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Stage 4 on thefinancial wellness roadmapis financial independence.
Fromfinancial securityto being financially independent, your ability to grow assets and create incomes streams frees you from the need to work for money whether for a period of time or for the rest of your life.
What is Financial Independence?
Financial independence means having enough income to pay your living expenses indefinitely without the need to work or earn income. Many achieve financial independence later in life through traditional retirement using 401(k)s, IRAs, pensions, and Social Security benefits. And some achieve this through an intentional and detailed financial plan of saving and investing.
At stage 4, you can answer questions like:explain the 4% rule?what’s your retirement withdrawal rate? how much money saved? how much is your savings earning? do you factor in inflation?
Financial Independence Key Features
- control lifestyle inflation;
- holds no debt;
- healthy savings accounts;
- earnings outpace withdrawal;
- passive income streams;
- diversified assets and investment portfolios.
Financial Independence Defined
Let me start by saying there really isn’t one definition for financial independence. Some would say financial independence means you have sufficient assets as sources of income to support your lifestyle. I define it as having the “right” amount of wealth to no longer be dependent on a job for income to pay for living expenses.
It sounds like retirement, but the main difference is when you get to live off your wealth.
Financial independence is reached when you have enough money to cover your basic needs and some luxuries too. Expenses are paid from savings accounts, income generated from assets or investments, and some work. Basically, you must havesufficient wealthto live without depending on a job. The sign of financial independence is when working is achoiceand not a requirement.
How to Become Financially Independent
Financial independence for everyone. Although media coverage focuses on people who retire from work after amassing a sizable nest egg, the truth is financial independence is a matter of lifestyle, income, and math.Accumulate a big enough nest egg in which you can withdraw money to pay for your living expenses for the rest of your life. Ideally, the nest egg includes appreciating assets that can be withdrawn or easily sold for cash. Although you can include your primary home, cars, jewelry, or anything of value in calculating your net worth, it’s more ideal to only use retirement accounts, investable assets (stocks, ETFs, etc), vacation and rental properties, and your ownership in business ventures.
Your path to becoming financially independent seems daunting, but it’s not as complicated as it sounds. The following can help you move forward on your path to FI.
1. Challenge your lifestyle choices
After living a certain way, you’ve made financial decisions to cultivate a lifestyle. Many of these decisions are made unconsciously but still impact our finances. Challenge your lifestyle choices by asking yourself:
- would I make different choices if it meant I could work less?
- will I change my lifestyle if it meant I could quit a high paying job I hate for a lower-paying job I’d enjoy?
- would I forgo buying a new car so I can pay off another debt?
There are no right or wrong answers to these questions. It’s a personal choice. And my point is to let you know you have a choice and one that affects your financial wellbeing. The lower cost of your lifestyle can mean a smaller amount of savings needed to finance that life.
2. Retirement is a financial number
In traditional retirement, you’re no longer earning income as defined by the IRS and eligible for government benefits such as Social Security. Traditional US retirement is usually achieved later in life around 70 years old. This is also the age that many have significant investment portfolios to live on indefinitely.
With financial independence, you’re “retired” from having to earn income. You have significant wealth to cover your living expenses without dependence on income from an employer or from your own business activities. Sure, you can work if you want to, but you don’t have to when you’re financially independent.
Most who want to achieve financial independence want to do so earlier. The reasoning–wanting to have more control over one’s time.
3. Take control of your time
One thing I’ve learned is the power of time and the ability to explore and experience the world when I’m not sitting behind a desk to earn money. With financial independence, the goal is to regain control over your time.
My philosophy on time–it’s borrowed and can be taken at any, well, time. Since it’s a liability we need to pay it back and that means living life fully.
Becoming financially independent can help you shift your attention to the more important things in life. You’re no longer worried about how to pay for basic living expenses. You now have time and your attention to create the life you’ve dreamed of. I covered the importance of time in my book, You Only Live Once: The Roadmap to Financial Wellness (get on Amazon or listen on Audible)
And financial independence can also mean you choose to work because you love the work you do. It’s a choice to work with a company and to be around coworkers. That sense of freedom is life-altering. It changes the way you work and how you interact with others. Imagine going to work because you want to, not because you have to.
4. Spend way less than you earn
In other words, lower your monthly expenses and cut your discretionary spending way down. Not everyone seeking financial independence is cheap, but they do take extreme measures to control spending. With every penny saved, it then has the potential of growing.
When you save more than you spend, you’re accelerating your FI timeline. There is a dual benefit to lowering your expenses and spending less: (1) the lower your expenses the more money you save and (2) having smaller lifestyle expenses means the money you actually need to save is lower. For example, if your lifestyle costs $100,000 a year, then you’ll need $1,000,000 to be independent for 10 years. If you’re lifestyle costs $50,000, then you have 20 years.
At phroogal, my philosophy is to spend on what matters to you. When you understand your values, you’ll realize how much you don’t need to spend after all.
5. Have a safety net
Achieving financial independence earlier than retirement age means you need to think about long-term sustainability. That may require having your money invested in stocks that carry a bit more volatility. To maintain peace of mind, have a two-year cash safety net in a savings account or certificates using a CD ladder strategy. This can protect you against market fluctuations. You can think of the safety net as your emergency fund but since you’re financially independent, you’ll need about 1-2 years in a liquid account when markets hit a downturn.
6. Eliminate debt
Your path to FI requires debt elimination. Why? Debt is an obligation. Having debt allocates more of your time to work rather than fun. The goal is to decrease monthly expenses by eliminating monthly debt payments. Sure there are further discussions needed regarding paying off mortgages and using leverage to create wealth. But for the vast majority of people, reducing the amount of debt fast tracks progress on the roadmap.
7. Diversify and multiply income streams
Having multiple income streams can support financial wellbeing. It’s essential to have diversified income so you’re not dependent on one source. You can certainly achieve financial independence with your investments, but ideally, a variety of sources will give you more freedom.
If your income streams (excluding your work income) cover your living expenses, then your present job is optional and you can consider yourself financially independent. You have enough income to pay for your lifestyle with work being optional. A great book to understand this concept is Work Optional by Tanja Hester (get on Amazon | listen on Audible).
8. Calculate a financial independence goal
You’ll need to calculate your financial independence number.Your financial independence number is the amount of money needed to be able to pay for expenses without depleting your money. Basically, once you have the amount of money saved/invested equal to your financial independence number, you can call yourself financially independent.
How much money do you need to achieve your FI goals? Use the rule of 25 which states you’re ready to retire when you’ve saved 25 times your planned annual spending. For example, your annual spending is $50,000, then you’ll need $1,250,000 ($50,000×25) saved.
To get your FI number, look at your desired spending, and multiply that by 25.
Rule of 25: Financial Independence Number = Yearly Spending x 25
There are some things to consider such as housing which is a big expense for many. Paying off a mortgage or downsizing can lower your FI number. In fact, traditional retirees have paid off their mortgage or moved to a lower cost of living area to extend their savings.
And the other is the 4% rule which says you can safely withdraw 4% of the value of your investments during your first year of financial independence. During the following years, you can withdraw the same dollar amount adjusted for inflation.
4% Rule: Financial Independence Number = Yearly Spending / Safe Withdrawal Rate
If you do the math, you’ll notice the Rule of 25 and the 4% Rule are quite similar and both require investing for long-term growth.
9. Buy appreciating and income-generating assets
Once you have your spending under control or you’re making additional income, you want to start using that money to invest in assets that appreciate in value or generate income. The stock market has a historically long-term track record of growth and is used by many financially independent people to build wealth. Avoid buying stuff that depreciates which includes cars and tech gadgets.
Remember, you need income to fund your expenses, and that money is most likely going to come from your investments. To earn the kind of return you need, it may be necessary to build a portfolio that is invested heavily in stocks. And choosing index funds may be the better option for most people. Index funds or exchange-traded funds (ETFs) allow you to purchase many companies trading in the stock market in a single transaction. You don’t have to figure out which individual stock to buy.
Learn how to invest in stocks.
If you work for a publicly traded company, inquire with your HR about employee benefits such as stock purchase programs, stock options, and RSUs. And participate in the program.
10. Stay consistent and keep investing
With investing, you need to be consistent through the good and bad years. It can be challenging to invest when the market is down but often that can be a time for buying at a discount. When you automate investing and remain consistent you can benefit from dollar-cost averaging and accumulate wealth long term.
You’ll need a taxable brokerage account to invest your money. There are no tax benefits to these brokerage accounts but you can pull your money out any time and for any reason. Find the best online brokerages here.
11. Think about minimizing taxes
You won’t escape taxes so plan to minimize your tax liability. Factor taxes in your financial independence planning. Use tax-advantaged accounts available with Roth IRAs being the better alternative. There are IRS limits to tax-advantaged accounts but if eligible should be part of your plan.
Since you don’t take a tax deduction for Roth IRA contributions (after-tax income), those contributions and their investment earnings grow tax-free. In fact, the IRS gets no cut when you take your contributions back out, and you can do that at any time, at any age. This is especially important for people reaching financial independence before 59½, the typical age for accessing retirement accounts without a penalty.
Employer-sponsored plan: participate in your company’s 401(k) plans. Many offer matching dollars which is extra cash that adds to your FI goal. Learn how to optimize your 401(k) for better returns and lower administrative fees.
Why Financial Independence Matters
Your path to financial independence leads you to time wealth. A period of your life when you own your time. When you’re no longer dependent on a single source of income and can confidently cover all your expenses without working, then you regain control over your time and the things you do within that time.
Being financially independent gives you more time to spend with loved ones, work on passion projects, volunteer, pursue a new profession, or even start a new business.
Whether you retire early because you are financially independent or retire in your 70s, you want to retire well. The steps needed to achieve financial independence are similar to traditional retirement. The only difference is an accelerated timeline and a big lofty goal. With FI, the main areas of focus are expense reduction and extreme savings.
In conclusion, I want to add that anything can happen. Financial independence is a great goal but life priorities shift and the world changes. Be flexible with yourself and continue to assess your values. I know of FI people who ran out of money through no fault of their own. These things happen. You can plan all you want but there are some things you can’t control. The important thing I’ve learned is to continue to grow your skills, learn new things, have better experiences, continue to grow your network, and be open to earning income with the right opportunities.
Next Stage: Financial Freedom
Additional reading:
- Begin your financial wellness journey with these 10 steps
- Learn the essential financial wellness skills
- Find the best financial apps for your needs
