The Power of Compounding
I’ve followed the news this week about the Invest America Accounts (‘Trump Accounts’) and no matter what you or I think about the politicians involved, if someone from the FI Community were to design a plan to make Americans wealthy, it would be hard to do better than a loose framework of:
Every citizen having a long-term permanent investment account funded from birth with low-cost index funds being the default option.
For fun, I went to a compound interest calculator to see what we’d have to invest monthly to have a $5,000 monthly income stream from our investments at age 70 (when you’d normally max out your Social Security benefits).
To assume this $5,000 monthly income stream, that means you’d pull $60,000 per year from your investments. Using the 4% rule of thumb, if you had $1,500,000 you could withdraw $60,000 annually, so we are solving for the monthly contribution at different investing age starting points to reach $1.5 million.
(assuming 8% annual return and monthly compounding)
Start Investing at to reach $1.5 million by age 70:
- Age 0: Monthly contributions: $38 (annual: $456)
- Age 10: Monthly contributions: $85 (annual: $1,020)
- Age 20: Monthly contributions: $189 (annual: $2,268)
- Age 30: Monthly contributions: $430 (annual: $5,160)
- Age 40: Monthly contributions: $1,007 (annual: $12,084)
- Age 50: Monthly contributions: $2,546 (annual: $30,552)
- Age 60: Monthly contributions: $8,200 (annual: $98,400)
It’s astonishing to see the power of compounding and starting early, but there’s also good news in there for “late starters”:
If you’re 40 earning $100,000 and you haven’t saved a dollar yet, but you commit to saving 12% of your income, you’ll be financially set in 30 years.
That’s staggeringly powerful and a great starting point.
Munger on Reading
One of my favorite Charlie Munger quotes is this one:
“In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time — none, zero. You’d be amazed at how much Warren reads–and at how much I read. My children laugh at me. They think I’m a book with a couple of legs sticking out.”
This is a lesson I reiterate to my daughters frequently: The best way to become knowledgeable in life is to read voraciously. Read everything you can get your hands on and learn consistently throughout your life.
Capital Gains Tax on Primary Residence
Last week I highlighted the power of the 0% long-term capital gains tax rates where you can “harvest” capital gains and today I want to revisit another powerful aspect of the tax code:
Capital Gains Tax Exclusion on Your Primary Residence:
Many of us have seen our homes increase in value significantly over the past few years, which for homeowners is obviously a great thing. I have a friend who is selling their home and they asked me how this appreciation would be taxed, and I realized this would be perfect for the FI Weekly:
As always, this is not tax advice as I can’t give you specific info for your life, but in general the US government gives us significant tax advantages for appreciated primary residences.
First, the gain is taxed as a “capital gain.”
If you’ve owned your home for less than a year, this is taxed as ordinary income, since it is a short-term gain.
If a capital asset has been owned for more than a year it’s taxed at special long-term capital gains tax rates. For most taxpayers that’s a 15% Federal tax rate.
That’s beneficial, but where the magic comes in is with the ‘exclusion’ on capital gains tax for your primary residence.
For single filers, $250,000 of your appreciated gain is completely excluded (non-taxable, $0 of tax) and for married filing jointly that exclusion doubles to $500,000.
Critical note: This must have been your primary residence that you lived in for a total of 2 of the previous 5 years to qualify for the exclusion.
Let’s assume a married couple bought a home in 2010 for $300,000, lived in it continuously, and it increased in value to $750,000 today.
They would normally have to pay tax on the $450,000 capital gain, but since they qualify for the exclusion, they pay ZERO dollars in Federal Tax on this sale and the resulting gain.