The Four Stages of Financial Independence

Financial independence is a tricky phrase because it can mean different things to different people.

Right now, I view financial independence as being a state where I no longer have to work for money. Yet, seven or eight years ago, I might have viewed it as simply being free from worrying about my next paycheck. At different points in there, I might have seen financial independence completely differently.

Along the way, I’ve come to realize that financial independence is made up of a series of stages. Some people might see more stages, while others might see fewer; I see four clear ones.

In my own financial journey – and in the journey of others that I’ve had conversations with – “financial independence” generally means the next stage that hasn’t been achieved yet.

For example, once upon a time, I viewed financial independence as not needing to rely on my parents or on my very next paycheck to survive. As I achieved that, my definition changed.

Let’s walk through these four stages and look at what needs to be done to achieve each one.

Freedom from the Paycheck-to-Paycheck Cycle

According to recent studies, 76% of Americans live paycheck to paycheck. In the words of the article:

“Fewer than one in four Americans have enough money in their savings account to cover at least six months of expenses, enough to help cushion the blow of a job loss, medical emergency or some other unexpected event, according to the survey of 1,000 adults. Meanwhile, 50% of those surveyed have less than a three-month cushion and 27% had no savings at all.”

In other words, a person is in this category if they’re going to see significant financial problems within a short period if they lose their primary job. You can define “short period” however you want – a month, six months, whatever.

I tend to define it as six months. If you were fired tomorrow and could survive for six months without getting a comparable job and without facing complete financial apocalypse or a huge explosion in your debt, you’re probably enjoying freedom from the paycheck-to-paycheck cycle. Believe it or not, three in four Americans can’t match that level.

A part of this is freedom from “financial outpatient” support from the Bank of Mom and Dad. If you still require a regular influx of cash from your parents to maintain your current lifestyle, then you are unquestionably still living paycheck to paycheck. Some people receive these kinds of gifts and channel all of it into savings, which is the best way to make financial progress with parental support. You must stand on your own two feet.

How did I do it? We achieved this level in late 2006 or early 2007, perhaps nine months after the beginning of our financial turnaround. We paid off several credit cards and built a very healthy emergency fund during those early months, but it took until the end of the year for us to begin to feel a bit of security about our situation.

How do you get here? The best method is to cut expenses. Live as cheap as possible and use the excess to get your bills up to date and build up some cash in your savings account. If you’re not fully employed, look for work as you need income to make this happen. Spend less than you earn and master it, as you’ll always want to be in that state.

Freedom from Debt

The next level of financial independence, in my experience, is freedom from debt. Why is this such a vital level? It represents the clearest possible case for minimizing one’s monthly expenditures. Once your debts are gone, your set of monthly bills is going to be awfully small, plus you won’t be giving away money in the form of interest payments.

When most people reach debt freedom, they’re often stunned at the amount of cash sitting in their checking account. It becomes much, much easier to invest for the future as you can take the money that was disappearing into a black hole of debt and instead apply it to your future. You’re building wealth instead of undoing earlier mistakes.

How did I do it? We achieved freedom from all non-mortgage debts in 2008 and complete debt freedom in 2011. Not only did it feel like a huge weight left our shoulders at that point, we noticed that our financial growth really began to accelerate. With no debt payments, we moved to a model where we have been banking my entire income since early 2012.

How do you get here? Build and execute a debt repayment plan. Keep your expenses low so that you can blow through that plan.

Freedom from Your Job

At this point, you can lose any of your family income streams and you’ll still survive. If you lose your primary job, you can keep rolling in perpetuity. You still need to work for a living, but none of your methods of earning money are a requirement. A pink slip is just shrugged off and changing career paths is completely fine.

Ideally, this is true because you have income arriving from a number of different sources. Maybe you earn money from your primary job, your investments, an array of Youtube videos you’ve posted, and maybe a book you wrote a year or two ago. If you lose any of those streams, you’re still fine – it just means you devote more time to the other ones. If you find your passion is gone from one of those streams, you can simply close one out and move to another one.

How did I do it? Sarah and I achieved this threshold sometime in late 2012 or early 2013. During that time, Sarah realistically thought about leaving her current career path for a while to pursue other things and we realized during that conversation that our finances really weren’t the primary part of the discussion any more. Yes, there would have been financial impact from that choice, but the discussion mostly revolved around Sarah’s personal goals. She was free from her job at that point; she chose to stick with it because she realized how much she loved her work.

How do you get here? Invest for the future so that your money starts producing income on your own. Spend some of your spare time creating things that generate income for you, like writing a book or recording Youtube videos. Keep your expenses low so that you can afford to invest a lot and so that losing an income stream isn’t devastating.

Freedom from Employment

The final level – which is the target that Sarah and I have for the future – comes when your investment income exceeds your living expenses, which means that you no longer have to work for money. You can spend your time however you wish as long as you don’t spend money foolishly. Ideally, your income from investments exceeds your spending so that you can roll some of that investment income into more investments, making you more or less inflation proof.

Our goal is to achieve this level by 2020 or so. We’re aware that we do have the expensive mountain of three children entering into postsecondary education all within five years in the early 2020s; otherwise, we’d probably be able to achieve it sooner than that.

How do you get here? Keep investing. Eventually, when you get close, invest in things that produce direct income for you, such as dividend-paying stocks or rental properties. Keep your expenses low, too.

Final Thoughts

There’s one common thread running through all of these stages: keep your spending under control. No matter where you’re at financially, frivolous spending is your enemy. It pushes your financial goals away from you and increases the time it takes to move to the next level.

Still, it’s a balancing act. Sometimes, expenses that bring joy today are worth putting off that financial progress. The key is recognizing that your spending is slowing down your progress. Always question your unnecessary desires; let them thrive sometimes, but put the stops on the sillier ones.

This progression isn’t going to happen immediately. Sarah and I took years to move from level to level, and we threw ourselves deeply into frugality while we were both working full-time jobs and I was starting a significant side business that was very time intensive and personal labor intensive. Be patient.

One final thought: it feels great to achieve each level. It makes your day-to-day life feel less challenging and less stressful. You experience much more freedom than before and you include many more factors – such as personal happiness and engagement – when making major life and career decisions.

Best of luck in your financial journey!

Trent Hamm

Founder & Columnist

Trent Hamm founded The Simple Dollar in 2006 and still writes a daily column on personal finance. He’s the author of three books published by Simon & Schuster and Financial Times Press, has contributed to Business Insider, US News & World Report, Yahoo Finance, and Lifehacker, and his financial advice has been featured in The New York Times, TIME, Forbes, The Guardian, and elsewhere.