You're targeting retirement in 25 short years and you don't own a home. The quandary is, should you buy a home so that someday you can do away with the cost of rent? Or should you focus solely on saving for retirement, even if it means you'll pay rent for the rest of your life?
Fortunately, there is a middle ground. It involves forgoing the home purchase and directing your excess cash into a dividend fund. The goal is to rely on those dividends to generate enough cash to cover your rent expense in retirement. Using this strategy, you can keep a roof over your head without liquidating positions. That reduces your exposure to short-term market volatility, because you don't have to sell something each month to fund your rent. It also protects your earnings power going forward.
To see how this strategy can work for you, let's walk through an example using Vanguard High Dividend Yield ETF (NYSEMKT:VYM).
1. Project your annual rent expense
The first step is to project your annual rent expense. If you're open to moving, you can find good neighborhoods that have rentals for less than $1,000 monthly. Median rent in Toledo, Ohio, for example, is $495. Or you could rent in Omaha, Nebraska for $820 month. But let's say you prefer a beach vibe, and you land on Pensacola, Florida, where the median rent is $818 monthly. That equates to an annual estimated rent expense of $9,816.
2. Address inflation
A $9,816 rent budget is enough today, but it won't be enough 25 years from now, thanks to inflation. Assuming 2% annual inflation, you'll need $16,104 for rent by the time 2045 rolls around. You can calculate your future inflation-adjusted budget on a spreadsheet with 2% annual increases or you can use a future inflation calculator online.
3. Account for taxes
Your contributions to your 401(k) and traditional IRA are usually tax-deductible and your earnings in those accounts grow without tax implications. But there is a trade-off. Any withdrawals you take in retirement are taxed at your normal income tax rate -- including withdrawals to pay your rent. You'll have to account for that by increasing the amounts you withdraw to cover your taxes as well as the rent.
The math works like this:
- Total withdrawals = Inflation-adjusted annual rent expense divided by (1 minus your tax rate, expressed as a decimal). For our example, we'll use a tax rate of 5.7%, which is the average federal tax rate paid by seniors. Subtracting 0.057 from 1 gets you to .943.
- Total withdrawals = $16,104 divided by .943
- Total withdrawals = $17,077
- Out of the $17,077, $973 pays taxes and the remaining $16,104 pays your rent.
- Note that Florida has no state income taxes, so we only account for federal taxes in the first step. If you pay state and local taxes, you'd add those rates to the federal rate in Step 1.
4. Divide by the fund's yield
Now comes the fun part. As you're researching dividend funds, look for the SEC yield, which is a standardized method for calculating a fund's dividend and interest payments relative to the share price. The Vanguard High Dividend Yield ETF has an SEC yield of 3.59%, meaning for every $100 of this fund you own, you'd expect to receive about $3.59 in dividend payments.
To figure out the size of the investment required to generate your needed dividends, divide your annual withdrawal amount by a fund's yield. In our case, the answer is about $476,000.
5. Start saving
Your next step is to start saving with the plan of reaching your target balance by retirement. A compound earnings calculator can help you determine how much to save each month, using the number of years you have left until retirement and your expected annual return. If you used the average annual total return produced by the Vanguard High Dividend Yield ETF since its inception, which is 6.8%, and 25 years remaining until retirement, you'll get to a required monthly contribution of about $600 . That assumes you'll reinvest the dividends you earn until you reach that $476,000 target.
Importantly, these required contribution figures can be a combination of your elective 401(k) deferrals and your employer match. If you are earning $150 monthly in employer matching contributions, for example, you'd only need to save $450 of your own money, instead of $600, to amass the $476,000 in 25 years.
If those numbers seem more manageable than you expected, remember that this strategy only attempts to pay your rent in retirement. You'll want to invest over and above these amounts for two major reasons. One, you need a cushion, since dividend payments aren't guaranteed. And two, you will have other living expenses to cover beyond rent. Your Social Security benefit can help with those, but it probably won't stretch very far.
Stay with it
As with any savings plan, you'll need to be disciplined about investing those monthly contributions even when it feels like a stretch financially. But stick with it and you'll have a nice source of income to keep a roof over your head in your senior years -- no mortgage required.