How to Become Wealthy

Want a guaranteed way to become wealthy? Read on.

I have said over and over again that becoming wealthy can be summed up in a few, simple, basic, financial principles. Apply them over a lifetime and you WILL become wealthy (compared to the total population, you'll be in the top for percentages in net worth.)

I wanted to put some numbers together that demonstrated this fact so the other day I developed a simple spreadsheet that had the following inputs:

• Starting salary -- what a person would make upon leaving college
• Annual salary increase -- the average annual salary increase a person would get over their lifetime
• Percentage saved -- the amount of the salary that the person would save every year
• Return rate -- the return the person would get on their savings

I started with some basic assumptions as follows:

• Starting salary: $30,000
• Annual salary increase: 5%
• Percentage saved: 10%
• Return rate: 7%

This person's net worth after 40 years would be $1.2 million. No, it's not a fortune and yes, it's $1.2 million well into the future (which is worth far less than $1.2 million is today.) Then again, I think $1.2 million will still put someone into a "decent" category compared to most others even 40 years from now. Besides, this is the "low end" of what someone can experience if they work at it.

Let's say this person really applies the principles I discuss regularly -- they work to grow their career, they increase the amount they save from their salary, and they earn a higher return rate. So I then plugged in the following:

• Starting salary: $30,000
• Annual salary increase: 9% (this includes bonuses, etc. -- see comment below: this is the return I've been able to achieve over 20 years)
• Percentage saved: Starts at 10% and builds proportionally to 30% at the end of their career
• Return rate: 8%

Their final net worth: $6 million. Not bad, huh? ;-)

Then, for fun, I plugged in my numbers. I won't go into specifics, but let's just say it was a very interesting exercise. A few comments on the results for my finances:

• The model is accurate for my salary, but not my net worth. My net worth is actually higher than what the model suggests it should be, so I either saved more money earlier that what I assumed, my return rate on investments has been higher, or a combination of both. I think it's the first option, but I don't have my numbers in front of me.
• At this point, I've moved from relying on my savings to grow my net worth to relying on my investments to grow it. No matter how much I save from my income, the real "make or break" for my net worth is how well my investments perform. The reason: they've become so sizeable that an 8% increase in them (my estimated annual return) is more than I could save in a year.
• I don't think I'll reach my "potential" because I don't think I'll work for 40 years -- and the last few years is where the net worth REALLY builds up. Instead, I think I'll take early semi-retirement in one form or another.
• I'm shooting to get to $3 million in liquid net worth. At that point I think I'll be set and won't need to push much from there. If my salary holds steady (flat), I save 1/3 of it (as I have been doing), and I get an 8% return on my investments, I should hit that level in a decade or so.
• If I take early semi-retirement and my salary drops by 20% (let's say I move from working five days to four), I still make it to $3 million in a decade or so. ;-)

Not bad. Thus is the power of growing your income, keeping expenses low to save a boatload, and time for compounding to work. Do all these and you WILL become wealthy.

And let's say you are already down the road a bit (40 years old or more) and you're thinking, "this won't work for me, I've already wasted too much time." Yes, it's true that you won't get the exact results noted above since you've lost 20 years or so of saving/compounding. But if you do apply the principles to your life and let them work until you retire, you will be MUCH better off than if you simply continued on your way as you have been. So get started today!

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Update: Don't get hung up on the salary percentage increase -- look at the PRINCIPLES!!! If you save early, live below your means, and increase your savings rate over time, you can become a multi-millionaire with a moderate rate of salary increase (see my comments below). So the point still holds true -- if you do these things, you WILL become wealthy.

Comments

[jeffinwesternwa]

The key is: "start but, start early, and often". 1) Save something from day one, 2) AVOID consumer debt, 3)INCREASE savings through the years and prosper. Never leave an "employer match" on the table, as a MINIMUM invest to get the match. ALWAYS have part of EVERY paycheck going to an EMERGENCY fund. Attempt to fund an IRA, preferably FULLY fund an IRA in addition to the full employer match and emergency fund EVERY year. Doing just that will go a LONG way to self sufficiency by middle age. Too bad, did you know just 40~ years ago "Public storage" didn't exist in the USA? Seems America went "shopping" and decided stuff was more important than financial independence and somehow thinks the govt is responsible to fix it. Too bad, the problem for most stands "in the mirror"!

[Beth]

A 5-9% percent salary increase each year? Does that exist?

I haven't had a raise in nearly three years because of the economy. Down turns happen. I don't think we can plan on a steady increase in salary throughout our career, unless we make it happen elsewhere (like taking on a side business).

[Mary W]

My husband has not had a raise in the past 2 years due to the economy. I'm not working because I take care of my elderly mother who moved in with us 4 years ago. When I worked I never had a salary increase of more than 3% per year. I only increased my salary by laddering my career from job to job. I did manage to 1) pay off my student loans in 2 years by putting a lot of my salary toward it and then 2) pay off our mortgage over several years by first refinancing to 15-yr and then putting most of my salary toward it. When I do go back to work it will be 1) more for the security of steady income as I am in a field that does not pay real well but I am frugal and 2) for the health benefits. Most people in this health care debate forget the fact that medicare does not start until you are 65 and only pays 80%. If you suddenly get sick and have medical bills, without supplementary insurance which you must pay for, 20% health care costs will bankrupt the average middle class wage earner pretty quickly, especially as this does not count the cost of medications and long term care which medicare does not pay for.

[Everyday Tips]

We haven't had a raise in awhile, and the bonuses have been getting smaller. Also, health care costs have increased, so part of the formula would definitely we negative for us.

I would also add that have a proper balance of stocks/bonds/commodities/cash/etc is key because we, along with many others, got burned in the most recent stock market 'crash'. We have saved quite a bit and should have a healthy bit of money set aside. However, it isn't as much as it could have been if we could have predicted the future.

[sammysosarules]

I think the 9% salary increase per year is probably a little agressive. I've been the most promoted person in my organization's history over 10 years, and I'm at 8% on average - this will probably tail off since I'd expect that I am topping out and the fact that usually the largest % increases come at the beginning of your career. But I started a lot higher than $45K also, not $30. I'm already saving 30% if you include matching contributions, but certainly I'm not at 8% return on investment during the 10 years since I've started due to the economy during that period.

[FMF]

All --

FYI:

1. I used the 9% salary increase because that's what I've averaged (actually a bit higher) over 20 years (I will update the post to reflect this).

2. If you use 7% versus 9%, you still end up with $5.4 million.

3. If you use 5% versus 9%, you still end up with 3.7 million.

So...the principles work!!!!!!

[Don Current]

It's true that it's never too late to start applying the principles. It's so important though to get these principles to the next generation. They're the ones that can make the most use of it. The most important factor in this equation is time followed closely by the rate of return on your investment.

I know it's really probably not feasible for people, but your example of % of money to save is really the reverse of what would have the most benefit. If you were to start out saving 30% and proportionally reduce that to 10% at the end, you would be much better off in the long run. Unfortunately that typically isn't what our income allows. A second job early on with the express intent of saving for retirement would have a huge impact on retirement savings.

We need to get this information into the hands of high schoolers to get the most impact out of this information.

[janetj]

40 years ago I was making zero dollars, and my salary has increased an infinite percentange since then: $0 + infinite percent = anything above $0 dollar. And back then, I was contributing 100% of my money into savings. Bonus - my investments earned an infinite percent interest since then. I got all of you beat.

[jim]

I think that promotions are the key to high salary growth over time.

You aren't likely to get 8-9% annual increases *every* year on a consistent bases if you're doing the same job the whole time. But you're a lot more likely to average your salary something in the 7-9% range on average if you get a few nice big jumps periodically due to raises or changing jobs. For myself over a 10 year period I averaged about 7.5% increases but that was mostly due to 3 promotions that netted me 15%, 30% and 15% raises. In other years I averaged about 3% increase. That includes 0% raise in 2009 and 2% in 2010.

[FMF]

Jim --

Exactly. See this post for more on this line of thinking:

http://www.freemoneyfinance.com/2009/07/how-you-grow-your-income-by-10-or-more-a-year.html

[MikeS]

I would agree that it is possible to grow your income by 7%-9% on average. Since I graduated college 12 years ago, my income increased about 8% on average, including the bonuses I receive. My actual salary increase last year was only 3%, but the bonus was about 19% of my base. I haven't been nearly as aggressive as I should have been to grow my salary, just a good hard worker.

I also think it's very easy to increase your savings rate every year. Every year I receive a raise, I increase my savings rate by 1%. Spread that across 30 years and you're saving quite a bit of money.

[janetj]

MikeS,

I agree you can keep up the 8% pace for 12 years, but not 40. Statistically speaking, your post college years net your largest gains.

[frodo]

9% per year increase only? PFffft! I'm looking to gain 25% per year. After 40 years of working my salary will be nearly $23 Million. At 9%, you'll only be around $900,000.

[jim]

I do think that 9% growth every year for 40 years is a pretty high goal. If you start working in 1970 with a salary of $10k then 9% growth would put you at about $300k right now. Only around 1% of the nation gets up to an income level of $300k and I'd wager that a large % of those people are CEO's and doctors.

Income will grow much faster in your first 20 years for most people but will start to plateau in your last 20 years.

Of course reaching for high goals is a good thing that helps you accomplish more.

[Shaun]

Jim, only 1% of people make that much because people don't follow, in general, sound financial planning.

My income is increasing by something like 300% a year and has been over the last two years, but I'm an entrepreneur, so it's way, way more volatile and less stable than most incomes.

[susansmith]

shaun,

I disagree. General, sound financial planning applies to those with low and high incomes, not just those with $300K plus incomes. And many who are above $300K are not following general, sound financial planning.

[Old Limey]

I worked for what is now the leading defense & aerospace company in the USA from 1960 through 1992.
In that 32 year period the average compounded raise that I received each year was 6.9%.
I moved up the technical ladder and not the management ladder and never supervised other employees. I started as an associate engineer and retired a a senior staff engineer reporting to a manager with about 100 engineers in his department. One contributing reason why I think that my raises were pretty good as well as being consistent was that the USA was fighting a Cold War with the USSR and there was a shortage of engineers but no shortage of lucrative defense contracts.
I have ended up wealthy but most of my wealth was acquired after I retired and was due in large part to the wonderful decade of the 90's experienced by the stockmarket. I also became a student of the technical analysis of the market right after I retired and used fund selection and market timing throughout that period managing to make 221% of the S&P500 but only matched 91% of the tech heavy Nasdaq 100's performance up to the crash in March 2000.

Living through some great times makes a huge difference.

[frodo]

Unfortunately, if you started work 12 years ago, the stock market has averaged 0% rate or return. The indices are at the same value that they were then. So from here on out you have to average 12% for your remaining 28 years of work (assuming you work that long) in order to get a final average of 8%.

[FMF]

Jim --

If you start with a $30k salary and earn 5% raises per year (the number I quote in a comment above), you end up 40 years later with a salary of $201k -- not an unreasonable number, especially when you take inflation into account (and the fact that $200k now isn't the same as $200k 40 years from now.)

That said, I agree with Shaun regarding concentrating on growing an income. It's one reason I spend so much time writing about the issue. If you develop your income to its full potential, you open up many more possibilities for yourself.

[Ken]

Well in my 5 years of working i have increased my pay over 50%, when including bonuses, but my base has been stagnant the past couple years.

My wife and I have 250k saved for just retirement accounts. With 40 more years to go until the SSA retirement age, and saving at the max in tax advantage accounts, 21.5k per person.

We should be able to grow our savings to 16.5 million at 8%. Now if one of us stops working, it would be 11 million.

But im sure it will be depressing when a loaf of bread is $1000.

[jason]

I started working as a professional in 2007 and this whole idea of making 8% returns is foreign to me. I believe people when they tell me that was the typical rate of return, however I've never experienced it myself. Any predictions or educated guesses as to when we can expect to these type returns again?

[Mike Hunt]

FMF,

So $3 million is your retirement number...? If the dollar devalues further or if prices go up will you be adjusting your number higher?

-Mike

[Shannon]

LOL, 9% salary increase. I stopped reading there

[M]

Your article does not take into account income or capital gains taxes.

[Jes Lookin]

A very oversimplified concept. Make money/keep money. In reality, annual increase is 1% lower than inflation maximum 3% and return is 2% or less, even if you think you are investing in something with a 7% or more return - they'll get you in the end.

[Juggler314]

I think your blanket assumptions leave something to be desired, your 30k starting salary employee is expected to be earning 200K/year in his 40th year of work. That is not even remotely realistic. Earnings wont even average out to a 5% increase per year. Your aggresive estimate of 9% results in a final salary of 864K and change - beyond unrealistic. These sorts of ever increasing salaries/compensation estimates would apply to a tiny tiny fraction of the population that lucky/works very hard at it.

Similarly even a 7% return on investments is likely to be extremely unrealistic from now on. You mention 20 years of history, but that means you were investing through more than just one HUGE boom - housing and tech. Even if you barely managed your portfolio at all and with the subsequent crashes still represents about 7.3% returns - something you have been blessed with for no other reason than being alive and earning money at the right time. If you instead invested from 1970-1990 you'd be looking at a 6% return - something I'd still consider to be aggresive - if you think you can get 7% returns for the next 20 years on average that means you also believe the dow will go to 40K in those same 20 years. It's become obvious though that stocks no longer represent what they once did and that all the money made in the market is going to be made by swings in prices, not a fairly restrained realistic upwards growth that tracks the actual economy.

The reality is that the next 20 years are going to be a major downturn from what the US has become accustomed to over the last 20-30 years. Real wages will not rise very much, there will be higher than average (not doomsday, just a bit higher than average) inflation. China and India will vastly overtake the US in terms of world economic supremacy. Most people fail to realize that the baby boomers have simply robbed the future generation (at least 1 generation) of it's wealth. All these people taking trillions of dollars out of housing stock like it was a bank. This sort of wealth generation is *never* going to happen again for those of us in our 30's or so.

It's a very sad future really.

[HP]

I've been in the workforce for over 20 years, and contributing to retirement funds the entire time. For the last 12 years the funds have been in a 403 b which I can control. Even by selecting the best performing, low-cost index funds in my plan, I'm lucky if I've got 100% of every dollar I've contributed.

By doing the right thing for 45 years, I'll be lucky if I can afford to eat name-brand cat food in my retirement. (Though being the frugal person I am, I know I'll be eating generic.)

[FMF]

Mike --

Yes, $3 million (cash and accessible -- not in retirement accounts) is the number I need to retire/go into semi-retirement. And of course if the economy (or anything else) dictates changes, I'll need to make them.

[mysticaltyger]

@Juggler:

Your numbers are way off. From 1970 to 1990 the S&P 500 returned 10.82% annualized, not 6%. Even a mix of 60% stocks & 40% bonds would have returned better than 6%. It's true that those returns might not hold true in the future...but get your numbers straight before spouting off inaccurate info, ok?

The link below shows the calculation:

http://www.moneychimp.com/features/market_cagr.htm