5 things to do now so you can retire before 40

Sam Dogen and his son play in Golden Gate Park, San Fancisco.
The Financial Samurai
Sam Dogen and his son play in Golden Gate Park, San Fancisco.

Passive income can translate to life-long success. But anything passive first takes active energy. The best time to put in the effort is when you are young and not yet ravaged by disease or burdened by family obligations. And, thanks to the power of compounding, the sooner you start, the easier it is to hit big passive income milestones.

It took me 13 years to build my framework, and I started off making $40,000 a year, living in Manhattan in a studio with a roommate. I went on to make much more, and being lucky enough to get a high-paying job gives you a real advantage. Still, getting to a place where you can retire early takes commitment and hard work. At age 34, I finally had the guts and the resources to negotiate a severance to be free.

Although it may seem daunting to build a passive income stream you can live on, the key is just to start. Save $100 and you'll be able to generate $3-$7 a year in passive income, depending on how much risk you take. Once you save $1,000, you'll be able to generate $30-$70 a year in passive income. Eventually you'll gain enough momentum where your passive income will start paying for significant expenses such as food, clothing, or transportation.

If you can work on building passive income for at least 10 years, you'll be able to taste more sweet freedom.

5 ways to generate the passive income you need to retire by 40

1) Save each month until it hurts. Without a healthy amount of savings, nothing works. You need to save at least 20 percent after contributing to your 401(k) and IRAs, since you can't touch pre-tax retirement accounts without a penalty until 59.5. Ideally, everyone should first max out their pre-tax retirement funds. However, if you don't have enough funds to do that and still want to retire earlier, then concentrating more of your money in after-tax investments may be preferable.

This savings guidance chart may be helpful if you would like to retire early. It shows, for example, that if you save 50 percent of your after-tax income for 18 years right out of college starting at age 23, you should be able to retire at around 41 years old. With 18 years worth of living expenses, you can last until 59 before you completely run out of money. But since you will be earning a risk-free rate of return of at least 3 percent during your 36 years, you should easily be able to make it until Social Security kicks in.

To understand this better, let's look at some numbers. If your disposable income is $100,000 a year after taxes, saving 50 percent means living off $50,000 and putting away $50,000. After 18 years, you will have saved $900,000. Given you were living off $50,000 a year, by definition you have 18 years of living expenses before running out of money at age 58.

But given that you can earn 3 percent risk-free a year by buying a 10-year treasury bond, you will have actually accumulated at least $1,200,000 after 18 years. At a 5 percent rate of return, you will have accumulated $1,476,000. And at a 7 percent rate of return, you will have a handsome $1,819,000. With $1,476,000 - $1,819,000 in capital at the age of 40, you can earn $44,280 - $54,570 in gross passive income assuming just a 3 percent rate of return. Therefore you shouldn't ever run out of money, especially after Social Security kicks in.

Note: Inflation erodes your long term buying power. The good thing is, so long as you earn at least a risk-free rate of return as dictated by the 10-year government bond yield, about 3 percent, you will be keeping up with or beating inflation. After all, in order for the government to sell treasury bonds, the yield must be higher than inflation to attract buyers.

What I did: From 1999 - 2012, I saved 50 to 80 percent of my after-tax, after-401(k) contribution every year because I had a goal of leaving finance by 40. However, at the age of 34, I decided to negotiate a severance because I had already saved over 30 years of living expenses. The severance gave me an additional six years worth of living expenses, which made leaving my well-paying job that much easier. Today I live 100 percent off my passive income and reinvest 100 percent of any income I make online or from part-time gigs like coaching high school tennis to build even more passive income.

"You need to have passive income goals. Otherwise, it's easy to lose focus and give up."

2) Determine which type of passive income suits you best. Earning a 3 percent risk-free rate of return is the minimum return expectation because it is guaranteed if you buy a 10-year government bond yield. In reality, you should be taking more risk when you're in your 20s and 30s to try and achieve a higher rate of return. Time and energy are on your side.

From market history, we know that a 100 percent bond allocation has a historical annual return of 5.6 percent between 1926 - 2016. Meanwhile, a 100 percent stock allocation has a historical annual return of roughly 10 percent, including dividends. You must decide how much public investment risk you want to take based on your financial needs and risk tolerance.

Beyond public stocks and bonds, there are other asset classes that provide passive income such as private equity, venture debt, P2P (peer-to-peer) lending, real estate crowdfunding, and creating your own online products. The best way to determine worthwhile passive income streams is by understanding their risk, return, feasibility, liquidity, and maintenance activity.

What I'm doing: I've accumulated 10 different passive income sources based on my interests and for the sake of diversity. However, I plan to reduce exposure to private equity and P2P lending once these investments come due. I think private equity valuations are too high and P2P lending returns are becoming less compelling. My favorite passive income source was physical real estate in my 20s and 30s but, now that I'm in my 40s, I'm focused on more passive real estate investments.

3) Determine your passive income's purpose. You need to have passive income goals. Otherwise, it's easy to lose focus and give up. A good first goal is to earn enough passive income to pay for food each month. A second goal could be to earn enough passive income to pay for transportation, and then rent and so forth. Calculate your overall basic expenses necessary for survival. Once you have those expenses covered, you are free to take more risks.

What I did: Based on years of budgeting, I determined that $80,000 a year in San Francisco would be enough for me to live a comfortable retirement life. After leaving work, I calculated that we would need to earn $150,000 if my wife were to join me in retirement. Today, we have a goal of consistently generating at least $200,000 a year in passive income in order to also provide for our son.

If we decide to move from San Francisco to the heartland, where everything is cheaper, perhaps my family can have an equally great quality of life with half that amount. Once you're able to generate enough passive income, there's no need to live in an expensive, congested city anymore.

"When it comes to their personal finances, too many people go through life just winging it."

4) Hold yourself accountable. Mark Spitz once said, "If you fail to prepare, you're prepared to fail." You must create a system where you are saving X amount of money every month, investing Y amount every month, and working on Z project until completion. Things may be slow going at first but, once you start to save a little bit of money, you will build momentum. Eventually, you will find synergies between your work, your hobbies, and your skills that will translate into viable income streams.

What I'm doing: I use Financial Samurai to write out goals and to keep myself accountable. I also keep track of my net worth and all 10 of my passive income investments with free online financial tools. I don't want to wake up 10 years from now wondering where all my money went. When it comes to their personal finances, too many people go through life just winging it. Given there is no rewind button. You must stay on top of your finances and watch them like a hawk.

5) Don't make withdrawals. The most frequent setback for people looking to build passive income is that they withdraw funds from their financial accounts too soon. There's somehow always an emergency which eats away at the positive effects of compounding returns. Make sure your money is invested and not just sitting in your savings account. The harder to access your money, the better.

What I do: I've set up multiple investment accounts outside my main operations bank that deals with working capital, e.g., checking, paying bills. By transferring my money to a couple brokerage accounts and two other banks as soon as it hits my main bank account, I avoid the temptation to spend on frivolous things.

Investments such as venture debt and physical real estate are less liquid than stocks and bonds and therefore may help you to invest for the long run. When the financial world was falling apart between 2008-2010, It was too difficult and too costly to sell my properties. Therefore, I just held on and collected rent. But with stocks, it was much more tempting and easier to bail.

Passive income snapshot for 2018-2019

Below is my latest estimated passive income streams which total about $204,000. My goal is to keep my passive income above $200,000 so that we'll be enough to pay for our son's grade school education if he can't get into his local public school in San Francisco.

CD interest income, $5,580/year: I only have one CD account left paying 3 percent. It expires at the end of 2018 and I'll have to reinvest the proceeds in another risk-free asset. I like to have at minimum 2.5 percent of my net worth in risk-free investments. Thanks to a rise in short-term interest rates and a flattening yield curve, I'm most likely going to build a CD Step Stool and not a CD ladder.

Online savings, $5,100/year: I'm actively trying to build a large cash stash given we've had such a strong bull run since 2010. Further, given higher interest rates, it no longer feels like a sin to keep cash in a money market account earning 0.1 percent.

Dividend income, $39,516: Dividend income is wonderful because it is completely passive and is taxed at only 15 percent if you are in the 10, 12, 22, 24, 32 and even 35 percent federal income tax bracket. If you are in the 37 percent income tax bracket, you will pay a 20 percent tax on your dividends. My dividend income portfolio consists mainly of dividend equity and bond ETFs.

Municipal bond income, $61,872: I own a portfolio of individual California municipal bonds that I plan to hold until maturity and several bond ETFs. Although the Fed is raising rates, I don't believe long-term rates will rise much higher. In other words, I expect the yield curve to flatten or invert by 2020, portending a recession. In such a scenario, fixed income investments should outperform equities.

Real estate, $43,080: I currently own one rental property in San Francisco which I bought in 2003 (2/2 condo), one vacation rental in Squaw Valley, Lake Tahoe (2/2 condo), and my primary residence. My rental income can have 25 percent swings depending on how good the weather is in Lake Tahoe during the winter.

Online book sales, $36,000: I published How To Engineer Your Layoff in 2012, six months after I had negotiated my own severance. Then I updated the book for 2018 with 50 more pages, so it's now 150 pages, total, using more successful case studies and highlighting more strategies for those who want to break free from the corporate grind with money in their pocket.

Venture debt, $12,240: I invested $200,000 in my business school friend's second venture debt fund. The target IRR is anywhere from 12 to 18 percent a year over the next 5 to 10 years. I'm hopefully being conservative as the returns are back-end weighted.

Real estate crowd-sourcing, $9,600: After selling my SF rental house in mid-2017 to simplify life and take advantage of high valuations, I proceeded to reinvest $550,000 of the proceeds ($810,000 total) in real estate crowd-funding to take advantage of lower rates and higher net rental yields in the heartland. With the SALT deduction capped at $10,000 and a lower mortgage amount maximum of $750,000 to deduct mortgage interest against, I expect coastal city real estate to slow and heartland real estate to outperform.

With sustainable passive income, you can:

  • Retire early and travel the world
  • Start a business in a field you are passionate about
  • Find a job that pays less, but is more interesting
  • Stay at home to take care of your family without having to worry about money
  • Volunteer for causes you truly care about
  • Be a big brother or big sister to kids in need
  • Spend more time with your parents
  • Sit in a coffee shop on a 76 degree day in Santorini for hours on a Monday afternoon
  • Write the next great novel from the balcony of a cruise in the Mediterranean
  • Eat tapas and drink sangria in Barcelona until 1 a.m. on a Monday evening
  • Live longer due to much less stress
  • Look and feel better due to much less stress
  • Experience perfect endless summers over and over again

Plan and get started already

Building a significant amount of passive income takes a long time. But once you gain some momentum, you will be hooked on seeing your money work hard for you.

If money is tight, consider creating your own income producing products that require little-to-no startup capital. I never knew that, one day, a book about how to negotiate a severance would generate more passive income than the rental income from a $1,200,000 property. There is a reason why we worked so hard on our creativity as kids.

Your goal is to build enough passive income so that by the time something inside you vigorously wants a change, you'll have the financial means to make it happen.

All the best on your passive income journey!

Sam Dogen started in 2009 as a way to cope with the financial depression. In 2012, he negotiated a severance after 13 years in finance in order to be free. He now spends most of his time taking care of his baby boy, writing about personal finance and playing tennis.

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