What Is Financial Independence?
Financial independence is the ability to live the life you want to live without depending on the money from a job to support that life. By generating enough passive income from investments to support your lifestyle, you are no longer reliant on the paycheck that working generates. While related, financial independence and early retirement are not the same thing. There is nothing that requires you to do anything differently once you reach your financial independence number, but it does open up an amazing number of options to you. Where would you live if you weren’t tied down to a specific job or line of work? Would you still spend 40+ hours a week working for someone else if you didn’t have to? What hobbies and interests have you put off simply because you didn’t have enough free time to enjoy them? Financial independence is all about opening up a world of options for yourself by removing the reliance on a steady paycheck to live your life.
Why Make Financial Independence A Goal?
Once again, financial independence is all about options and the freedom to construct your own life without the restrictions that come with a standard job. Everyone would handle these options differently, and the beauty of financial independence is that it allows it. No matter what you want to do with your life (within reason of course), having a significant amount of money stored away that can now generate a yearly income for you makes it possible.
- Freedom to Live Where You Want – Without the need to commute to work, the entire nation (and maybe even the globe) opens up as possible places to make your permanent residence. You can now select a city that meets all of your ideals without having to worry about finding a job to support you there. Proximity to the beach or a mountain to ski at might become one of your top priorities when selecting somewhere to live.
- Freedom to Travel at Your Own Pace – One of the larger expenses of traveling is often the airfare to get you there and back, so the longer you stay in one place, the cheaper each night of your vacation becomes. You will no longer be restricted to the 3 weeks per year of vacation time that your job offers, so you can spend weeks or even months exploring new locations across the globe. If you’re really adventurous, you could even cancel your lease or rent out your house for 6 months or more and use that money to travel the world.
- Freedom to Choose a Job You Like (or Not!) – While financial independence offers the ability to not work at all, you can still choose to work for the several benefits it provides. Since the paycheck is no longer the only thing supporting you and/or your family, why not pick a job that you enjoy, even if it pays a little less. And if you end up not liking the job for whatever reason, simply quit and walk away. Imagine how much stress would melt away in the workplace if you knew that walking away financially secure at any time was an option.
- The Freedom of Time – Without the schedule that comes with a full-time job, imagine all of the time you will have to do what you want. Take up new hobbies, dedicate some time to a personal project, exercise, or just spend time with friends and family. Do whatever you want to, that’s the whole point!
Aside from small number of options that come with financial independence I listed above, financial security and peace of mind is a huge benefit of becoming financially independent. Any stress that would come from the fear of losing your job just goes away because you know that you and your family will be fine regardless.
How To Achieve Financial Independence
In order to call yourself financially independent, you need some amount of money stored away that will last you the rest of your life, but how much money is that? The exact number is different for every situation, but it always depends on how much money you need to support your life on a yearly basis. Once you determine the amount of money required to live your desired life, the rule of thumb is to multiply that by 25 in order to get your financial independence number. This is based on a large study (The Trinity Study) that determined 4% (100% divided by 25) was a safe withdrawal rate out of your investments to not lower the principle over a long period of time. This means 4% of whatever amount of money you initially have invested can be withdrawn on a yearly basis to support your life without lowering the total amount of money that you have invested. For example, a person who has 1 million dollars invested would be able to safely spend $40,000 every year (adjusted for inflation) for the rest of his or her life. As I said, this 4% is a rule of thumb that will vary slightly depending on each person’s particular choices and needs, but it won’t be too far off.
Now making this amount of money last for decades and longer will require smart, long-term investments, not simply throwing your money at the stock market and hoping for the best. A portfolio of diverse index and bond funds will allow your money to grow as long as the economy of the US and/or the world grows rather than being tied to any one company or stock. I won’t go into too much detail here, but the idea is to invest in the stock market as a whole via index funds and have some of your money in bonds to protect your income needs through the ups and downs of the market. For more information, I highly recommend reading through the Bogleheads wiki and forum. The people there will do a much better job than myself explaining the merits and theories behind smart long-term investing.
So how does one start working towards achieving their financial independence number? Quite simply, spending less that you make and investing the rest is all it takes. The amount you are able to save away per year on a percentage basis will change the time it takes to reach financial independence, but the principle remains the same. You may have heard anywhere from 5-15% as the general guideline for retirement savings, and that will keep you on pace to retire financially secure in your 60’s, but if you are able to ramp this % up, the power of compound interest really shortens the time you need to retire. By increasing this percentage to 25%, you’ll be able to cut 10+ years off the time it takes to reach financial independence. Get up to saving 50% or even more of your income and becoming financially independent before your 40th birthday might even be possible. As with most things relating to investing, time is your friend, so the earlier in your working career you start saving, the easier it will become to reach financial independence.
A good starting point for figuring out your financial independence number is to simply take the average amount of money you spent over the past few years and multiply by 25. You don’t know how much you spent the last few years?!? Time to start paying attention to where all your money is going before you reach the end of month and just can’t explain what happened to it all. Tracking your spending is probably the most powerful tool available in the game of personal finance. Some of you might be afraid of finding out exactly how much you spent at Starbucks last month, but facing the truth of where your money is going is the first step to improving your finances. Even if you don’t change anything, a certain amount of peace of mind comes with knowing the details of your money going into and out of your life. I use mint.com to track all of my spending which makes the whole process pretty much hands free once you set it up and the cost of this amazing service is a mere $0, I highly recommend it. Once you figure out how much money you need to support your lifestyle, it’s much easier to start looking ahead towards financial independence or any number of other financial goals.
As I mentioned earlier, 4% is a good rule of thumb, but I want to call out a few important details that may increase or decrease this number. The amount of money you are spending now is probably not the amount you will be spending 30 years from now. If you are able to pay off your house (or other living situation), that’s a significant amount of money that no longer needs to be generated on a yearly basis. Another major decrease in spending will come if you choose to leave your job. This includes items such as money spent on your commute (gas, car maintenance), the job itself (clothes, tools, etc.), and other things like the money spent eating out for lunch every day. All of these things mean that you need to save LESS than 25 times your current spending to be financially independent. One thing that may increase the amount of money you need to save away is a longer time span. If you choose to live entirely off of your investments for a really long time (more than 30 years), a little extra cushion for life’s emergencies and various market conditions may be necessary. These along with many other factors will impact when you can feel comfortable calling yourself financially independent, so there is no hard and fast rule that will apply to everyone.
More Actively Working Towards Financial Independence
Once you realize that financial independence is even possible, you may want to go the extra mile optimizing your finances to achieve it even faster. There’s a lot of different ways to go about this, but they all probably fall into one of the following 4 categories:
- Eliminate expenses that don’t add value to your life.
- With financial independence on your mind, when you sit down to examine where you are spending all of your money, there might be a lot of items that you question whether or not you really need them. It’s perfectly fine to spend money on wants along with needs, but make sure that those wants actually benefit you in some way. Every person is entirely different when is comes to identifying what adds value to their life, so every person will choose to spend their money in different ways which is perfectly fine. A huge car enthusiast might spend way more than the average person on their choice of car, but every cent of that could be adding significant enjoyment to their life. The same person might notice they also spend a lot of eating out every month and realize that they don’t even like it that much. The trick is to be honest with yourself and identify the things that are actually meaningful to you.
- Not only does eliminating unnecessary expenses lower the total amount of money you need to reach financial independence, but it also increases your savings percentage each year which speeds up the time it takes to reach that total number. This double effect will make a significant impact towards achieving financial independence sooner than you could otherwise.
- Reduce the cost of the expenses left over.
- There will always be things that you have to spend money on whether it’s food, clothes, or your living situation, it’s almost impossible to cut out all expenses. Reducing the cost of these items will have an impact in the same way that cutting out expenses does, but probably in a smaller way. Simply using a rewards credit card can reduce a large number of your expenses by 2% or more. Shopping around for the best deals and buying quality items that will last for a long time will reduce the amount you have to spend on many of life’s necessities.
- A few percentage points here and there may not seem like a lot, but just like eliminating expenses, the double effect of reducing the amount required for financial independence AND increasing your savings rate will have a large impact over time.
- Supplement your income.
- If you’ve run out of expenses to eliminate, you have whittled down what is left over, and you STILL want to expedite your path to financial independence, maybe it’s time to look at ways to increase your income. One way to accomplish this is increase the amount you receive from your full-time line of work. Whether this means working extra hours, making the necessary moves to get promoted, or even switching to a higher paying job, the extra income will help you towards your goal.
- If those options either aren’t available to you or you don’t want to pursue them, maybe do some work on the side. Do you have a hobby or skill that you could use to start generating a little extra income? Buying and restoring items like furniture, tutoring students in a subject you’re familiar with, or watching dogs on the weekend when their owners are going out of town are a few of many different options that can be used to generate extra income.
- Because you have already determined the amount of money you need to live comfortably on, all of this extra income generated can go straight into your savings and investments, further decreasing the amount of time it will take to reach financial independence.
- Maximize your utilization of tax-advantaged accounts.
- This part actually falls under reducing the costs of necessary expenses, but it’s so powerful and important for financial independence that it deserves it’s own section.
- Taxes are a huge part of anyone’s expenses even if you might not pay attention to them in the same way as food or a mortgage. Several tax-advantaged accounts are available to anyone with an income, and they can reduce the amount spent on taxes in a major way. There is a reason they only allow you to put a maximum amount into them each year and that is because they save you a huge amount of money in the long term. IRA’s, 401k’s, HSA’s, and more allow you to avoid taxes when making investments, withdrawing investments, or sometimes even both. Utilizing all of these accounts to lower your taxable income significantly reduces the amount of time required to achieve financial independence.
- Putting in the maximum amount into each account available to you should probably be one of your first goals once you start getting serious about your long term finances. Investing through one of these accounts will yield far more money than a standard brokerage account simply because of the tax benefits that come with them.
But Wait, There’s More
Narrowing down all the different things racing through my head about financial independence into this introductory post has been a challenge and you can definitely expect more posts diving deeper into the various points I touched on. If you are as excited as I am about the possibilities that come with financial independence and can’t wait to read and discover more, here are a few resources that I have either utilized in the past or continue to utilize on a frequent basis relating to financial independence.
- Mr. Money Mustache – MMM is probably my favorite blog to read on the subject of financial independence, early retirement, avoiding “consumerism”, and living life to the fullest. His posts are entertaining and easy to read, so I recommend checking him out for yourself. (Start with this post)
- /r/financialindependence – This is one of the first places I stumbled across the idea of financial independence and continues to be a great source of discussion and ideas relating to the subject.
- FIRECalc – FIRE stands for Financial Independence/Retire Early and this calculator allows you to simulate a huge number of scenarios for testing how your investment plan would have fared in the past. This is the best calculator I have found that let’s you modify everything from retirement year to investment splits to withdrawal strategy and is a great way to see if you’re on track.
- Boglehead Wiki and Forum – A community dedicated to the investment philosophies made popular by Vanguard founder, Jack Bogle. If you have any questions about smart long-term investments, the best way to utilize tax-advantaged accounts, or anything else related to investing, this is probably the place to go. The Wiki has a breadth of information and the forum is a great resource to find questions ranging from simple to complex answered.
- Your Money or Your Life – This book has a heavy focus on looking ahead towards financial independence by identifying what adds value to your life and how to start spending money on your freedom instead of things. They also include a series of easy to follow steps that will help get anyone’s finances into shape. I highly recommend this book to anyone thinking about financial independence.
- Early Retirement Extreme – This book and the corresponding blog take frugality and saving money to the extreme in order to reach financial independence at a record pace. A lot of the ideas are a little extreme for me, but there is a lot of good information about living life to the fullest while hardly spending any money at all.