A recent article on Seeking Alpha drew quite a bit of interest as it claimed that a 20-something could retire after a working career of a mere five years after stashing just $330,000. Needless to say, I had to read this article, as I'm well past the 20-something phase. The numbers worked out in the hypothetical situation, and showed that a person who was very frugal could make this dream a reality. However, there were a couple of problems with that that would preclude most people being able to achieve it. The first was the fact that the hypothetical early retiree had an after-tax income of $70,000. This is entirely possible for professionals and some upper-middle class couples. However, the median income for an American family was just below $54,000 in 2014. This is before taxes.
If we look at a couple making $54,000, it would be impossible for this family to save the $46,000 that the example given above called for. Another possible problem that the article in question had was that it called for getting a 10.3 percent average yield. This is actually possible in today's market, but a yield this large indicates that there are risks that are higher than many people want to take. For the investor who is concerned with income and who makes somewhere around the median income, a more conservative route might be preferable. The upside is related to the likelihood that the income will be more stable. The downside is related to the amount of time that it will take to retire.
If we take a hypothetical couple with no children and give them the median income for an American family in an average town, what would the possibility of an early retirement look like? Note that this example would not be as likely in an upscale neighborhood in New York or San Francisco, but would rather have a better likelihood of success in a city like Cleveland or Pittsburgh that does not have sky-high property values. Here is what a couple might expect to bring home after paying federal (but not state) taxes:
Note that our couple is employed by someone else; hence the FICA withholding is only 7.65 percent, rather than the full 15.3 percent. The example does not take into account personal property taxes, sales tax, nor state income taxes, as these can vary greatly, depending upon the part of the country someone lives in. In New Jersey, these taxes will be quite a bit higher than they would be in Wyoming. We are assuming that our couple puts $10,000 into a taxable account. After deducting for personal exemptions and standard deductions, the tax liability would be $3,467.85 on a taxable income of $29,269. There are other variables that could affect this example, such as mortgage interest deductions and charitable contributions, but this article assumes that the standard deduction is higher than any itemized deductions our couple could take.
The investments are in taxable accounts, as our hypothetical couple is looking to use dividend income in their retirement. A tax-deferred account would be more tax efficient for a couple who planned on retiring at the "normal" age of 65, allowing them to effectively save their marginal tax rate on top of their 401(k) or traditional IRA savings. However, withdrawing early can become more problematic because of the need to pay taxes on the withdrawal in addition to the possibility of an additional 10 percent penalty if the proper rules are not followed.
Under current tax laws, qualified dividends are not taxed at that rate as long as the person earning them falls within the 10 or 15 percent tax brackets. Our couple would need nearly $75,000 in taxable income to get their qualified dividends taxed. This would be nearly $100,000 in gross income overall. How would our couple look after saving $10,000 (in today's dollars) every year for 20 years?
After 20 years of investing, our hypothetical couple would have nearly $500,000 in total portfolio value. An 8 percent return would be throwing off more than $36,000 in interest as compounding takes effect. The example assumes that purchasing power and total investments are static in today's dollars. An 8 percent return after inflation might be a bit optimistic, but the sequence of returns would affect the total overall return immensely. Please note that the returns for year 1 assume that the couple started with $0 in savings and built up to the $10,000 in investments over the course of the year, hence the 4 percent return for that year.
At this point, the couple could decide to invest in dividend-paying investments so that they can get income from their $500,000 nest egg. As shown in the article that argued for only $330,000, it is possible to get a 10.3 percent yield, albeit at a somewhat significant risk of a dividend cut or suspension at some point. What if our couple decides to be a bit more conservative?
The Vanguard High Dividend Yield ETF (NYSEARCA:VYM) currently has a dividend yield of 3.24 percent. This would throw off $15,957 annually, and the payout could be expected to grow a bit over time as some of the companies in this ETF will no doubt increase their payouts. Some will also probably cut their distributions as some point in the future. For some couples, $16,000 might be enough to have a somewhat livable existence. After all, the ever-popular Mr. Money Mustache supports a family of three on ~$24,000 per year. However, most people will need a bit more than this. This is where selecting quality companies that have positive cash flows that provide for a growing dividend can come in handy.
Instead of buying the Vanguard ETF, buying companies like AT&T (NYSE:T), which currently has a yield of 4.79 percent and has a history of growing the dividend slowly over time, could provide more income than VYM. It is possible to get a dividend yield of 4 percent if companies are bought at good valuations and sufficient diversification is employed. A year ago, AT&T had a yield that approached 6 percent. A 4 percent yield will provide nearly $20,000 in income. At this point, our hypothetical frugal-living couple could cut back on paid work, but probably not completely retire, as this $20,000 would be tax-free under current laws. This could change, but it is not terribly likely in the short term, as Democrats seem to only want to tax really wealthy people and Republicans seem to want to tax no one on unearned income at all. For most people, this would put the early (SEMI) retirees at somewhere between 40 and 45 years of age. The money and income that they've amassed could provide additional options regarding the work they choose to do.
If our couple decides to give it another five years and continue working full time while saving $10,000 in today's dollars, they would have a portfolio worth just north of $787,000 (in today's dollars) if everything goes as planned, and the dividends yielding 4 percent would pay off nearly $31,500 in income. If the couple could safely find a yield of 5 percent, they'd be realizing more than $39,000 annually, which is more than they took home on their median income after paying FICA and income taxes and investing $10,000. All of this could be accomplished by the age of 50. If the couple could live on this amount, they could retire and (hopefully) not have to touch their principle investment portfolio, living off dividend income alone. Any amount of very part-time work would only increase the standard of living that our couple could afford.
Obviously, this assumes that the couple starts at the median income and that this income can keep up with inflation over time. This hypothetical family is very disciplined, and can save $10,000 in today's money over a 20- or 25-year working career. It presupposes that the couple does not buy a McMansion or $50,000 four-wheel drive trucks or SUVs, but instead opts for affordable lodging and serviceable used vehicles. In spite of the idea that it is impossible for the middle class to get ahead, this exercise shows that retiring 15 or 20 years early is not outside the realm of possibility while using fairly conservative numbers on a very middle-of-the-road income if there are no major roadblocks like major illnesses or long-term layoffs. Life does not always work out this way, but it's worth a try to get it to work out.
Disclosure: I am/we are long T.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am not a licensed financial professional. This article is only for educational/entertainment purposes and should not be construed as a recommendation to buy or sell any securities. As losses up to and including all capital invested can occur, be sure to do due diligence and check with a financial professional before investing in securities.