I love this topic. Learning about the concept of financial independence and what makes it possible was like turning on a light for my investing journey. Suddenly everything else clicked into place and I had a better idea of what the future could look like if I kept saving.
There are a bunch of definitions of financial independence, but this is the one I like most:
Financial independence is the point at which you are generating enough income through passive means to fully find your lifestyle now, and for the foreseeable future.
It’s about reaching a point financially where you no longer need to work, but could if you wanted. If you need $5,000 to live each month then this is the point where you’ll have $5,000 coming in for the rest of your life.
“Passive means” can mean different things to different people. Some people consider income from renting out real estate as passive, others don’t. Some people consider charging scooters or picking up the occasional passenger in a RideShare as passive, others don’t. Choose a definition that works for you.
For me, this means income that I’d still have if I was in a coma for the year. That’s the level of passive that I’m personally going for.
For you, this might mean a combination of some real estate, some money saved up in investments, some doing side jobs. There’s no right or wrong way to get there.
The area we’re focusing on for this course is the stock market investment side, so we’ll assume that’s our one and only asset – no real estate or side hustles.
Here’s how the stock market investment side works:
Step 1: Calculate your Income. Calculate how much you earn every year. If you’re in a household with multiple income contributors, add everyone’s income.
Use your after-tax, after-insurance income amount. So if you’re making $5,000 a month, paying $1,000 in taxes, medicare, and insurance, then your income is $4,000.
If you’re earning any income from real estate investing, part-time jobs or side hustles, also add the after-tax amount for that. If you have a 401k that’s providing a company match, add the company match portion as well. That may boost your income by 3% or 6%.
Don’t add any one-time income events that don’t happen every year. For example, if you sold your car or a house and had a big windfall, don’t include that.
Also, don’t add income from stock market investments, dividends or savings. If your stocks are earning you some dividends, that’s great! But we won’t include that here.
With all of your income added together, you’ll know your total after-tax income.
Step 2: Determine how much you spend every year. This can take a surprising amount of lot of work. There are a number of strategies to find this too:
- You could add up everything you’ve earned and base it on that.
- You could add up everything you spend manually or using something like Mint or Personal Capital.
- You could use a budgeting app like You Need a Budget to understand your spending.
Spending is what you have the most control over. Any given day you can wake up and spend less. The hard part for me (and many people I read about) is usually finding a spending balance that works for them long-term. There’s no point in cutting your spending for a week if you’re just going to raise your spending the week after.
I’ve found that it’s important to understand spending by tracking it for a full year – not just one month and multiplying it by 12. One month will give you an estimate, but one year will give you actual data.
If you do this for multiple years, you’ll become extremely familiar with your spending habits. I’ve found ours have been in a range within about 10% each year – which gives me a lot of confidence in estimating how much we’ll spend in future years.
This will be your baseline spending level. You’ll have other expenses for sure, but this is a good starting point.
Step 3: Sum your current cash investments. Add up all of your investment accounts, savings accounts and checking accounts. That’s your total “investable” cash. This is also called your “liquid investments”. This includes the sum of all the money you have that could be invested.
Ok, once you have those 3 things calculated, you’re ready to understand when you’ll be financially independent!
Let’s say your total household income is $100,000 a year, you currently spend $80,000 and you have absolutely nothing saved up.
How long would it take to become financially independent?
When I first looked at these numbers I assumed it would be something like this:
I spend $80,000 a year and may live for another 60 years, so that means I need about 60x$80,000 in money saved up, or about $4,800,000. This is all wrong! It assumes your money isn’t invested and isn’t making money. In this bootcamp you’ll learn how to invest that money, which will drastically lower the amount of money you need to save up!
To find that out, you can use these two numbers to calculate your savings rate. Savings rate is the percent of your total income that is going into savings each year. You can calculate this by using:
$80,000/$100,000 = 80% spending rate
(100,000 – 80,000) / 100,000 = 20% savings rate
So, how long would it take to reach complete financial independence in this situation? Well, we can find 20% on this chart and see it would take 35 years.
(open up the Interactive Guide to FIRE and try this out!)
That’s 35 years assuming you saved this exact amount, adjusted for inflation each year.
Seeing this chart can be a major realization for how savings impacts years of work. Just saving 20% is the difference between never being able to retire and leaving the workforce after 35 years.
If you raised your savings rate to 30% you can reach FI in 28 years. At 40% it’s 22 years. At 50% it’s down to only 17 years!
Imagine learning about this when you’re 22 and right out of college. If you were able to save 50% of your income during your entire career then you’d be FI by the time you were 40!
This chart assumes that all of your money is invested in the stock market and it’s growing at about 7% a year – or 5% plus 2% inflation. There’s no way of knowing what the stock market will do going forward, but historically it’s performed this well.
One of the reasons this works is because of what’s called the 4% rule.
The 4% rule says that if you withdraw an inflation-adjusted 4% of your invested money each year, it’ll last somewhere between 30 years and the rest of your life.
If, as in our case, you’re spending $80,000 a year how much do you need to be able to withdraw 4%? Well, 100%/4% = 25. So $80,000 x 25 = $2,000,000. So if you saved up 2 million dollars, you’d likely be able to withdraw about 4% a year.
The reason this works is because if you withdraw $80,000, or 4% while the stock market rises 7% then it’s going up in step with what you’re spending.
There are a lot of caveats to this “rule”. It doesn’t take into account a lot of specifics:
- It assumes you’ll pay $0 taxes on the money withdrawn.
- It assumes markets will behave in the same way as they have historically.
- It assumes your spending will stay the same (adjusted for inflation).
- It assumes you don’t have any other major expenses like a down payment on a house, paying for college, a new car, etc.
- It assumes you won’t receive social security.
In other words, you’ll likely want to use a withdrawal rate lower than 4%. That sounds a little confusing, so let me break that down.
If you have $2,000,000 and you withdraw 4% each year, then you’re withdrawing $80,000 each year.
If you have $2,000,000 and you withdraw 3% each year, then you’re withdrawing $60,000 each year. If you need $80,000 to live then you have a shortfall. If you wanted to withdraw only 3% each year and still be able to withdraw $80,000 a year, then you’d need to save more than $2 million.
For that you’d need to save (100%/3%) * $80,000 = $2,666,666. That’s quite a bit more than $2 million! Historically, if you saved this amount then that would be enough for you to afford to live for the rest of your life – regardless of how many years you live.
So how much do you need to save? 3%, 4%? It’s impossible to know. If you’re very risk-averse, lean-to 3%. If you can lower your spending for some years, then 4% might work. There’s really no way to know.
Personally, I’ve aimed my savings to reach that 3.5% withdraw rate amount. Historically that’s been safe! For this situation that would involve saving (100%/3.5%) x 80,000 = $2,285,714.
Once you know how much you need to save up and how long it can take it can either be empowering or depressing. You can use it to motivate you or get you down.
Tweaking these stats can become a game in a way. You can try to lower your expenses and save more. You can try earning more income and discovering ways to spend less. It’s one of the reasons why so many people have become fascinated by financial independence lately!
These are just the basics, but I hope they show you what’s possible by saving some of your money and investing it in the stock market.
Ok, recap time! Financial independence is a massive topic. For many, myself included, it’s an inspirational and empowering topic. It can help shape how you spend your money, how you spend your time and how you plan your life. For FI, there are a few core concepts that we’ll look back on a few times throughout this course:
#1 – Understand how much money you’re spending! In order to know how much money you need to save up, you’ll need to know how much you’re currently spending. Finding this number can be difficult. I recommend tracking your spending over an entire year to get a full picture.
#2 – Using your spending and your yearly savings, calculate your savings rate. Your savings rate is the percentage of your total, after-tax income that’s going into savings accounts and investments. You can use your savings rate to determine how when you’ll be financially independent.
#3 – To calculate how much money you need to be financially independent and never work again, you can use the 4% rule. Take your yearly spending and multiply it by 100/4. Also, multiply it by 100/3. If your household spends $80,000 a year, then this would give you $2,000,000 and $2,646,666. If you had that much money invested in the stock market, then, historically you’d be set for life!
Financial Independence is a topic that I care a lot about. For me, it helps on two fronts – having a long term goal of how much money I need to save up to. And a short-term goal for constantly looking for ways to lower my spending. Both help get you to FI faster.
One of my favorite quotes about FI comes from Vicky Robin, author of Your Money or Your Life. She’s one of the very first authors who wrote about financial independence. A a high level, it all comes down to this:
Money is something we choose to trade our life energy for.
Vicki Robin, Your Money or Your Life
Reaching financial independence is about getting to the point where you no longer need to trade your life energy for money. The options at that point open up!
In the next lesson, we’re going to try something new: an activity. We’ll be getting into some numbers and figuring out what your plan should be for investing.