I’d just moved my young family half-way around the world to pursue my academic career.
We owed thousands more than we owned. What’s known as having a negative net worth. And making under 60% of the median income of the time, things didn’t look good for the future.
Fast forward many years, and our fortunes (no pun intended) have truly changed.
Over the past 3 years, we could have lived off our passive income, and still grown our net worth. But we still worked, so including our active income, our savings rate was over 55%.
We’ve truly come a long way.
I won’t lie, much of it was due to a combination of building successful solo businesses (that bring in much more than a median income), and exceptionally good market returns.
However, the following 3 simple steps would have allowed us to build wealth even without those advantages.
First What Is Wealth?
Let’s start by what I don’t mean by wealth.
I’m not talking about a Bill Gates, Warren Buffet, or Jeff Bezos level of money.
I’m not even talking about having over $11 million and making it into the top 1% of net worth.
What I do mean by wealth is having enough passive income to cover your spending, with a comfortable margin. Some people call that “FU” money.
Personally, I prefer to call it FI money — financial independence.
For me, that’s what wealth really means. The freedom to choose what you want to do with the rest of your life, without worrying how you’ll cover expenses.
Next, What’s the Median Income in the US?
The median US income is defined as the level of income where half of American households make more than you, and the other half make less.
According to the US Census Bureau, the median household income was $67,521 in 2020. According to DQYDJ.com, the median income dropped by 1.39% from 2020 to 2021, which would make the 2021 median income in the US $66,582.
The average income was almost 44% higher than the median, skewed by the extreme income inequality in the country. You can see that inequality in the following graph. Instead of a normal bell curve, 38% of households make less than 10% of the top percentile income, and the median income is at just 13.4% of the top percentile.
What’s Financial Life Like at the Median (if You Plan for the Future)?
You make $66,582.
Let’s say you’re in your mid-30s, have a spouse and a couple of kids, and live in Maryland.
You just bought a house at the national median price of $346,900 with a 20% down payment and a 30-year fixed-rate mortgage at 3.5% interest. Your monthly principal and interest are $1558. Adding in insurance and property taxes, your monthly payment is $1930.
According to the H&R Block federal tax estimator, you’re eligible for a $10,000 tax credit, which after your federal taxes are taken into account means you actually get $5314 more from the IRS than was withheld from your paycheck.
According to GoodCalculators.com, your Maryland income tax is $2325.
That makes your after-tax net income $69,571, so your mortgage payment is about a third of your after-tax income. Not great, but not horrible for this part of the country.
You’re committed to reaching financial independence, so you live frugally and set aside 15% of your income, or $10,000 a year. And yes, I know from personal experience that this is pretty darn hard to do, so kudos!
Your employer offers a 401(k) plan and matches dollar-for-dollar up to 6% of income. You take advantage and contribute $3995 to capture the full match.
You contribute another $3000 into a traditional IRA, and another $3005 into a taxable account, where you invest it in a low-cost index fund like Warren Buffet recommends.
How Much Do You Need to Set Aside Each Year to Reach FI?
Taking into account your employer’s 401(k) match, you’re saving 21% of your pay. But wait, you’re also paying down your mortgage each year, starting at $6657 in Year 1 — another 10%+ savings. Overall, your savings rate is actually over 31%!
However, for the purpose of figuring out what you need to cover your retirement spending, we can only count the 15% you’re setting aside from your own income.
That means you’ll need the other 85% of your income to cover expenses. Taking into account that some expenses will drop (no kids to take care of in retirement, no commuting expenses, no payroll taxes, etc.) while others will increase (higher healthcare costs, higher leisure spending, etc.), let’s say you’ll need 80%, or $53,266.
According to Fool.com, you can expect Social Security benefits to replace about 40% of that, so you only need to cover the remaining $32,000.
Using the venerable 4% rule, your target is $798,984, which we’ll round up to $800,000.
With 32 years left until retirement age, what I call your “add-on factor” is about 80.
That’s the number by which you divide your target portfolio value to get the amount you need to invest each year. This is based on an assumed inflation-adjusted return of just under 5%/year.
Using this factor, you’ll need to invest $10,200 annually, or $850/month.
Of course, you’ll need to adjust that for inflation each year to reach your ultimate target in terms of purchasing power.
After all, it would be a shame to reach that $800,000 only to realize that in today’s dollars you only have $424,500! That’s what would happen after 32 years of 2% annual inflation. If inflation averages 5%, you’d only have $167,893 in today’s dollars.
So what does all this mean?
The bad news is that your current $10,000 isn’t going to cut it.
The really good news is that you’re almost there, you just need to increase your annual set-aside by 2%, going from 15% of income to 15.3% of income.
You can do it!
Your 3 Simple Steps to Building Wealth
The first step is one you’ve already taken — buy a home at a fixed affordable monthly payment. Ideally, that’s under 28% of income, but in no case more than 36% of income. Generally, you want to target homes that cost under 3 times your annual income, but these days that’s very hard to do. Thankfully, with mortgage rates near historic lows, you can squeak by with 5.5 times your annual income.
I first did this somewhat late, at age 38. At the time, I was paying $1600 a month rent for a 3-bedroom apartment in a not-so-great part of town, and that was by far the best deal available at the time. In today’s dollars, that translates to $2587/month.
Assuming a 20% down payment, 1.2% of house value for insurance and taxes, and a 3.5% 30-year fixed mortgage, I could buy a home worth over $570,000 and have lower monthly payments. And that’s before counting the mortgage interest tax deduction or the fact that part of each payment pays down principal and increases my net worth. Plus, rent is almost guaranteed to go up with inflation (if not more), while a fixed mortgage keeps your payment constant (though the insurance and taxes do go up over time).
Your second step is also simple, and surprisingly easy. Each time you get a raise, bonus, or significant cash gift, direct at least half to your retirement savings. Personally, I target 2/3 to savings. Spending the remainder on great experiences, replacing an old clunker of a car, or some other improvement to your standard of living is ok. In fact, it’ll make it easier to stick with your long-term plan.
However, take into account that if you increase your spending, you’ll need to revisit your portfolio target. For example, say you just got a 10% raise, and decide to save half of it, and spend the other half. Your portfolio target just increased from $800,000 to $840,000, and your annual savings requirement upped from $10,200 to $10,700.
That seems a burden, until you realize that investing the other half of your raise increased your $10,200 to $13,500. This is how you painlessly increase your savings rate, while balancing your future self’s needs with your present self’s desires.
The great news is that if you stick with this step, you’ll likely blow past your target portfolio value much earlier than you ever thought possible. In my case, I only started setting aside and investing serious money toward retirement 13 years ago, and I already have more than I imagined possible back then.
The third step is also simple. It’s to invest your long-term money in the stock market or some other plausible-risk, high-return asset. I’m not advocating you take up day trading, or dumping all your money into crypto, or even that you start investing in individual stocks.
Instead, learn how to pick good mutual funds or exchange traded funds (ETFs) and/or educate yourself on building wealth through rental real estate. Preferably, do both to diversify your investments.
While this last step is simple, it isn’t always easy or painless. On average, the stock market loses money about one year in every 4, and while it has averaged about 6–7% inflation-adjusted returns over the past century, it has lost over 20% in a single year dozens of times.
The important thing is to not panic-sell when it crashes.
Just remember that on average, the market has made it back from such losses in 2–3 years, and even in the absolute worst case, it has never had a 20-year period with losses. If you think the market is currently overheated, with a poor risk/reward ratio, you can temporarily allocate more money to safer assets (e.g., money market funds, CDs, short-term bonds, etc.), and move them back into stocks once the crash comes.
The Bottom Line
Even on a median income, which is less than 1/7 of the top-1% income, you can build real wealth. By that I mean a portfolio large enough to cover your retirement spending.
All it takes is a bit of knowledge, a bit of planning, a good bit of grit to keep on plan when (not if) things go sideways for a while, and following the above 3 simple steps.
This article is intended for informational purposes only, and should not be considered financial, investment, business, or legal advice. You should consult a relevant professional before making any major decisions.