• 02:27:16 am on October 21, 2008 | 8

    Accounting for Inflation

    I just want to go over the way that we account for inflation when it comes to calculating our Number

    Let’s look at how Josh calculated his Number:

    240K per year x 20 = 4.8 million. The amount I would need to realize 240K per year in interest.  If I were to factor in inflation for 7 years from now, I would need – 6.35 Million (assuming 4% inflation). If I were to factor in inflation for the next 75 years (the amount of time I would plan to live for) I would need 96 Million (assuming 4% inflation)

    Josh is accounting for inflation:

    a) Leading up to achieving his Number, then

    b) For inflation after achieving his Number.

    Josh understands that inflation is the pup nipping at your heels … you hardly feel it until you look back and realize that all those little nibbles have taken a chunk out of your shoes.

    It’s the thing that causes a sixteen ounce loaf of bread to cost $0.19 in 1950 and $2.10 in 2008 …

    And, if inflation averages just 4% a year for the next 20 years (BTW: predictions are for 5%) that same loaf of bread will cost you $4.10 in 2018, just at a time when you are wondering what that walking stick is going to cost you!

    So, you need to allow for inflation, in order to maintain your expected lifestyle for as long as you can live to enjoy it …

    Here’s how:

    a) Adjusting for Inflation while you work on achieving your Number

    1. This is simply a matter of calculating your required income and other expenses (e.g. house, cars, etc.) as though you were buying them today.

    2. Then decide how long it will be before you reach your Date i.e. the date that you want to begin ‘life after work’ (you know, when your Number has to begin supporting you for the rest of your life).

    3. Then to estimate the cost of that same item:

    5 years out, simply add 25% to the current cost.

    10 years out, simply add 50% to the current cost.

    20 years out, simply double the current cost.

    Simple!

    OK, now that you have achieved your Number, how do we make sure that it will last the rest of your life?

    b) Adjusting for Inflation after you have achieved your Number

    This is even easier; inflation is already built into the Rule of 20!

    You see the ‘rule of 20’ really allows for you to spend 5% of your capital / nest egg (i.e. Your Number) each year.

    But, let’s assume that you can earn 10% (after tax) on your money each year (that should be easy IF you have plans for your money OTHER than just letting it sit in the bank!): that leaves you 5% to spend and 5% to reinvest to allow for inflation.

    That means that if your Number was $1 Million, at the end of the first year you would have earned $100,000 interest of which you spent $50,000 and saved $50,000 … meaning that your ‘nest egg’ has now grown to $1,050,000 – just enough to keep up with inflation (i.e. it’s still only ‘worth’ $1,000,000 today … but, that’s good enough for us).

    Better yet, our income also rises with inflation because the next year we get to withdraw 5% of $1,050,000 which is $50,250 … a ‘pay rise’ of $250. Again, just enough to keep up with inflation.

    Now, there is timing associated with this (i.e. during Year 1 if you withdraw $50,000 then you will not be earning interest on the full $1 Mill. for the full year), but it is close enough for helping us come up with our Number.

    So, Josh needs $6.35 Million if he’s going to stop working in 7 years, but he doesn’t need to build up $96 Million before he retires – i.e. to last the next 75 years – and, he doesn’t even need to think to much about that number throughout retirement: inflation and reinvestment of half his dividends will automatically do that for him!

     

Comments

  • Scott 8:08 am on October 21, 2008 | #

    Adrian, when you consider withdrawing 5% of your number to use this as ‘income’ to live your life’s purpose, is this a full ‘after tax’ 5% of your nest egg? In other words, on a number like 5 million, a full 250k withdrawn that can be spent over the course of that year?

    If so, how are taxes calculated on invested money(on money making 301 strategies) and capital gains as it applies to what we are trying to achieve here? Is it merely based on whatever tax bracket you fall into depending on how much you earned in interest for that year(similar to working income)?

  • AJC 10:50 am on October 21, 2008 | #

    @ Scott – Great question for my LIVE show on ajcfeed.com this Thursday!

  • Scott 12:17 pm on October 21, 2008 | #

    LoL, ok, I just hope my internet at home is back up. It’s been down all week 😦

  • AJC 1:22 pm on October 21, 2008 | #

    @ Scott – Phone a Friend? 🙂

  • Scott 4:31 am on October 22, 2008 | #

    YAY, internet is back up again! Now it shouldn’t be a problem to tune in on Thursday night!

  • AJC 10:08 am on October 22, 2008 | #

    @ Scott – Great 😦 Now, I’ll have to think up an answer to your question …

  • Diane 11:16 am on October 29, 2008 | #

    I hope I can find an answer to this question! I am learning that there is a difference in how to do things in real estate transactions that make a difference in whether something is taxed at one’s normal rate and whether it qualifies for the capital gains tax. I’d never really thought about that before.

  • AJC 12:26 pm on October 29, 2008 | #

    @ Diane – It is very difficult to plan for future taxes, so I don’t try … who knows (beside McCain/Obama) when you sell whether Capital Gains Taxes will be higher or lower than Income Taxes?

    Instead, plan to hold for the long-term and ask your accountant to set up a structure that minimizes:

    (a) your liability-related risks (e.g. your tenant sues you; or there is a fire and insurance fails to pay out), (b) current taxes on the property ingoings (and/or maximizes future benefits, if you are carrying a short-term ‘paper loss’), and
    (c) the cost of setting up (a) and (b)

    For your first residential rental property, this may simply mean ‘do nothing’ and leave it all in your name … all the way thru’ to setting up a complicated trust + (multiple) LLC structure.


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