Most people do a great deal of future planning. We go to college and learn skills with the intention of using them for ~40 years. We plan out our career and our long-term relationships. We buy houses and decide where we’ll live for many years in the hope of someday being financially independent.
All of these are best guesses. A small number of people know what will make them happy for their entire lives at age 18 enough to plan the rest of their lives. Relationships end and life (or jobs) take us to different cities. Even the best-laid plans for life change. The more attached you are to these plans, the more painful these changes are.
So What is It?
Check out my Interactive Guide to Early Retirement and Financial Independence for a great overview.
Financial independence (abbreviated FI), is the point where you have the funds needed to live without needing to work day-to-day. Although you may not need to work, what you decide to do at that point could be anything (continue working, work part-time, etc). Like Mindfulness or Minimalism, most of the time in someone’s life is pursuing FI — saving money, lowering expenses and the such. Most of the time is the journey, and that’s the part to focus on finding a way to enjoy.
What Do I Need to Do?
Like mindfulness and minimalism, pursuing FI includes a number of things you’re probably doing already. The difference to me is the degree to which you do them. If you feel these areas of your life are in order, then I’d say Congrats! You’re pursuing FI! Here are a few of the core topics that form the foundation of Financial Independence (to me):
Keep Expenses Low
The lower your expenses, the fewer savings you’ll need.
Battling Lifestyle Inflation
As you make more money, try not to spend more too.
Being Mindful of Cost
Understanding what the long-term cost is for decisions.
Allowing your money to make more money.
The less clutter in your life, the more you can focus on what you enjoy.
Saving a High Portion of Your Income
As much as you can. Ideally 50% or more.
The common theme from these is spending money on what adds the most value to your life, and saving (and investing) the rest. It’s also about cutting out as much as you can from your life that’s a vampire for your energy and your money that isn’t enjoyable.
How Much Money Do You Need?
How much you need may surprise you. Take how much you spend each year and multiply it by 25. That’s the bare minimum you’d need, assuming it’s invested and markets do moderately well. A more stable number would be to multiply your spending by 33.3. This is what’s known as a withdrawal rate — the amount you could safely withdraw from your investments each year to live sustainably.
There’s this famous paper called the Trinity Study which is a study of what a “safe withdrawal rate” should be. Here’s a quote from that paper:
If history is any guide for the future, then withdrawal rates of 3% and 4% are extremely unlikely to exhaust any portfolio of stocks and bonds during any of the payout periods shown in Table 1. In those cases, portfolio success seems close to being assured.
The “table 1” reference identifies this as being over a 30 year period. This means that 4% is historically safe over a 30 year period. For longer periods, a rate closer to 3% is safer. So, if you have some money saved, and withdraw 4%, it might last. If you withdraw 3% it will likely last.
This is your spending too, not your salary. Here’s a quick snapshot of the amounts needed for various spending levels.
4% starts to get risky over more than 30, but 3% is relatively safe long-term based on historical performance.
|Yearly Spending||4% Withdrawal Rate||3% Withdrawal Rate|
As for how to read this — find your spending in the first column. Then the amount you’d need to be financially independent would be the value in either of the other columns.
The big takeaway for me is that for every $10,000 you shave off your required spending, you’ll need at least $250,000. If you can lower your spending from $100,000 to $70,000 then congratulations! You now need $750,000 less. This is where lifestyle inflation comes in. If you get raises throughout your career, and your spending grows with it, you’ll need considerably more funds in the end to maintain your lifestyle.
Wait, What About Taxes?
Disclaimer: I’m not an expert in taxes, so take this with a grain of salt.
Taxes work differently for investments than for payroll income. You might be aware that the “capital gains tax” is 15%. That means if you have an investment, and you hold it for a year and sell it, you’ll pay taxes on 15% of the gains in selling that investment. So if you bought $10,000 of Apple stock, held it for a year, then sold it for $11,000, you’d likely pay 15% of the $1,000 gains, or $150 in taxes — leaving you with a net gain of $850. This is how capital gains taxes work when you’re in your working career.
When I realized this about capital gains taxes, I was very surprised!
All of that changes when you aren’t working and making at least $37,000 a year (or $75,000 a year if filing jointly). The capital gains rate if you’re making under these amounts is 0%. In other words, if you’re married and making less than $75,000 in capital gains (not total withdraws — but the actual gains), then you’ll be paying $0 that year in taxes.
What About Retirement Investment Accounts?
There are some ways of getting money out of retirement accounts early, like the Roth IRA Conversion Ladder. The short answer though is that if you’re saving 50% of your income, you’re probably be putting a good deal of it into an after-tax investment account. I’d plan to still max out retirement accounts, but then not plan to touch them until much later in life — then make withdrawals from them in the most tax beneficial ways.
How Much Should You Save?
This MMM article started it all for me.
Similar to the table above which shows the huge difference in savings needed based on your spending, the impact the percent of your savings has on how fast you will make it to those rates is amazing. The first time I saw this chart on Mr. Money Mustache, I was amazed at the simplicity of it. The higher percent you save, the less time you’ll need to be saving — it’s really as simple as that. It also accelerates the more you chip in.
|Savings Rate||Years to Retirement|
If you’re constantly saving 50% of your income starting when you get out of college, you’ll likely be financially independent in 17 years. If you start after college, then you’d be FI by 40!
Designing a Life
Pursuing Financial Independence to me is about structuring my life and making choices that reflect what I truly want — and constantly asking myself if this is it. That isn’t about being overly frugal, and cutting corners on things you should be spending money on — like fixing a hole in your roof. This is about not spending $30,000 redesigning your kitchen, or buying that huuge house that won’t make you happier, or learning how to cook (or make cocktails) rather than eating out as much or learning a skill that you enjoy that allows for additional income (or lowers your expenses).
For instance, this weekend we’re fixing our bathroom after a leaky pipe flooded it. This isn’t an area I’m at all experienced in, but I’m enjoying the challenge of it. It’s something new, an opportunity to get better at a skill I’m not familiar with. While growing this skill, I’ll be able to use it later and save money. If it proves to be something I don’t enjoy though, I can always hire someone to do it. I’ll never know if I don’t try though.
Stoicism talks a good deal about having a “philosophy of life” — a way of living that is true to yourself. I have a personal mission I’ve written for myself in this sense. The minimalism and mindfulness sides make up part of this philosophy for me, but the financial independence side is the supporting structure for how it works in practice.