculations.
It appears to me that you’re ignoring income tax. If you account for the 20% tax on inflation, then you don’t need $38K. You need what $38K would be after taxes.
It’s things like this that make me wish I were immortal. All I’d need to do is scrimp and save for a century or two, then I could goof off for the rest of eternity.
amarone, where did you get your median income number from? The 2001 census cites the $42k number, expressed in 2001 dollars. That’s a pre-tax number, so as Achernar indicates, we don’t need to account for tax separately. The taxes might be different based on interest vrs. wages; I’m not an accountant.
The other issue you raise is adding back to the capital for future growth of the median income. Since median income declined from 2000 to 2001 (all the searching I’m willing to do at this point) I don’t think it’s appropriate to assume it grows the same as inflation.
Okay, I did more searching. This article, published in 1996, claims a 5% drop in median household income between 1989-1995, following an increase of 11% between 1981-1988. I agree it should be accounted for, but can’t find any decent data for it.
So, I stand by my original statements. It will take about a million dollars, and the largest error term is what rate of return you can get. After more searching you can take any number between +4% and -3% as the real interest rate and find someone to agree with you. The first number I generated is the low end at 4% interest.
My median income figure was older than yours (1999), so I will happily swap to yours.
Here is how your original calculation does NOT account for inflation (the fact that the 4% return includes an inflation element is irrelevant), and how tax IS relevant.
Year 1: interest gets you $42,228 and you have preserved your capital of $1,055,700.
Year 2: interest gets you $42,228 and you have preserved your original capital of $1,055,700. But oops - there has been inflation between year 1 and 2, so your $42k is no longer worth as much in year 1 dollars.
Every year you will get $42,228, and every year it will be worth less. So you have to index the $42k. At 2% inflation, in year 2 you will need $42,228 x 1.02 = $43,072. As you are still getting 4% interest, that means you will have to dig into your capital for the extra $844, so the original conditions of the OP have been broken - you have not maintained your capital.
At the end of year 1, your capital needs to be $1,076,814 in order to generate $43,072 in interest the following year. This is an increase in capital of $21,114. So in year 1 you needed to generate income of $42,228, plus capital of $21,114.
Here’s where tax comes into play. The $21,114 is after tax. I’ll accept that the $42,228 is pre-tax, but you need all that $21k to add to the capital. With an income of about $80k, what percent tax will you pay? You need to use the marginal tax rate as if you want to earn the median income, you have to assume that you pay the normal taxes on the $42k (i.e. get all the normal allowances). The tax rate on $42k to $80k if you are a single person was 27% in 2002. Add state tax (6% in GA), and the total tax take is 33%
So to earn and keep $21,114 to add to your capital, you need to gross $21,114 / 0.67 = $31,513 in addition to the median income.
Add this to the median income that you want to be left with of $42,228 = $73,741.
If you are earning 4% interest, that means your starting capital needs to be $73,741/0.04 = $1,843,536.
This is a bit less than my original calculation as I took out the tax for all the income, but I agree that the median income part of what you earn can and should keep the tax element in.
Thanks for expanding on that.
We’re interperting the OP slightly differently. We both recognize that median income isn’t constant, so you assume it should be indexed to inflation, answering what capital is needed to maintain a 2001 standared of living. I’m ignoring that, because while I agree it should be adjusted, I don’t know how. The only data points I have are a drop of 2% from 200-2001, an increase of 11% in the 80’s, and a drop of 5% in the first half of the 90’s. Stepping back, it seems that it should grow somewhat faster than inflation to account for a rising standard of living. Since any adjustment on my part is pretty much a shot in the dark, I prefer to leave it out.
We’re also using a different interest rate. You’re assuming a 4% pre-inflation rate and accounting for inflation separately. I’m trying to think through the implications of accounting for capital inflation using a 4% post-inflation rate, and my brain is too muzzy. My gut feeling is still that the difference in the interest rate dominates the error term.
This is what I hate about real world problems. It’s simple enough to answer in five minutes (which I did the first time) but there are enough wrinkles to keep us busy for weeks. A factor that anyone could legitimately beat us about the head with is that real interest rates aren’t constant.
Thanks for keeping me honest; the question was more complicated than I treated it as.
Hal
The respondents have talked about financial investments…but can you make a reasonable return on real estate? For example: you buy an apartment building (for around $2 million), on which you put 5% down.Now,with rents and depreciation, can you live on the income off such an investment?
I’ve been thinking of doing this for a while !
According to testimony shown on courttv this week, there must be a huge difference between 1.6 million and 2.
In the Michael Peterson murder trial, the prosecution using tax assessments of real property showed Mr. and Mrs. Peterson were worth “only” 1.6 million at the time of Mrs. Peterson’s death, so he must have murdered his wife.
The defense showed various appraisals, showing 2+ million in net worth, ignoring personal property insured for $700,000. They argued the Petersons were not in sufficient financial trouble to suggest he murdered his wife.
desdinova, commercial real estate appraiser at your service!
One of the most important factors in how much cash you pocket is your debt service. Let’s assume some nice conservative terms, 25 year amortization period, 6% fixed interest rate, 75% loan to value ratio on a $2,000,000 property. Based on these terms, you’ll be paying $115,974.24 a year in mortgage payments.
Now, let’s say you purchase the property on a 9% capitalization rate. This means that 9% of the property’s $2 million value is returned in “net operating income.” NOI is gross rental income minus typical operating expenses (utilities, management fees, property taxes, routine maintenance) and for our purposes I’m also including some allocation for reserves in the cap rate (cash you save each year to help pay for major repairs down the road). A 9% cap on $2 mil is $180,000 of NOI. Subtract your debt service and you’ve got $64,025.76 in cash each year. (divide this into your $500,000 equity portion and you’ve got a 12.8% return on equity).
Depending on the local apartment market, you may also see significant increases in rental rates, and if your expenses aren’t keeping up with them you can see annual increases in your NOI. Assuming fairly level cap rates, this will yield a nice increase in your property value as well.
The risk, of course, is always present in apartment complexes, but if you’re smart and invest in a property in a good market (read, nice tight supply of apartment units and high rental unit demand) you can get a return on your equity similar to a well-performing stock.
Oh, sorry, you want to pay 5% down. Recalculate the mortgage payments accordingly, and while you’re at it, you may want to plug in whatever other mortgage terms you think you’ll get.
I don’t know anything about real estate investment, but I do know that there are large vacancy rates at the moment. Every apartment development around Atlanta seems to be offering large incentives to attract new renters. I doubt the rental income is holding up very well.
Right, thus the qualifier, “if you’re smart and invest in a property in a good market.” Not all markets are created equal, some are experiencing massive vacancy and others are pretty tight. What you’re looking for is areas of high population and income growth, with minimal new rental supply. Thoroughly studying the ins and outs of apartment markets (and the economies as a whole in which they are situated) is what I do for a living, and people pay me lots of money to answer exactly that question: is this a good market to buy (or build) this apartment complex?
Even at that, though, even in a relatively poor market, you can get a good return on your investment if you know the market is soft and base your forecast of NOI (and your capitalization rate) accordingly. If the current owner balks, there’s plenty of other apartment complexes in the world.
how does increased productivity play into these calculations?
For example, when coke first came out roughly 100 years ago it was 5 cents for a 6.5 ounce bottle. now it is 99 cents for a 67.2 bottle, which is only a price doubling over 100 years.
As technology creates cheaper and more efficient ways of production & maintenance, prices will go down. Cars will cost less and last longer, food will be less expensive, etc. I think i read housing was the only thing thats price didn’t go down over the last 25 odd years.
Wouldn’t you need to calculate those things in as well to determine long term financial independence?
Sure. Fortunately there’s an agency called the Bureau of Labor Statistics that calculates these things for us, and they call it the Consumer Price Index, which we commonly call the inflation rate. They break it down into some pretty narrow categories, such as heating costs, or consumer goods minus housing related costs, and you can even just look at costs for your particular region of the country.
so productivity increases are factored in with inflation?