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The Path to Financial Independence in Detail
Gary writes in:
What exactly do you mean when you talk about financial independence? Can you break it down a little?
In simplest terms, when I talk about financial independence, I’m referring to a situation in which your living expenses are fully covered by your investments for the rest of your life. In other words, you no longer have to work for a living because you have enough in the bank to allow you to live your current lifestyle year in and year out for forever (or close to it).
Depending on which financial advice you read, that means you need to have somewhere between 25 times and 35 times your annual income in investments. That number changes depending on the aggressiveness of the investments and how many years of financial independence are being assumed. In general, I aim for the middle of that of that range and usually use a 30x multiplier (about a 3.3% withdrawal rate).
So, let’s say for example that you can live a life you like on $20,000 a year. That means you need to have somewhere between $500,000 (25 times that amount) and $700,000 (35 times that amount) invested. My target number would be $600,000 (30 times that amount).
Once you’ve reached that point, you simply withdraw $20,000 a year from your accounts and live on that amount (about $1,667 a month). You’ll be able to slightly increase this amount each year to account for inflation, so we won’t muddy the numbers with inflation.
If you need more than that, you can do the math pretty easily. Figure out how much you need per month to live a comfortable, simple life. Let’s say you decide it’s $3,000 a month. To hit that amount, you multiply it by 12, giving you $36,000 a year. You then multiply that number by 30, giving you $1,080,000. That’s how much you would need to have socked away in order to have financial independence while living on $30,000 a year.
Your Target Number and Your Lifestyle
Obviously, the big challenge is getting there, and it’s a multifaceted challenge.
In general, the journey to financial independence can be expressed with a very simple equation.
Your total income = your living expenses + money you can put aside for the future
In order to achieve financial independence, you need to be putting a lot aside for the future. That means maximizing the first number (total income) and minimizing the second number (living expenses) so that the third number can be as large as possible. The bigger that number is (and the smaller your living expenses are), the faster you can get there.
The first thing to consider is what kind of lifestyle you want to establish. Obviously, you’re going to need to be living on less than your income, but what portion of your income are you going to live on?
Let’s say you make $60,000 a year, which is pretty close to the American average household income. Can you live on half of what you make, $30,000 a year? Can you live on two thirds of what you make, or $40,000 a year?
It really depends on the kinds of lifestyle choices you want to make. Do you need to have a large house? Do you need to have a shiny car? Do you need to have a constant stream of “goodies” in your life? It’s all about the lifestyle choices. The more expensive things you choose to have in your life, the more you need to spend each year, and thus the larger your target number is going to be.
Even worse than that, the more you need to spend each year, the less you have available to save each year to reach your target number. Your expenses really do hit you both ways.
So, the absolute most important thing you can do if you want to achieve financial independence is figure out the minimal expense lifestyle that makes you happy. This isn’t worth doing if your life makes you miserable. On the other hand, this is impossible if you spend every dime you make. There’s a balance somewhere in the middle, where you’ve cut expenses that don’t make you happy and downgraded the big things in your life to the point where you’re maximally happy considering their cost and upkeep time and personal benefits.
For example, right now, I have a fully paid for house that I’m happy with, but I actually would like to live in a smaller one once my three children move out. Without kids, we don’t need this much space; arguably, we don’t need this much space right now. What does your minimal house look like, the one that minimizes expense but still leaves you with a comfortable pleasant life? Is it smaller than what you have now? If so, downsizing might be good for your financial state.
Another example: we have two cars for our family, one with more than 100,000 miles on it and another with more than 200,000 miles on it. We could definitely replace either one with something much newer… but why? What do we gain out of this that matters to us? Very little. There are others, with different lifestyles and different interests, who might get a lot of value out of a newer car, but for us, the primary use of a car is to get from point A to point B and these automobiles do the job well. What does your minimal transportation cost look like? Do you need the number of cars you have? Do you need to replace them before they utterly wear out? If you’re replacing cars before you’ve extracted the full value from them, then stop that cycle.
Do you get enough value out of cable to be spending $100 a month on it? That $100 a month becomes $1,200 a year, which adds $36,000 to your target number, and that $100 a month is $1,200 a year that you’re unable to save to get you to that target number. Is it really giving you that much joy? Are there other cheaper options that give you the good life? Consider cutting the cord (and here’s my guide for it).
Every single expense in your life needs to be considered that way. You need to find the minimal expense lifestyle that’s still comfortable and happy and joyous for you and actually live that lifestyle. The cost of that lifestyle sets your target number, and it also sets how much you need to get there.
Don’t Forget Your Career
As I just explained, your income breaks down into two parts.
Your total income = your living expenses + money you can put aside for the future
There are two variables here you can change based on your own actions. You can change your total income (ideally increasing it) by working smarter and harder and also by investing. You can also change your living expenses (ideally minimizing them) by finding ways to cut your expenses that don’t hurt the joy of your lifestyle.
Those two numbers really determine the “gap,” which is what I use to refer to that third number, the money you can put aside for the future. That’s the money that you actually use to get to financial independence.
Often, the living expenses are the more directly actionable part of the equation, as explained earlier, but you can definitely work to increase your income as well. The thing to remember is that efforts you take to increase your income don’t have to have immediate effects; if you can start doing something that improves your income a few years from now, it’s going to significantly improve the amount of money you can save each year as long as you don’t alter your spending along the way.
So, if you make $60,000 a year and spend $40,000 a year, you have $20,000 to save each year.
If you make $60,000 a year and cut your spending down to $30,000 a year, you have $30,000 to save each year.
If you get a raise to $80,000 a year and keep your spending at $30,000 a year, you have $50,000 to save each year.
The more you have to save each year, the better, obviously, so career improvements play a big role, even if they’re career choices that won’t directly pay off immediately.
Thus, if you’re serious about financial independence, you should take a strong career-focused approach to your job with an aim to improve your income as much as possible over the next decade or two.
That means doing things like getting certifications, getting a better degree, building lots of professional relationships, positioning yourself so that you’re known positively to lots of people in the high-paying places you want to work, completing projects, taking on leadership roles, and so on. I’m not going to write out an omnibus of career advice here, but I am clearly saying that part of the path to financial independence involves maximizing your career beyond just what your responsibilities are at work today. You need to be aiming for better career positions that pay a better income, and you need to not increase your living expenses along the way.
Getting From Here To There
So, let’s look at that equation again.
Your total income = your living expenses + money you can put aside for the future
Once you’ve done what you can to maximize your total income and minimize your living expenses, what exactly do you do with that money left over that you’re putting aside for the future?
The first thing you need to do is pay off debts. Almost everyone agrees that the first step is eliminating your high interest debts – everything with an interest rate of about 8% or so. You’ll find a lot of debate about what to do with lower interest debts, whether you should pay them off rapidly before starting to save so you don’t have those minimum payments around your neck and can save even more or whether you should start saving for the future now and make minimum payments on those debts. A lot of that has to do with personal philosophy and personal risk assessment – I don’t think either path is strictly right or wrong. Whatever you decide, though, get rid of higher interest debt and do everything in your power to keep from acquiring any more of it.
The second thing you need to do is build an emergency fund and start saving for irregular expenses. An emergency fund is a pool of cash, usually in your savings account, that you can use to deal with major unexpected events. Avoid using a credit card for this, as many emergencies will deny you the use of that card. Cash is king. Irregular expenses are things like car repairs, home repairs, appliance replacements, car replacements, and so on; it can also include infrequent bills like property taxes. Start saving so that those things are covered when they come around rather than having to take on debt to cover them. The best way to do this is to start automatically transferring a healthy amount of cash each month to your savings account and then using that account for genuine emergencies and for any irregular bills you can’t handle out of pocket.
Once those things are covered, start putting money aside for the future. My general recommendation is to follow these steps in order, using your “put aside money” on each step until you’re out. Any further money you begin to earn from an increase in income should be handled the same way – just go through the steps and put the money in the first step where it fits.
First, contribute to your workplace’s retirement savings plan up to whatever amount you need to get every drop of matching funds from your employer. If your employer doesn’t offer a plan or doesn’t offer any matching, skip this step.
Second, if your income is low enough, open up a Roth IRA and fully fund it. If it’s too high for that, open a Traditional IRA and fully fund it. Here’s some good advice on opening a Roth IRA that almost entirely applies to Traditional IRAs as well.
Third, go back to your workplace’s retirement savings plan and contribute up to their limit. There’s almost always some cap on contributions, so keep adding to this until you hit that cap.
Fourth, open up an account with an investment firm of your choice and start investing in a broad-based index fund like the Vanguard Total Stock Market Index. If you’re at this point, it probably makes sense to start learning more about investing, so pick up a book like The Bogleheads’ Guide to Investing or The Simple Path to Wealth.
All of these contributions should be automatic ones. Your workplace should be able to handle automatic contributions to your workplace retirement accounts and your investment firm of choice should be able to handle automatic contributions to those investments.
The trick, of course, is living on what’s left.
Part of what you’re actually doing with aggressive automated investing, where you never actually touch the money at all, is learning how to live on what’s left behind once those investments are covered. You’re paying yourself first, but doing so with gusto.
This will require some adjusting as time goes on. You might learn that you’re being too aggressive, so you need to dial something back. You might decide you can be a little more aggressive, so you increase a contribution. Aside from that, this entire system should move you automatically toward financial independence.
What Happens When I Get There?
People have somewhat different exact definitions of what it means to be financially independent, but my view is that if you can meet your living expenses for the year solely by withdrawing 3.5% or less of your investments, then you’re financially independent.
So, what happens then?
At that point, you have a lot of freedom to decide what to do with your life. In short, you no longer have to work to earn an income, so your sole motivations for continuing to work are either because the work fulfills you in some way, you want to slowly increase your standard of living now and when you’re no longer earning an income, or you want to do something else with that income (like make charitable gifts). If none of those are present for you, then walk away from work and fill your day with whatever you like.
For some, work might be deeply fulfilling and they choose to continue to do it. In that situation, salary really doesn’t matter too much unless it’s being used for one of the other purposes listed here. My feeling is that, if you’re financially independent, you shouldn’t be spending your time doing work that isn’t fulfilling – otherwise, what is the point of becoming financially independent? I’m all in favor of doing fulfilling work, but if work isn’t providing deep meaning in your life and you don’t have to work for income… find something else to do.
Some others may want to continue to increase their savings for the future, either so that they can slowly start ticking up their lifestyle or so that they can have even more security when they do choose to walk away from work. Many people may be theoretically financially independent but don’t want to do it quite yet because their standard of living would be thinner than they would like, so they keep working. Others may want even more security.
I know of at least two people who continue to work at jobs they’re content with even thought they’re financially independent and could live on their savings. In both cases, they give significant amounts to specific charities they care about – in at least one case, this person is sustaining a pretty important charity just out of their pocket.
The point is this: once you reach the point where you no longer have to work for money, you have a lot more freedom to decide what to do with your time, but that doesn’t mean you have to retire and sit at home and do nothing going forward. There are countless options for you.
What Happens If I Change My Mind Along the Way?
Many people start down this path and, after several years, realize it’s not what they want. They may decide that they want to raise their living expenses. They may get married and have children, which requires at least some raise in living expenses. They may want a less intense career or a more meaningful one. There are lots of reasons why people might choose to stop working toward financial independence.
What happens then?
Usually, people who make that decision after years of saving heavily for retirement have a very, very nice retirement nest egg built up, so even if they dial back their retirement savings significantly, they’re still going to have a very nice retirement when they reach typical retirement age, and that’s something they’ll always appreciate and have in their back pocket. I can’t imagine anyone seriously saying “I wish I had less money saved for retirement.”
In other words, chasing financial independence is a goal that, even if you decide to switch to another goal, you’re not going to regret the progress you made along that path. That cash will be there for you no matter what you decide between today and full financial independence.
Financial independence is a wonderful financial goal, but achieving it early in life (say, well before typical retirement age and Social Security benefits) is a stiff financial challenge. For some people, the personal freedom that it offers makes it an intoxicating target, particularly if they’re willing to take a radical approach to their spending habits and live on a relatively small percentage of their income. Thus, financial independence is often very appealing to individuals who are interested in living a minimal lifestyle while chasing a high-paying career.
Sarah and I have financial independence as a long term goal in our lives, but because we started down the path relatively late and chose to have three children (like it or not, children are expensive and delay large financial goals), we won’t be retiring incredibly early in life. We do aim to retire somewhat early, likely right in time with our youngest child leaving the nest.
Financial independence might not be the right goal for you, but it is a sensible financial goal for people who are driven for personal freedom and opportunity above all else.