Financial Independence: Defining It and Figuring Out How to Get There

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My big, overarching dream is to achieve true financial independence. By that, I mean that I have enough money saved and invested that I can live off the interest and investment income – a point that I’ve discussed before as the crossover point.

This is a huge goal, one that I won’t achieve for many years no matter what path I choose. I dream about achieving this goal around the time my final child graduates from high school – roughly twenty five years from now.

What’s the exact goal? The first step in figuring things out is to determine exactly what I’ll need. Do I want to replace my living expenses alone – which would mean that I’d have enough to live, but wouldn’t be very protected against inflation – or if I want to replace my whole salary, giving me a lot of breathing room. The actual number I’ll probably need is somewhere in the middle – enough to maintain some growth, but not my current salary.

Let’s say I shoot for $50,000 a year in today’s dollars – in 25 years. Given 4% inflation between then and now, I’d need an income of $133,291.80 then. If I invest it in a stable fashion, I should be able to rely on returns of 7% annually. meaning I need to shoot for $1.9 million in investments in 25 years.

What tools do I have? I have a number of options at my disposal to reach that goal.

Retirement plans / 401(k)s If I actually retire at that point, I can start taking withdrawals earlier than the normal retirement age – that’s a 72(t) withdrawal. Thus, it makes a lot of sense to dump a big allotment into my retirement plan now. Given that the date I need is 25 years off and I’m targeting a very big number, I need to go pretty aggressive here – for now.

Standalone investment accounts A person can also put their after-tax money into investment vehicles like individual stocks, bonds, and mutual funds. There are many investment books that can help with this. My current plan is to adopt a portfolio from The Lazy Person’s Guide to Investing and add in a small piece for individual stock purchases – I plan on buying into a few individual companies eventually.

Paying off debts early Debt repayment is merely an investment at a known interest rate. For example, if my home mortgage has an interest rate of 6%, an extra payment on that debt is an investment that will return 6% through the end of the original mortgage – it’s interest you won’t have to pay on that money, so it’s investment returns in your pocket. Since this 6% is incredibly stable, it’s often useful to make it part of your investment portfolio. Of course, this does assume that when you’re done with that debt, you take both the original payment and the extra payment and roll it into some form of investment, but I plan on doing that.

This doesn’t mean that it makes sense to take out loans and then pay them off early. You’re better off not taking the loans at all and instead saving up for big purchases like automobiles. However, if you’re starting with pre-existing debts, it’s useful to look at them as opportunities.

Extra work Right now, I make some additional income from blogging, which I’m rolling into this plan. In addition, I’m also writing a book and working on a few other interesting items that can potentially put some money in my pocket over the long haul in a passive income sense. This basically generates more money to invest in this plan, making it easy to meet my investment goals each year and to perhaps exceed them – and do it consistently over time.

What do I need to do? Let’s say that each year I can earn an 8% return (on average) on my investments. I’m intentionally going low here so that I don’t underestimate the personal sacrifices I need to make to get it done. I need $1.9 million in investments in 25 years. What do I need to sock away each year to get to that level? Some simple Excel calculations show that I need to be socking away $26,000 per year to reach that goal.

Now, if I put the maximum allowed limit into my retirement plan ($15,500), I need to be investing $10,500 more on my own each year from here on out. This is a number I can actually reach fairly easily right now, but the real question is where should I be putting it? Right now, I’m paying off all of my debts with an interest level of 6.5% or above – basically, everything but my mortgage. I view that as an incredibly stable investment with a rate of return approaching what I need.

Once those are paid off, I’ll actually have a bit more to invest in a year – about $12,000 after my retirement plan, according to my math, and perhaps even more than that. This money will be used in a diverse portfolio that I’m still working on – one piece of it will be advance payments on my mortgage, which will provide an incredibly stable 5.875% component (there’s no tax implication because my standard deductions for all of my dependents are substantially more than the house interest). The rest will be in a portfolio, as I discussed above.

All of this adds up to one thing: reaching true financial independence is realistic – and it might happen sooner than I think.

In a nutshell, the idea is that you can only achieve audacious accomplishments if you set audacious goals to begin with. What are your biggest goals? What’s the game plan for getting there? If you’ve never thought about where you want to go, how do you know if you’re following the right path to get there?

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33 thoughts on “Financial Independence: Defining It and Figuring Out How to Get There

  1. It would be more efficient to work on the goal of getting the same lifestyle for less than 50k a year. Being really smart (frugal?) with expenses it is possible to attain a middle class lifestyle for a quarter of that amount. This means that one only needs half a million and thus there is 1.5 million less to save. This can cut approximately a decade off of the time it takes to become financially independent. For me the choice was simple.

  2. Unfortunately, you won’t be able to draw down 7% a year if inflation is running at 4%. If you could lock in 7% as a guaranteed number, that would be a 4% decrease in your principal every year which theoretically gives you 25 years before you either have to die or go back to work. But most studies show that with market fluctuations — even with a conservative retirement portfolio — one bad stretch (whether it’s a down stock market or high inflation hitting bonds/CDs/savings) dooms your nest egg within a decade.

    Pretty much, you have to aim for at most 1% real decrease after inflation. 7% increase – 4% for spending – 4% for inflation. That 1% is usually enough to cushion against the real world. Most studies show 4% withdrawal on 7% returns last about 30-40 years when overlaid against stock/bond/inflation fluctuations. So the number you’re really looking at is 133K / 0.4 = 3.3M.

  3. Mossy makes some good points. However, I don’t imagine Trent will still be socking away the same $26,000 when his salary is at the $133k range (just using his assumed $50K number now). I don’t know Trent personally, but his blog gives me enough to assume his lifestyle will operate accordingly at a higher income level, and thus his contributions will increase, thus increasing his compounded return.

    In addition, Trent’s goal of 25 years is a goal (and thus subject to performance). Even if Trent did keep with his $26,000 investment contributions, he would probably have a lot of other cash value other than retirement. Even if he didn’t, if he adjusted his retirement goal by only 5 years to be 30 years instead of 25, he then ends up with ~$3.2M.

    This is also a conservative operation at 8%… if he comes in slightly higher, say 10%, he has ~$2.8M at 25 years just staying at $26,000 input. If he increased that to $40,000 input after 10 years for the remaining 15 years, he is over the $3.3M mark.

  4. I try to operate everything conservatively. This plan would produce what amounts to my current income ~then~. That means I would still be able to reinvest a substantial amount of my investment income then. I can retire at 55 strongly with this plan.

  5. I was reading my fresh copy of Beckett Baseball Card Monthly and was immediately attracted to an article about the overproduced cards of the 80s and 90s. Our very own renaissance man, Trent, is quoted several times in the article! It even references this website.

    Wow, Trent, maybe there is a correlation between spending lots of money on baseball cards as a child and now being focused on our finances? Nevertheless, I wouldn’t trade those days of collecting for anything. Like you said, I never saw it as an investment and I don’t regret it at all. Great article!

  6. In addition to a SEP-IRA, I would also consider a solo 401(k). Between those two in addition to your current methods, you should be able to save enough for financial independence in tax-deferred or tax-advantaged accounts.

  7. I agree, Trent, that this plan would allow you to retire strongly. If you live the principles set out in “Your money or your life” and practice even a fraction of the creative frugality Amy D wrote about in “The Complete Tightwad Gazette” my guess is that you could reach your crossover point years earlier than 55. How exciting :) Good luck with your plan and keep up the great posts!

  8. If I only knew about finance when I was your age. At 45 things are a lot different, then 25, I have been maxing out my retirement for the last few years and plan on having my home paid off (our only loan) in less then 8 years. But even with this and other investments I don’t see myself being able to retire in 10 years. Your plan is great, they need to teach this to kids in school while they are young. Econ for Kids 101. They worry about sex education, they had better start thinking about financial education, it should be mandatory like gym class. I know high school students who still can’t make change, do simple math without a cash register. Not to long ago a fast food rest. lost their registers and the managers were having to add the food purchases up and make change, how sad, I was doing this in 4-H, while in grade school when working the consession stands and all that was there was a cash box, paper and an pen.

  9. I’d be curious as to why you didn’t go with a Roth IRA in your plan? I realize you wouldn’t be able to take out the money without penalty with your plan to retire a little early but from what I remember reading you plan on still working in some form even after you reach the crossover point so you would still have income until you got to the magic 59.5

  10. If you don’t need $50K because you won’t be investing $26K during refirement/financial independence, don’t use $50K as your expenses number then. Use $24K as the projection.

  11. I think Brian makes a good point Trent, with 4% inflation its unrealistic to assume you will be not be increasing the amount (26K) you put towards retirement every year. If you increase the 26K by 4% a year and use the 8% ROI assumption, then you will have around 3M after 25 years.

  12. Hi Trent

    We have a similar life plan mapped out (but in Australian dollars) and I am just wondering how you intend to cover your children’s education in the future. It’s a growing trend over here to send children to private schools, both for accessibility to resources and opportunities, which for us adds up to $9,000 per year and our kids are 5 yrs and 6 yrs (and our school is mid-range price-wise). I have estimated this amount will be $12,000-ish per year when they are in high school. We are planning ahead for these costs which are not insignificant…but is difficult to know what vehicle to use.

    My question is do you have the same sort of needs and how do you intend to manifest this future investment. I hope that is not too impertinent a request – just wondered how you are plotting these costs in your life map.

    Kind regards and just love your blog – every morning it gives me renewed interest and motivation to save more and spend less.

    Lorraine

  13. There’s a website & forum about 72(t) distributions at 72t.net.

    Those distributions aren’t for the faint of heart. Once you start, you need to continue for 5 years or you get hit with taxes and early withdrawal fees. And since you need to amortize your sum for your entire life, this method doesn’t work for many early retirement scenarios. But it’s worth checking if it will work.

  14. …there’s no tax implication because my standard deductions for all of my dependents are substantially more than the house interest…

    You’re gonna want to check that, Trent. If you mean literally, the “standard deduction,” it’s not affected by your dependents. If you are referring to the standard exemption for dependents, you still get that exemption whether or not you take the standard deduction.

    So I hope you mean that your standard deduction (for married filing jointly, I assume) is a lot more than your house interest and any other Schedule A deductions. If so, carry on, I’m just picking on your wording.

  15. There was an article in Money magazine (I think it was money) a month or two ago that spotlighted a couple who “retired” at 40 years old using 72t distributions. As the article pointed out, once you start these withdrawals you have to let them run without stopping them for several years (without penalty).

  16. Let me get this straight. If you are earning 50K, you need to put away 52% of your pre tax income (e.g. 26K) in order to fund yourself at that same level at retirement (the percentages remain consistent over time). Okay, so lets add the 7.6% for Social Security and Medicare, say 5% for health insurance, 2.4% for life insurance, 8% for federal income tax (you get the kids as deductions), 6% for state income tax and we end up with about 29%, and I think I’m being generous here. That makes 81% of you 50K that’s pretty much gone each paycheck. Leaving you with about $792 a month to feed, clothe, and house your family of five. Is it me or is this a bit wrong.

    If we were to tack on a 10% monthly payment for a mortgage, and 2% times 2 for each child’s college fund, you’d then have a whopping 5% to feed and clothe yourselves, or around 50 dollars a week for a family of four, and I haven’t even tacked on electricity, cell phones, gas, etc.

    Frankly, I think this example is whacked. It isn’t realistic. The only way it works is if you have determined that the 50K equivalent is what you feel you need at retirement, but your current income is signficantly higher.

  17. @Peter: The only way it works is if you have determined that the 50K equivalent is what you feel you need at retirement, but your current income is signficantly higher.

    Um, yes. That’s the way Trent said it was. Re-read this section:

    The first step in figuring things out is to determine exactly what I’ll need. Do I want to replace my living expenses alone – which would mean that I’d have enough to live, but wouldn’t be very protected against inflation – or if I want to replace my whole salary, giving me a lot of breathing room. **The actual number I’ll probably need is somewhere in the middle – enough to maintain some growth, but not my current salary.**

    Let’s say I shoot for $50,000 a year in today’s dollars – in 25 years. Given 4% inflation between then and now, I’d need an income of $133,291.80 then. If I invest it in a stable fashion, I should be able to rely on returns of 7% annually. meaning I need to shoot for $1.9 million in investments in 25 years.

  18. @Peter: Yeah, from what we know of Trent’s skills, I’d guess his income is higher. His real world job might be something related to software (he was able to customize wordpress) or is bright enough to pick simple HTML&PHP on the side. Even living in Iowa I can’t imagine him making less than 70k with that background.

    There’s also the income from this site, which I’d guess might be between 4k and 8k.

    Even at that amount, saving 26k/yr still restricting. I know that firsthand.

  19. I lost a little over $7,000 (IRA) this year in the stock market. I think I would have been better off if I had gamble cause at least I could have claimed the losses on my taxes. Everything I read talks about how you can make money in the stock market. Well, I must be in the wrong stock market. I make around $27,000.00 a yr, in a 401K putting in 11% every 2 weeks which has a losey rate of return of around 4% if I’m lucky , single homeowner(bought last year), no children (no tax deductions to speak of) & am still only getting about $900.00 (even with PM ins) back from Federal. I need to use about $600.00 of it to have blinds professionally installed. Any hints of what I should do with the $300.00 to make some great stock investments? I’ve read a lot about REITS & they seem to be the best thing to put your money in these days. Would I be better off taking my money out of the IRA & putting it back in a Money Market at my credit union even if it’s only 5%?

  20. To be able to put $41,500 into savings, you’d have to be earning a ton of money. With a Ph.D. and 20 years of steady work I make a decent salary, and that amount is well beyond my reach. It’s significantly more than my take-home pay. This semester I took on a second full-time equivalent job and even with the added income, I couldn’t begin to put that much aside.

    My income from the first job is well above the state’s median. It puts me in the “upper middle class” when measured by that online tool that’s supposed to tell you what your financial status is (sorry — I forget the URL but it’s been featured on several blogs & news sites). Both incomes combined presumably would jack me into the high-income category. I live frugally and have no debt except a small 2nd mortgage that will be paid off by December.

    In 2010, I certainly will not retire with almost $2 million. Had we not been faced with the recession we now see barreling toward us, I might have retired with nearly $1 million, but at this point I think that is extremely unlikely. In fact, thanks to the mismanagement of the US economy at the federal level, I don’t expect to be able to retire. Period.

  21. Wait! I misread Trent’s post & so have to take part of that back.

    Let’s see: $15,500 + $12,000 = $27,500.

    Hmmm…. My 403b gets $14,404 a year. According to the figures I cooked up for yesterday’s post at my site, I could in theory set aside $33,244 a year (= 100% net pay from side job + maximum possible savings from net salary of main job + 403b savings & match totaling 14% of main job salary). To do so would require me to continue working two full-time jobs. First, though, I will have to pay off the 2nd mortgage, which will take until next December.

    If my side job were to drop down to a more sane 50% FTE workload (which it probably will), I would be able to set aside $26,524 a year, ASSUMING utility bills do not rise significantly, gasoline prices stay where they are, food costs do not continue to rise, and the recent county property tax revaluation yields a significant drop in tax bills. That is on a total income well above average with a lifestyle I think of as frugal and my friends regard as ascetic.

  22. Hi Trent,

    7% yield after taxes consistently is way too high. Where did you get those numbers? Did you take fees into consideration? Even Vanguard charges them.

    If you can make 7% after taxes, you should take more money out of your home at 6.5% mortgage rate and invest it for 7%. You’d be stupid not to.

    I think 4% after taxes is more realistic. Check the numbers. 4% also means that conservative investments are only a protection against inflation.

    Another tip from me is check out the early retirement calculator at http://firecalc.com/, it helps to determine how much money you need for retirement.

    Keep up the good work,
    Fubek

  23. @Funny about Money I am not doubting your statement about not being able to save 26K a year, but, this year I conservatively expect to save ~35K. I say “conservatively” because this figure assumes I don’t pour every extra dime I make doing other stuff into savings -which I do.

    I am Trent’s age, support a wife and child with another on the way with just my income. My income is just slightly above the median for my state. Not that this matters, but I also do not have a Ph.D. I’ve been working in my industry since I was 18 and attended night classes @ college while working full time.

    We’ve managed to do this by living a modest lifestyle, and careful management of what we have.

  24. My husband and I are just about at the crossover point but we have the advantage of a small military retirement in addition to our savings. We have always saved 20% of our income and given away more than 10% and we have four kids. We are currently 46 and 47 years old. You might be interested in Ray Lucia’s new book called, “How to Retire in Comfort and Safety.” If you follow his advice you don’t need to save nearly as much. Also, it is important to really figure out how much you need to live on. You don’t need as much as you think you do. Good luck.

  25. @Pearl

    I’m no finacial advisor, but you should reasses how you look at your IRA. You said it was in the stock market. If so, you’ve lost “value” but haven’t lost shares (unless you’ve sold it or shifted to less volatile funds). Hopefully you have time to allow the shares to recover their value and grow beyond. Keep in mind, the market goes up, it goes down but on “average” it trends up. Some years your shares are worth more, and some years they’re worth less. When do you want to buy new shares? When they’re worth less or when they’re worth more?
    When do you want to buy goods for your house, when they’re offered at a discount, or when they’re in demand and priced high?
    You pay more per share when they’re riding high. If you take you’re money out now, you really will lose $7,000. The real issue is how long you have before you need to start drawing down your shares. Anything over 6 years and most folks I’ve read would recommend leaving the money in there. I would expect this year will be another losing year (election years are always questionable). But if you have time and can stomach some risk, now’s a good time to buy IMHO.

  26. One more tip: check out the 2007 Berkshire Hathaway Warren Buffet letter to the shareholders. Warren mentions that the DOW on average “only” made 5.8% in capital gains in the last century. Plus 2% dividends. Now, deduct the fees from that and taxes, and you are no way near 7% after fees and taxes.

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