My 24-year-old nephew just graduated from a 6 year Pharmacy program and he is about to start working his first full-time professional job. He will be making around $130,000 per year which will be offset by a substantial school loan of mortgage-like proportions. This means that as of right now his net worth is negative $150,000. He is worth less than a newborn… Over the last year we’ve been talking about his financial future and I found that my nephew is very interested in the concept of financial independence and the freedom of choice that it brings. While trying to figure out what to get him as a graduation gift I decided to start by writing a letter laying out what I would do if I were in his shoes. I’m posting the entire letter below as it was sent to him. It’s a loooong read but it will be interesting to refer back to it as the years pass to see if my nephew took any of it to heart. Also, if you take the time to read it, I’d love to see if you’d change anything. Comments are always welcome!
The other day I was thinking how crazy it is that my nephew, whom I remember holding as a baby, is about to graduate and start his life in the real world as a Professional Adult. This is an exciting time on many fronts and I know for a fact that you can’t wait to start getting those big paychecks. I was in the exact same spot after graduating with an MBA – and there are at least a couple of things I would’ve done differently. You and I talked about this several times and you certainly took the right steps by reading the books I recommended and opening/funding a Vanguard brokerage account. Just by doing that, you are already ahead of the 90% of your classmates.
The truth is, what you do in the first couple of years after college will have a huge impact on the rest of your life. I can’t begin to tell you how much I’d want to have the advice and the resources you have. But it’s not just the resources – it’s your will to execute that’ll prove to be of most importance. After our conversations I know that you have what it takes to get yourself to the point where you’ll never have to worry about money, and get there much quicker than most of your friends.
I’m sending you a short book that has good advice that will virtually guarantee that you’ll have a nice retirement around age 65. The links to the reading materials the author provides are also great. One of the books he recommends is the “Millionaire Next Door” which, of course, you’ve already read. Now, there is nothing wrong with guaranteed comfortable retirement at 65 but I know you can do much better… read on.
You’ll notice that Mr. Bernstein (the author) echoes what we talked about and goes into a couple of more topics in more detail. Knowing your personal situation, I’d change a few things and recommend a simple plan. I know I’ll be repeating myself, but this is in written form which might come in handy later.
- First couple of years: Contribute to employer 401k plan up to their match and then use all available funds to pay off your school loans as fast as you can. It’s also fine to max out your 401k and THEN use all remaining after tax income to pay off your student loans too. Both approaches have benefits, but if it were me I’d concentrate on getting rid of your school debt first because it’s a great return that’s guaranteed. Whatever you decide, make sure to put enough into your 401k to get full employee match – that’s free money and a 100% return on your investment. If they match up to 4% make sure to invest at least 4% in their 401k plan. Putting everything into one target date fund is fine and you won’t ever have to re-balance (that’s what I do too). We’ll need to look at your options to determine the most cost-effective fund.
- Once school loans are gone: I’d start maxing out 401K and Roth IRA (if you qualify for Roth) and dumping the rest into Vanguard’s brokerage you opened. Mr. Bernstein recommends 15% of your salary which is fine if you want to be able to quit working at 65. Personally, I’d invest everything I can while still enjoying life. This is where it gets interesting – we’ll talk about it in a second.
- While you are doing all this don’t forget to set aside an amount that will cover at least 3-6 months of your living expenses. While you should always have a few grand easily accessible at a bank, the rest of this money does not have to sit in a savings account. Remember that you can withdraw all contributions that you made in your Roth IRA account (but not any gains). This way your money can be working for you while still accessible if you really need it. Of course, keep in mind that whatever you have in Roth is subject to market ups AND downs, so you might find that you have a lot less than you thought exactly when you need it most. Personally, I still keep a nice cash cushion, but then again it’s different with a family and a mortgage. You can afford to take more risk.
After student loans are paid off and with your high salary, you should target to save/invest AT LEAST 50% of your take home pay. I want to give an example so you understand how it works because this is THE most important concept.
For the sake of round numbers let’s say your monthly pre-tax salary is $10,000. Out of this amount you contribute 15% into your 401k, so that’s $1,500 per month. Now you have $8,500 that will get taxed. Lets say you pay $2,500 in taxes so now you are left with $6,000 take home per month.
We need to add $1,500 back to $6,000 because you are really taking home $7,500 – it’s just that you don’t get to see the 401k money which is invested automatically,
Using the 50% rule you should be saving/investing AT LEAST $3,750 and living on the other $3,750.
Now remember that you’ve already saved/invested $1,500 in the 401k so you need to save/invest $2,250 out of the $6,000 you bring home every month. The other $3,750 you can spend as you wish (this would include car payments, insurance, food, utilities, travel, etc). By the way, if you own a house at this point then you get to count principal payments as savings. All the other stuff (property taxes, interest payments, home insurance, etc.) will all have to come out of your $3,750 spending budget, but principal payments are counted as savings so that helps. If you pay rent then of course all of it is counted as an expense.
So in this $10,000 per month paycheck scenario if you are saving $3,750 then your savings rate is 50%. Now why is this THE most important concept you need to understand?
At 50% savings rate you will be financially independent (FI) in 17 years or soon after you turn 40 years old. I’ll give you links to additional reading on this further down, but for now – trust me on this. At this point you’ll have accumulated enough money/assets working for you to cover all of your expenses for the rest of your life, all without you having to show up at work.
17 years might sound like a long time now. To put it in perspective, I’ve been working 14 years already so time does fly.
Since you have 150K in student loans to kill first, let’s round-up and say that it will take you 20 years from today at 50% savings rate to get to FI. You will be in your early to mid 40s and most of your peers will still have at least another 20-25 years of mandatory work left IF they did everything right, consistently saved 10-15% of their salary and did not get into too much financial trouble with bankruptcies, divorces, failed businesses and stuff like that.
They will continue to stress about mortgages, car payments, impending layoffs, credit card bills, office politics, douche-bag bosses, kid expenses, “having to work till they die” and many other recurrent topics that you’ll soon discover after working with older office drones for a while.
Fortunately at that time, YOU will be in a completely different financial situation. You don’t have to stop working in your early 40’s if you still like your job. However, chances are pretty good that after 17-20 years of working full-time, possibly married with young kids, you’ll be ready to explore other options. Luckily, the portfolio you’ve built will be generating enough income to cover all of your expenses from this point forward until you die without having to show up at work if you’d rather be doing something else. And your early 40’s is a perfect time to try something else – believe me, I’m almost there and even after “just” 14 years of doing what I do for the money I feel like it’s time for a change.
Unfortunately, I didn’t do what I’m describing here early enough so I must continue working in the same field for a while longer. Hindsight is 20/20 and I know that when you are my age you’d really appreciate the real freedom that financial independence brings. When you know that all your expenses are paid you can take risks, turn your favorite hobby into your main occupation, say no to things that you don’t want to do, take time off to travel and learn, live in another country if you’d like, spend as much time as you want with your family and kids…
If that sounds like something you’d like for yourself and you want to get there even faster – it’s simple. If you can get your savings rate to 65% you will be financially independent in as little as 10-13 years. Think about it, you can be younger than I am now and have this entirely different world of opportunities for you and your family.
Does it sound far-fetched? Well, I mentioned before that we are at about 65% savings rate now and have been for a few years. That’s with a child, expensive house, 2 cars, vacations and all other comforts of the upper middle class life. Don’t forget, I was making $24,000 per year at my first job after college in a high cost of living area renting my own apartment and owning a (cheap) car. With your income and knowledge you should be able to pay off your loans and get to FI at a much younger age than me.
You have this incredible opportunity to REALLY start living your life on your own terms in a short period of time that will pass in a blink of an eye. You worked extremely hard for the last 6 years to get the education and the job that can propel you to freedom that most people will never achieve in their lifetime.
Congratulations on graduating at the top of the class from one of the most intense Pharmacy programs in the country!
P.S. Here are a few links to keep you thinking… As always, I’m here if you have any questions.
– Logic behind the numbers explained in detail: http://www.mrmoneymustache.com/2012/01/13/the-shockingly-simple-math-behind-early-retirement/
– Great intro post on how one family reached FI at 30: http://www.mrmoneymustache.com/2013/02/22/getting-rich-from-zero-to-hero-in-one-blog-post/
– “Fuck You Money” in action: http://jlcollinsnh.com/2011/06/06/why-you-need-f-you-money/
– Some inspiration to get you thinking about how to pay off your student loans quickly: http://nomoreharvarddebt.com/about/
– Best graduation speech ever: https://www.youtube.com/watch?v=PhhC_N6Bm_s