By Dr. Jim Dahle, WCI FounderI realized something only a few years ago. I'm not sure why it took so long. It seems simple and obvious now. You've probably already realized this, but if not, here's a nugget of truth:
How much of my gross income can I spend each year and expect to sustain my standard of living throughout my life?
It turns out the answer to that, at least as a general rule of thumb for a high-income professional, is “about half.” Why is that, you ask? Because the other half has to go to taxes and savings. It has to. The taxes aren't optional, and they're going to be fairly high for most of us during our peak earnings years. The retirement savings are optional, I suppose, but not if you wish to avoid eating Alpo.
Take a look at the math.
Taxes Eat Up Lots of Your Gross Income
First, let's think about taxes for a bit. When I was making the average physician income, my effective tax rate was in the teens. But it turns out I was a fairly unusual case. Most docs pay an effective tax rate in the 20%-30% range—some a little more, some a little less. If you subtract 30% of your gross income for taxes, that leaves you 70%.
More information here:
Top 10 Ways to Lower Your Taxes and Lower Your Tax Bracket
The 1 (Weird) Tax Trick the IRS Hates
Safe Savings Rate
Next, let's look at what kind of a savings rate is needed to provide a reasonable retirement. Long-term readers know I generally recommend docs use a 20% saving rate. Will they be OK with 15%? Probably. But 5%-10% just isn't going to cut it. Let's demonstrate why it needs to be higher than that with a simple future value calculation.
Let's take a doc making $200,000 who starts saving for retirement at 35 and hopes to retire at 60. They earn 5% real on their investments and save 20% a year. How much will they have at age 60 and how much of their pre-retirement income will that replace? Plug this into your friendly spreadsheet:
=FV(5%,25,-40000) = $1,909,084
Multiply that by about 4%, and it gives you an income from your portfolio of about $76,000 real per year. That's about 38% of your pre-retirement income, which is smack dab in the middle of that 25%-50% range that a typical doctor needs in addition to Social Security to maintain their standard of living in retirement (assuming the kids are launched and the house is paid off).
Subtract out another 20% from that 70% you had after taxes, and that gets you to 50%. That's what you can spend if you hope to avoid ever having to decrease your standard of living. Said another way, if you spend more than that regularly, you're going to have a lower standard of living in retirement.
More information here:
Higher Earners Have It Worse
The percentage gets even worse if you make and spend more than the typical doctor. That's because the tax code is progressive. It is progressive during your earnings years, and it is still progressive in your retirement years. In addition, the more you make and spend, the lower your relative contribution from Social Security will be.
Consider another example:
How much peak earnings income does it take to create a sustainable $400,000-a-year after-tax spending level? A lot more than you might imagine. Let's start at the end and work back to the beginning.
To spend $400,000 a year in retirement, you need about 25 times that as a nest egg, or $10 million. At that sort of spending level, Social Security can almost be ignored. But wait, you need $400,000 in after-tax money. At that sort of tax bracket, you're probably looking at an effective tax rate of at least 24%, perhaps 32%, even in retirement. We're really talking about perhaps a $13 million nest egg.
How much do you need to put away each year at 5% real to have $13 million after a 25-year career?
=PMT(5%,25,0,13000000) = $272,381.
Add that on to your $400,000. Now, we're up to $672,000 you need to earn to sustain a $400,000 spending level. But wait, we haven't considered the taxes as you're earning the money. At that sort of income level, perhaps 35% of what you earn is going to be going to taxes. That means you need a gross income of $1.04 million during your career to sustain a $400,000 spending level throughout your life. That's 38%, significantly less than the 50% for an “average doc.”
Sobering, isn't it? I've written before that you can never grow all the way into your income. If you're smart, you'll never grow into more than half of it and you'll begin your career living like a resident on much less than that. And we're not even talking about retiring early here. This is just regular old retirement.
Did you imagine that you would only be able to spend 40%-50% of your gross income when you applied to med school? How much of your gross income do you spend after taxes and savings? Do you think that is too little or too much?
[This updated post was originally published in 2017.]
Great post. Is inflation considered in the 5% ROI? When considering even a modest inflationary rate I had to increase my target retirement fund significantly to have the option of early retirement lasting several decades (just turned 40 & am tracking to have the option at 50).
Yes, I use 5% real (after-inflation) in my calculations. If you prefer a higher or lower number, feel free to use.
I don’t understand the notion that spending as a percentage of income should be constant as income increases. The percent of income spent should drop sharply. Taxes will go up, but many costs are no higher for someone in the 1% than for anyone else. Orange juice is orange juice no matter how much money you have. Postage stamps and gasoline coat the same. My income has been relatively stable and reasonably high by national standards. We save more than we pay in taxes and pay more in taxes than we spend. For this calculation we agree with the comment above that sales and real estate taxes are considered consumption.
We don’t take fancy vacations because.they are a waste of money. A nice benefit is that by avoiding flying all over the place we also limit our carbon footprint. We buy cars used and replace them when they wear out, after 15-20 years. Short commutes save money and again limit emmissions. I hate fancy restaurants, don’t drink alcohol, don’t collect things, buy my work clothes at thrift shops and on eBay, skip lunch… The consequence is that I have been financially able to retire for years, but by continuing to work I further increase my margin of safety and ability to provide for my heirs.
I don’t feel any need to spend as much as I can. Being the richest corpse in the graveyard would be an admirable goal, but there are plenty of people who generate so much more income that we will never be close.
What I don’t get is the notion that the only limit on spending is fear of poverty. Once your real needs are covered- healthy food, clean water, safe roof over your head, medical care when you need it- a huge share of spending is simply wasted. People convince themselves they need a lot of expensive things that were invented solely to separate them from their money.
Stop wasting money and retirement should be no problem for any physician.
While I don’t disagree with your last sentence, I think your spending should be guided both by your income and your happiness. If expensive vacations don’t bring you any happiness, then sure, don’t take them. But some people actually derive some level of happiness from not wearing thrift store clothes, eating lunch each day, and celebrating a special occasion at a fancy restaurant and would much rather use their money on that rather than estate taxes.
Great post! Would you consider saving for a down payment for a house to be in the “save” column or in the “spend” column?
Uhhh…..such hard questions. I guess save. But when you actually buy the house, that’s spend. 🙂
I didn’t have this site when I started my training, but we didn’t have money growing up, either. I was lucky that way; I learned delayed gratification from infancy. It was a really good lesson.
Became a high earner with relatively less debt than peers, bc of undergrad and med school merit scholarships and financial aid. Still had to borrow for med school a bit, but on the order of $40k. But I was paid less than half average salary at my first job, because I wanted the academic position, and they were paying pcp income to a surgeon.
Now, here’s where WCI’s lessons really came in handy (though I hadn’t found the site then, if it existed). I became really ill out of nowhere, 5 years into practice. And it scared me.
I got somewhat better after a scary year, but salary was lowered bc of my illness, so I had to pick up and move elsewhere to improve my salary. That was when I also cut back so that I lived as WCI describes, on 1/3 of gross or half of net, and started a brokerage account at last, instead of just relying on tax advantaged accounts. I downsized my home, too, and couldn’t really spend as much on travel anyway. I was six years into practice then.
By year 12 of practice and having undergone multiple surgeries and complications, I had to retire. It was terrifying in my mid 40s to be in that situation. But that aggressive level of savings was a huge help. Now, even getting by on a modest disability income, I know that as long as I keep my hands off my investments (and I’m no brilliant trader, mainly set and forget, and have made several lackluster purchases), I’m going to be okay. Even with outrageous medical expenses (Medicare mostly doesn’t have caps, folks), crazy prescription prices, and COLAs that don’t keep up with inflation, I’m not going to be destitute when disability payments stop. And as a single person with no outside resources or expected inheritance, no kids, this is a huge relief.
Morals of the story? It’s not too late, for one. Start now, even if you were more profligate before. I only got seven years working (while ill and undergoing several surgeries and months of underpaid leave) in which to build my nest egg, already badly underpaid for my specialty as a female, and really, only started investing in brokerage accounts four years before having to retire. But I had a good chunk to throw at it, put my savings there and probably closer to 70 % of net income for those last four years, just because I was afraid I would have to retire early. When it happened, I was still terrified, but over time, I realized it was going to be fine. I can live comfortably now, but I still will have enough for later.
The problem in life is that there are no guarantees. You can have a brain tumor tomorrow, or be crushed in a car accident. Living like this isn’t just for retirement years from now. Even when it doesn’t happen at 65 as planned, this is still a foundation for a safe and comfortable retirement.
Oh, and if I do have cash saved, I use it to pay for Roth conversions each year, small ones to stay in a decent tax bracket. And that will lower RMDs and taxes later, and give me more flexibility with spending down my savings in the future, when needed.
I’m sorry to hear about your challenges, but nice job overcoming them. Thanks for sharing your story.
It also demonstrates the importance of getting enough of a disability benefit to be able to continue to save for retirement.