A few months ago, I discussed the crossover point, the dollar amount you need so that proceeds from your investments exceed your living expenses. Here’s a visual example:

In the above graph, the person is investing 30% of their income each year and receives a 4% raise each year. That person reaches a crossover point at age 48 (crossing over living expenses) and a second one at age 53 (crossing over salary).

Why do I show you this? For some people, **the crossover point makes a brilliant long term investment goal**, one that can be broken down into smaller pieces over time. In fact, it’s a wonderful example of how to set and reach a long term financial goal. Let’s take a closer look.

First of all, **define the larger goal**. You want to reach the crossover point for your salary in twenty years? How much will that take? Take your current salary and multiply it by 1.04 times the number of years until you want to cross over – that’s the salary you need to shoot for. So, if you make $40,000 now and want to reach that crossover point in twenty years, you’re actually looking at a salary of $87,600 at that time. Assuming your investment will need an 8% annual return (you can figure higher, but this is a nice safe number to make sure you don’t start devouring your principal when you cross over), **you’ll need to have $1.1 million in investments in twenty years to reach that crossover point.**

Next, **define the general gameplan**. What percentage of your salary would you have to invest each year at that 10% rate to reach the crossover point in twenty years? It turns out you’d have to invest 36% of your salary each year, something that’s doable but very challenging. Can we break it down even more?

If you look at a month-long goal, you’ll have to save 3% of your annual salary each month, or $1,200. You can break it down even further to $300 a week. If you’re making $40,000 a year and have a low cost of living, can you sock away $300 a week? My best friend is actually doing something close to this, so I know it can be done.

**Then, focus on the short term**. One good way to approach this goal is to use nothing more than that weekly metric. Try to beat it every week by as much as you can so that during weeks where things crop up, you can deal with them. Each week, when you make that $300 (and especially when you blow by it), you can feel a sense of accomplishment.

**How can I do that $300 a week when I’m barely getting by?** Learn about frugality. Start cooking at home. Cut out unnecessary monthly expenses. **Get out of all of your debts** and don’t get back into debt. You also may have to define a different goal – look at a crossover point that’s further out, or simply define another goal entirely – perhaps a net worth of a certain amount by a certain birthday.

**One big advantage** to this type of goal is that it’s very flexible. If you’re moving towards this goal for five years, but then suddenly decide to get married and have children, you’ve got enough cash for a monster down payment. If you suddenly decide to start your own business, you have seed money.

A certain net worth is a great goal to have – it’s very tangible and lets you move towards it steadily, at your own pace. The way to make it work, though, is to make it immediate and stay vigilant.

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Trent,

I just noticed a little mistake in the third paragraph after the graph:

“Take your current salary and multiply it by 1.04 times the number of years until you want to cross over – thatâ€™s the salary you need to shoot for. So, if you make $40,000 now and want to reach that crossover point in twenty years, youâ€™re actually looking at a salary of $87,600 at that time.”

If I’m reading correctly, it sounds like you would multiply 40000 x 1.04 x 20.

Shouldn’t it be 40000 x 1.04^20?

Gah, I meant to say

40000 x 20^1.04

Need. Some. Coffee.

Angel – yes, you were right the first time.

But That’s what Trent’s numbers add up to.

However, I’ve read several times that the only safe number for withdrawals based on exhaustive historical data – if you plan to never work again & have much of your net worth tied up in an index fund – is 3% per year, not 8.

Angel—you were correct the first time. The equation is supposed to be

initial salary*(1+ percentage of yearly raise/100)^number of years

or

40000*(1.04^20)

It’s similar to the way you would calculate interest earned if it were compounded yearly…ie invest 40000 at 4% over 20 years.

Just finished reading Your Money or Your Life, and this is a great visual representation of one of the steps to FI. Great Post!

Regarding the safe withdrawal rates, here is a good article:

http://www.retireearlyhomepage.com/restud1.html

Basically it comes down to your risk tolerance and time horizon. There are lots of other good articles on this site.

3% seems pretty low, seeing as you can make 5% in the bank. Obviously the index funds might not beat the bank EVERY year, but if you stored away an extra year or two worth of salary in a bank, you could probably be safe with some down time in your index fund.

Plus, if you’re retiring at 45 or so, you can probably stand to work a little on the side in a down year ;). Or at least reduce your number of European vacations to say, 3 a year, instead of 6.

Getting a 4% raise for 20 years makes your new salary = 4000 x 1.04^20, or 87645. This is just a typo since Trent used 87600 as the result.

Trent, please post a spreadsheet, or go into more detail about how you calculated this — there isn’t enough information in your post to really understand what’s going on.

Thanks,

Jeremy

Why use salary rather than expenses for a crossover goal? The difference between my income and expenses should be in savings. Once I’m living off of my savings, the amount I’m saving should be zero, finances in balance.

Trent – thanks for a good article. I tried to cover something like this in my blog a little while back, but you have done it in a very clear and concise way. Keep up the good writing. I’m trying to reach that cross over point as soon as I can, and that’s a good way to talk about it.

Chris, if you use salary as a target, you can continue to invest and hedge yourself against inflation. If you use just your living expenses, you won’t be gaining ground any more (or at least not very much).

I just want to say how much I appreciate posts like this. I don’t understand numbers (with or without coffee), so “The Simple Dollar” really helps me wrap my mind around certain concepts. Although this idea is not new to anyone who has read “Your money or your life,” it is always helpful to see the concept spelled out through examples.

Keep up the good work.

s – 3% is not low, unfortunately. The problem is that you have to factor in inflation. Inflation runs at about 3% by itself. So in about 25 years, that 3% will get you 1/2 the buying power it did now.

Aside: Inflation is actually a much debated quantity. Many people think the US government is now under-reporting inflation. Others think it barely exists at all (see

Your Money or Your Life).To follow up on lorax’s point to “s”:

If inflation is 3% you need to save that much from your 5% so your interest next year keeps up with inflation. But your friendly Uncle Sam is going to tax the entire 5%. Say your combined federal and tax rate is 20%. 20% of 5% is 1%. So after taking 3 of the 5% interest to compensate for inflation and 1% for taxes you’re left with 1%. If you had $1 million in the bank, that’s only $10,000 to live on. If you managed to have that much in a tax-deferred IRA, then you’d get to take out 2% on which you’d have to pay taxes. $20,000 less taxes. Better than $10,000, but you’re still eating cat food.

And that’s also a point to Trent. Yes, having your investment gain equal your salary is noteworthy. But it’s not good enough on which to fully retire. If gains minus inflation minus taxes is greater than expenses, then you could think about it. That is if you can expect the gains to continue consistently. A few bad years in a row can put a serious dent in your portfolio.

i created a spreadsheet to play with the numbers, with the following columns: my income, wife’s income, total income, spending, investing, return, and portfolio. this made it very easy to play with the numbers and make them more realistic, e.g. wife leave job in 3 years and goes to school full-time, etc.

as i was pasting left and right, something that’s fairly obvious struck me: the lower your income (and, hence, spending), the sooner your crossover point will come. who knew living frugally/modestly could buy you several years of freedom?

p.s. true, there is inflation, fluctuations in the market, etc., but i think the point still stands.

p.p.s. if anyone’s interested, i’ll be happy to provide the spreadsheet.

ataman..

easier to hit the crossover with less income? I beg to differ. One can with effort save 36% of a 40,000 income (leaves you with 25,600 to live on).

But to save 36% of a 30,000 income leaves you with $19,200. This is an amount which is much more difficult to live on. Perhaps possible depending on debts and the area of the country.

At 25,000 you have only 16,000 to live on. There comes a point where you cannot reduce the amount expenses proportionally to the income.

But the reverse is true. As your income increases it is easier to _not_ increase your expenses proportionally….

Okay, so my brain is -incredibly- broken today. In fact trying to add 1 and 1 gives me 3. But I’m still want to figure this out. Can someone drop down … not the an excel sheet, but what is in each equation is? I’m trying to create it, in general terms. If can re-create it means I understand. Thanks.

@Sharon:

I ran a similar calculation quite independently last night and came to the same conclusion: the lower my salary is now the lower it will be in 20 years, and the less I’ll have to save to reach the crossover point. I might have to save 25% to 30% of 30,000, but it won’t be 36%…

@Dave:

Here’s my rudimentary stab at this:

http://spreadsheets.google.com/pub?key=pQmY2tyk-bfcGTc64A7BaXA

Great post. I love the concept (and loved the book Your Money Or Your Life). It’s a little early in the am for me to wrap my mind around the math, but I have a lot of debt to pay off before I can work on this part.

This is a great post. I’m new to this blog and you really seem to have a good grasp on figures. I’m 24 and just now starting to learn how to really save and build wealth. (I’ve also started a blog to archive personal achievements and seek feedback along the way). Good Advice.

Great post! I don’t think that I will be able to invest $1200/month because I’m struggling with $700 right now. However, it is good to give yourself a goal to shoot for.

@MITBeta

I took a look at your worksheet, but I’m wondering if you could label your columns? I’m sure I could figure it out, but isn’t that the nice thing about Google Docs – someone else does all the work? :)