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Time is on My Side

Hi, everyone. Recently, I wrote about the importance of understanding Social Security’s role in determining one’s retirement picture. As I thought about this trend, another issue with it is that leads to despair in some that they may have waited too long to have a decent retirement. (After all, if someone is ten years from retirement,Social Security won’t be there as the doomsayers say, and one needs 75% of income to survive, this is going to be difficult, if not impossible.) With that being said, I don’t want you to think that I am against investing in your retirement. I have an IRA, and I think that these are vital programs to add to, but not replace, Social Security in order to build a stable retirement income.

Now or Later

Dave Ramsey argues that the most important thing that someone should do is pay off all debt except for home ownership (mortgage is something that can wait in his formulation and payments should simply be made until other things are taken care of). Once this happens, one should take all of that debt money and then start to build for retirement. He says that this is so vital that one should use every spare penny for this purposes even going so far as refusing a matching funds from a 401(k) because he feels that the key to financial freedom is a total focus on each part of the plan. However, most investment advisors argue that the most important thing to do is to pay yourself first. I’ve seen some say 15 or 20% is what is required, and others that say that 10% will do the trick. (I personally think that the answer to this question depends on the age of the person building the account.)

The ultimate problem with this way of thinking is the way compound interest works. Ultimately, when one is truly financially independent, the best way to make money is to get out of the way, and just keep breathing. In his book The Slight Edge, Jeff Olson gives an example of compound interest working for someone vs. against someone. He gives as an example a story of two friends at the age of 24 who decide that they want to invest $2000 a year into an IRA that has a yield of 12%. They decide to invest until they have enough money that they will have $1 million by their 66th birthday. The first friend starts right away, and he makes the annual $2000 investment every year for six years. He stops because he already has enough in savings to get to his goal. The second friend finds out about this at the age of 30 and decides that he’d better get started after putting it off. He finds out, much to his shock, that he will have to invest for thirty-three years in order to get to $1 million by his 66th birthday.

But what happens if someone decides to keep investing? My wife and I each have money in an IRA. I have a little bit more because I started six months earlier. We have decided to, as long as our health permits, hold off until the age of 67 (our full retirement age) to start cashing in our IRA. However, I turn 67 in October 2046, and she turns 67 in February 2054. Based on the kind of money that we should be able to earn right out of college, I did some math and decided to see what happen if I invested at $350/month and she invested at $200/month out of college, if we both invested $50/month until then. Well, by the time I turn 67, I would have over $1.9 million in my IRA. This isn’t a bad amount. However, by the time my wife turns 67, even investing 30% less than I would, she would have a total of a little more than $2.7 million in her account. This is basically the difference between investing for 36 1/4 years vs. investing for 43 years.

So, what does that mean about debt reduction? I think that debt reduction is a good thing, but it has to be a part of the total picture of financial health. Flipping through the TV over the weekend, I saw Suze Orman talking to someone who was amortizing her house to the tune of an extra $1500/month in order to pay it off a lot sooner. Suze said that her goal was noble, but she noted that she wasn’t putting nearly enough money in her IRA because of this strategy. Granted, the “get rid of all your debt first” strategy I mentioned above excludes home ownership, but this means that it is operating at the expense of time. I know, using myself as an example, that I will have a lot of student loan debt, as will my wife, once we get out of school. If it takes us five years of laser focus to get rid of our debts, and we hold off on building our IRA’s, how would that look? If we simply held onto them for five years and invested the same amount, my IRA would be less than $1.1 million, and my wife’s would be less than $1.7 million. So, combined, those five years of staying on the sidelines would cost us a total of $1.8 million. How much would our monthly payment to our IRA have to be in order to make up for those five years on the sidelines? My $350 monthly contribution would have to go to $646, and her $200 contribution would have to go to $341.

I think that this as an example of a good idea that goes too far. Debt reduction is good, but there is a reason why people like David Bach, George Clason (in The Richest Man in Babylon) and Suze Orman advise you to pay yourself first. The other advantage to starting young is that the farther out you are, the more you can afford to take risks that lead to higher yields (example: my IRA is 89% stocks, and my wife’s is 91%) which adds even more importance to the value of time.

How do you make time work for you?

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11 Responses to “Time is on My Side”

  1. July 30th, 2011 at 5:03 am

    Terrific Tonya Heathco says:

    Steve,

    Your brilliant article led me to think about my future. I related well to the books you pointed out in this article and have read all of them, it took reading your article to really get me thinking about financial security in my future.

    I admire your knowledge and the ease in which you offer it to your readers. Kudos to you!

    Keep up the great work -

    Terrific Tonya Heathco
    National Seizure Disorders Foundation
    Terrific Tonya Heathco´s last [type] ..NSDF Helps Children Understand Seizure Disorders

  2. July 30th, 2011 at 2:36 pm

    marquita herald says:

    Great information Steve. I was married for 25+ years and I allowed my husband to talk me into funneling all our extra money into his retirement account because his company featured matching funds. Made sense at the time – and then we divorced and I lost all that money and had to start over. So, I am working on both saving and paying off all credit card debt … it’s a challenge, but I’m making progress. The funny thing is now my credit card companies are increasing my limits like crazy – I work at ignoring that and just focus on the shrinking balance! My goal is to be completely debt free by this time next year – yee ha!
    marquita herald´s last [type] ..Neat Little Boxes

  3. July 31st, 2011 at 4:08 pm

    Debbie Lattuga says:

    I think that Compound Interest and How to Use it to Your Advantage should be a class in high school.

    I didn’t come across the concept until I was in my 30s. My kids sure know about it though. Thanks for the great explanation.
    Debbie Lattuga´s last [type] ..My Quest for Creativity

  4. August 2nd, 2011 at 7:41 pm

    Evie says:

    My first job out of college was for a small company that offered a 401k plan and matching. Everyone was highly encouraged to participate and I realized I wouldn’t miss the money in my paycheck.

    I’m now self employed and still saving every month for retirement. My only frustration is that I can’t convince my sister of how important it is to start saving. She’s been putting paying off debt first.

    Great advice! and I agree with Debbie that this should be taught in high school.

  5. August 2nd, 2011 at 7:42 pm

    Evie says:

    Correction: my sister has been putting off saving for retirement to pay off her debt first.
    Evie´s last [type] ..Is Your Path to Happiness Blocked?

  6. August 2nd, 2011 at 11:32 pm

    Kevin Martineau says:

    Hi Steve:

    Interesting thoughts on this subject. I guess to compare apples to apples you would have to compare how much you are paying in debt interest in that time too. Also, if you are not paying off debt are you still able to make the same amount of payments to your retirement? I would be curious to know if these actually make a difference in the end picture.

    Thanks for the thought provoking article!
    Kevin
    Kevin Martineau´s last [type] ..Marginless living

  7. August 4th, 2011 at 2:09 pm

    Steve Nicholas says:

    Thank you for your reply, Tonya! I’m glad to hear that my blog post helped you put everything together. I know that if you follow the strategies and end up a millionaire, you will definitely be proud of your accomplishments!

  8. August 4th, 2011 at 2:12 pm

    Steve Nicholas says:

    Thank you for your reply, Marty! I can’t wait to hear that you are completely debt free! You have given an example of something that can be tricky. Currently, neither me nor my wife are at a company that allows us to match, and we each have our own separate IRA’s. I think that working together is important, but also knowing that you can retire on either person’s retirement instead of needing both is also a great reward.

  9. August 4th, 2011 at 2:18 pm

    Steve Nicholas says:

    Thank you for your reply, Debbie! I couldn’t agree with you more about the importance of understanding how compound interest works for you. It still amazes me to think that, if we get a 12% annual yield, how $33,000 would end up costing $1.8 million by the time we each hit retirement age. When I have kids, I will make sure that they learn the lesson to get started.

    I know that yesterday, I was talking to my brother, and when I mentioned that the market slide has cost me about 6% of my IRA, and he said that I should just put it all in a savings account instead for retirement. I pointed out to him that, even with the slide, I still have a yield of 3% for the year, but a savings account will only yield 1/2%. It’s amazing how much people miss when they don’t understand this key point.

  10. August 5th, 2011 at 1:49 am

    Steve Nicholas says:

    Thank you for your reply, Evie! I think that getting rid of debt is a good thing, but it has to be a part of a larger strategy. If $33,000 costs $1.8 million over time, I’d rather stay in debt for another year or two. This is why people like David Bach, Suze Orman, and George Clason point out that you have to pay yourself (i.e., wealth-building and retirement) first.

    I saw an episode of The Suze Orman Show over the weekend, and she was talking to someone who wanted to take $100,000 out of her 401(k) to pay off the last $50,000 on her house. Suze explained to her that this was a horrible decision, not just because of the tax consequences but because of what will happen to her future savings. A good rule of thumb that I’ve seen was 10% to pay for retirement and 20% to pay off debts. Once you’ve paid off all non-mortgage debt, then move to other investments with the money that used to go to debt. If staying in debt a little while longer will lead to literally millions later by continuing to pay yourself, I couldn’t recommend that path high enough. Feel free to show your sister the example that I used calculating the “pay your debt first vs. pay yourself first” strategy works ;-)

  11. August 5th, 2011 at 2:18 am

    Steve Nicholas says:

    Thank you for your reply, Kevin! If there is no effort to amortize a ten-year student loan of $150,000 at 6.8% paid off over ten years, this would be a total of $207,144 paid ($1726/month). If the loan is spread out over 20 years, this would come to $274,802.40 ($1145/month). So, even at the worst-case scenario, this would cost nearly $125,000 in interest. Nothing to sneeze at, but it’s a whole lot less than $1.8 million.

    Using a modified version of the debt formula of continuing to fund retirement, but still using some money from extra earnings to amortize, let’s say for the sake of argument that using the modified version, this would mean being able to pay off an extra $800/month, which would reduce the total for the ten-year loan to $183,380.57 and be paid off in six years and one month. Over twenty years of amortizing under this schedule, it would be $197,750.35 and paid off in eight years and six months.

    If you amortize to the tune of $1350/month instead of $800/month, the loan would be paid off for $176,058.43 in four years and ten months for a ten-year loan. Doing this for a twenty-year loan would result in a total payment of $183,924.21 over six years and two months. For a ten-year loan, this will save $7322.14; for a twenty-year loan, this will save $13,826.14. I certainly don’t think that this is worth the potential loss that could be measured in the millions just to be able to say “I’m out of debt” two years early. Again, paying off debt is good, but it has to be a part of a larger strategy.

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