Can you “buy” passive income?
Of course you can! This is exactly the whole point of saving your money and stashing it away for retirement and financial freedom. But how much is a dollar saved really worth? How much financial freedom does this really buy us in the future?
Up until what I’m about to show you below, this has been a pretty abstract concept for most people to wrap their heads around.
Sure, you could go to some fancy online calculator, punch in some numbers, and get some future value amount.
But how often do we really do that? For most people, they need that instant gratification of a reward that they can connect to their effort to:
- Save my money now, and I’ll have enough for a new car
- Save my money now, and I’ll have enough for the down payment on a new house
But in terms of how much passive income a dollar saved today will be worth to you, the answer is not so clear:
- Save my money now, and I’ll have $??? of passive income every year for as long as I live.
Not as transparent … That is, until now!
In this post, we’re going to go through the analysis and see just exactly how much annual passive income a dollar saved today could buy you in the future. This will be really helpful to you because you will now have a “reward” you can connect to your savings efforts.
How Savings Builds
The general misconception of saving money is often this tale:
- Put a dollar in the bank today, and
- Tomorrow I have a dollar to spend.
But of course we know we can do better!
By investing and letting compounding returns work their magic, we can start making money from our money. Eventually this will build into a pile of cash so large that we could withdraw a small amount of it every year, and the pile will never deplete.
To illustrate this point, let’s imagine you put $1,000 into an investment account, and put it all into a simple stock market index fund. We know from sources like Vanguard and NYU that overtime this stock market index will return approximately 10% annually.
If we adjust for inflation (approximately 3% per year), what will this $1,000 be worth after 10 years?
In other words, it potentially could be worth double what you started with!
What if we wait 30 years? Now how much will our initial investment be worth?
… approximately seven and half times our original value!
So without doing anything, no fancy investment strategies, no checking stock tickers, and no real action on your part, you managed to create 7.6 times the value of your savings – just by allowing time to pass.
By the way – Congratulations! You just beat over half of the so-called wiz-kid investors out there.
But that’s not the end of the story. The real power hasn’t even occurred yet!
Turning Savings Into Passive Income
What if we took our simple example to the next level higher, and made it so that this $7,612 pays us a “paycheck” of money every year for the rest our lives!
Is that possible?
Absolutely it is!
We know from the research of William Bengen that the 4% safe withdrawal rule is a reasonable place to start. Basically what this rule says is that there is a very high chance of success that if we start by withdrawing 4% from our savings and continue to do so (inflation adjusted) every year, we will not run out of money.
So let’s apply this knowledge to the $1,000 we saved:
- After 10 years when it grows to $1,967, we can withdraw $1,967 x 4% = $79 of passive income every year
- After 30 years when it grows to $7,612, we can withdraw $7,612 x 4% = $304 of passive income year
That’s absolutely amazing!
So, again, for doing nothing more than saving our money and allowing a significant amount of time to pass, we’ve created a steady and reliable stream of money that will continue to pay us for the rest of our lives!
This is a very powerful concept because it quantifies just how important saving your money can be. Every dollar saved could grow to be an endless supply of money you pay yourself in the future!
That’s definitely the road to financial freedom!
To fill in the blanks for other time periods and illustrate this point further, here’s a graph of just how much $1,000 would produce for you each year after allowing it to grow for a set number of years.
As you can see, depending on how much time you have to work with, there is a definite and real quantifiable benefit to each dollar being saved.
How Much You Need to Save for a Specific Income Level
So now that we know there is an actual relationship between a dollar saved today and how much passive income it could potentially generate for you in the future, we could look at this another way:
Let’s say you want to generate $1,000 of continuous annual passive income to enjoy in the future. The question then becomes:
How much money do you need to save right now in order to make that happen?
Using the same numbers and assumptions we just calculated above, we can work our equations backwards to find out how long we would need to save, and how much we would initially need to save. Again, this will give us some reasonable expectation as to how much our money would be worth after allowing it to compound for some finite amount of years.
Here the results below.
Again, this is really powerful stuff!
To illustrate, let’s say a young professional tightens his budget and decides he’s going to save the full IRS 401(k) maximum of $18,000 this year.
How much passive income will this generate starting in 30 years?
Look at the last row of the table above:
$18,000 / $3,284 = 5.48
5.48 x $1,000 = $5,481
Outstanding! One year of mega-savings just added $5,481 of future income for this individual!
Keep that up, and it’s going to be a very luxurious retirement for this person some day!
Obviously the numbers used in this example are for simplicity. There is never a guarantee that you will make money in the stock market. It goes up and down when it wants to. The stock market certainly never goes up at a real annual rate of 7% every year, and we only use that geometric average based on historical data.
Also, different investment types would produce different rates of return.
There is a very real and definite reward that comes with saving your money. Using a very simple investment method and being patient as time allows compounding returns to build, we can turn every dollar saved into future passive income. Multiple this fact across years of savings, employer contributions, and tax-sheltering, and you can easily and systemically build your way to a bright and prosperous financial future.
Readers – How do you quantify the value of a dollar saved today? How much future passive income do you think your savings will be worth one day?
Featured image courtesy of Flickr