How Does Passive Income Figure Into Your Retirement Calculations?

We all need financial goals. It’s always surprising to me when I speak with doctors who don’t know what their goal nest egg for retirement is. Without a goal, how can you set a plan? And without a plan, you are in trouble. So, this post will visit two important concepts: (1) figuring out your retirement goal and (2) understanding how passive income figures into this retirement goal.

And this second point is very important. Ignoring passive income in our retirement calculations puts us at risk of either:

Ignoring an important option in our journey to financial freedom (passive income), or
Overestimating your required nest egg for retirement

Let’s start at the beginning…

How much money do we need for retirement savings?

This seems like a simple question on its face, but it’s one that requires a lot of forethought and planning.

Your goal nest egg is such a major factor in setting the how and when of retirement. Once you set your number, you can focus on attacking these important questions.

Without knowing your goal, I can assure you that you will never get there. If you don’t have a set, determined retirement savings amount, you won’t know when you can stop working. More importantly, you won’t know if you will have enough money to live on when you want to stop working.

Again, the concepts are not difficult but so many of us fail to take these steps. Not knowing where the end is can certainly lead to burn out.

Determining the goal retirement amount for my wife and I was one of the first steps that we took after becoming financially literate.

How do we find our number

First, you really should have a budget that includes monthly and yearly expenses for needs and wants.

Knowing your expenses

I’m not going to go into the nitty gritty of creating a budget here but it’s super important and I go in detail about it here. So, step one is create a budget or at least get a general sense of what your monthly and yearly expenses are.

Once you know what you will be, on average, spending, you have a general sense of how much you will want to have per month and per year when you retire.

Knowing what won’t be expenses in retirement

Keep in mind though that in retirement you should hopefully have paid off all of your debt, including your current mortgage, so any debt servicing should be zero.

Similarly, you will no longer be saving for your retirement, you’ll be living it. You also will not be paying for disability or life insurance in all likelihood. So, you should not have to include these contributions towards your expected retirement expenses.

Now, other expenses, like traveling, may increase. So keep this in mind too…

Your withdrawal rate is the key factor

How much of your retirement savings can you take out for living expenses each year in retirement without running out of money? That’s the biggest piece of the puzzle to estimating how much of a nest egg you will actually need.

A classic financial study demonstrated that if you withdraw 4% of your retirement savings each year during retirement, your nest egg will have the best chance of living as long as you do. This means you will not run out of money before you die. You withdraw 4% per year and the rest of the money is working for you in your investments to keep replenishing so that you have enough for the golden years.

People are usually surprised at this concept as they imagined that they would be able to withdraw a higher amount per year – I know I was!

The magic equation for retirement savings

Regardless, you now have your goal yearly expenses ($X) and a safe withdrawal rate (4%). The following simple equation will then allow you to compute how much of a nest egg you need:

4% = $X/Nest Egg

So, say you predict your monthly expenses to be $10,000. Your desired yearly withdrawal amount is then $120,000 ($10,000 x 12).

Some back of the envelope math will show you that you then would need a nest egg of $3 million ($120,000/4%). Was this more or less than you were expecting?

Again, that number can be shocking to most as they didn’t predict it would be that high.

The good news is that as physicians, our income is definitely high enough that we can create a savings rate that will certainly get us to our goals through wise investing in broadly diversified, low cost index funds.

Finally, we have our goal amount. Now all we need is a plan to get there.

But there’s a catch here…and that catch is passive income!

Take for instance that you say your expected yearly expenses is $120,000.

However, you have passive income of even just $2,000/month. That is equal to $24,000 annually.

Therefore, you already are covering $24,000 of your expected yearly expenses in retirement via passive income! Now, you just need to save and invest enough to cover the remaining $96,000/year.

That is a big difference!

And I will argue that every physician is capable of generating at least $2,000 in passive income or alternative income streams. This can be via real estate or many other options. Over the past 2 years, I have generated 5+ sources of income as you can see in detail here.

Here are some resources to help you do it:

So now that we know how to figure out our goal nest egg while factoring in and understanding the power of passive income, we can move on to developing our strategy to actually reach this goal retirement number!

How to get to your goal retirement savings number

On Microsoft Excel, there is a Future Value function that can help predict the growth of your money through savings and investments.

For example, I want to know how much my nest egg will be if I save $50,000/year and expect my investments to grow at a modest 5% after taxes and fees.

I type the following into Excel:

=FV (5%, 30, -50000, 0, 0)

The first value is the interest rate
The second value is the number of years you are contributing. Let’s say you are 32 like me and will retire in 30 years
The next value is the annual contribution amount which must be put in as negative
The first “0” is your current savings. If you have $10,000 already saved, you would put “-10000) in this position
The last value is a “0” if you are contributing at the end of the year, which is default, or a “1” if contributing at the beginning of the year.

So, we punch this equation in and see that our money would be worth $3.3 million when we retire.

You now know that you have to save $50,000 annually in wise investments with a net annualized interest of 5% and you will be able to retire when and how you want (assuming your goal nest egg is $3 million). That is powerful!

And now let’s look at how passive income changes this equation…

Remember, in our example, our goal nest egg is $3 million to cover our goal annual expenses of $120,000. However, we have generated $2,000/month of passive income or alternative streams of income. This brings our goal annual expenses to cover down to $96,000.

Using the same equation as above, we find that instead of $50,000 of annual savings for 30 years at expected 5% returns, we just need to save $37,000 annually under the same conditions.

Alternatively, you could save the same $50,000 with expected 5% after-tax, after-fee returns for only 25 year to reach your new goal nest egg (with passive income factored in). This saves you 5 years on your journey to financial freedom!

Again, powerful stuff…but don’t forget…

Your written financial plan is the guide to your goal

The last step however is often the hardest for most people. You now need to go back to your budget and allocate to savings whatever annual contribution is necessary to reach your goal nest egg. This needs to become an integral part of your written financial plan.

(Reminder, if you don’t have a financial plan, check out my previous post and use mine as a guide or you can check out my course)

In the example above, the $50,000 of annual savings is 20% of an annual salary of $250,000. Most physicians will be making around this much. It’s tough love but if you can’t live on a $200,000 annual salary, you have a spending problem and not an income problem.

It’s all about mindset. Everything dollar you spend is a trade-off with something else. Do you want to ensure your financial future for yourself and your family or do you want a car that can go up to 200 mph even though you’ll never drive it that fast?

Budget and spend intentionally on the things that make you the happiest. Save and invest the rest.

Once you have this plan in place, you can rest easy and know that your financial future is secure. This will allow you to enjoy the present without worrying as much about the future. It will make you a better doctor and a better person.

It’s a prime example of financial well-being enhancing your personal well-being!