What is Financial Independence
Welcome to the final lesson in this course which is more of a bonus lesson than anything. In the previous lessons we set up the foundational necessities of your personal finances. In this lesson we are going to discuss Financial Independence and then we are going to calculate your Financial Independence Number. Your FI Number is the amount of money you need in savings to be able to consider yourself retired. Once you’ve reached this number, you'll be able to quit your job, and theoretically, never earn a single dollar again. And from the money solely in your nest egg, you will not only survive, but continue living the lifestyle you’re accustomed to. Yes, it may sound crazy and impossible, but it’s far from that. We will go over the concept Financial Independence and discuss how it works in addition to calculating your number.
Before we start doing math, let's talk about the phrase Financial Independence or simply FI for short and some people call it FIRE which stands for Financial Independence/Retire Early. FIRE is a movement in the personal finance community founded by nobody specifically, but much of credit goes to a guy named Mr. Money Mustache who popularized the community goal in his blog. This community is a group of people (mostly born in the 80's and 90’s) who believe we don’t have to live the hamster wheel life. You know the life society has normalized, yet has proven to be financially backwards and personally unfulfilling in many cases. But instead, we believe we can live lives full of things we love, working jobs we enjoy and using money we earn to make life more comfortable and enjoyable rather than using debt to buy things we think other people like.
A quick disclaimer: this is my definition of what the movement means to me and what I am personally striving for. Others may have their own interpretation of what the FIRE Movement means to them and if you find these views resonate with you, you should research it, experience it, and form your own opinion of what it means to you. FIRE as a whole is a journey not a destination, even when considering reaching that retirement number, because after reaching your number you still have to find fulfillment in life by balancing your life's desires and resources. For me the journey has been fun and challenging and I’m still far from perfect. I learned all about FIRE and many other personal financial topics from many podcasts, blogs, and books. My top favorite being Bigger Pockets Money hosted by Scott Trench and Mindy Jensen in addition to many others including but not limited to: Earn your Leisure, Mad FIentist, Choose FI, Paychecks and Balances, JL. Collins
Lastly, I want to re-define retirement for people who have a definition already programmed in their brain because the widespread understanding of retirement is much different than the value of the word to people in the FI community. Usually, people think of the word retirement as work, work, work and then one golden day in the future you get to stop working and do nothing! Maybe live on a beach and drink mimosas and margaritas every day and not have any responsibilities, especially not anything related to work because you’re done with that part of life. In the FIRE community we often talk about retiring in our early 50s, 40s, and many people shoot for 30s. The community gets a lot of backlash from those not in the community who either don’t understand what we mean by retirement, or some times backlash comes from close minded, old thinking, traditional debbie downers who think we’re a bunch of entitled millennials which couldn’t be farther from the truth. What we actually mean by the word retirement is simply removing the necessity of working for money and especially not working in undesirable environments due to the pressures of financial obligations. Instead, most people striving for FI have a plan of what they will do after they "retire", a lot of times this still involves earning money. The amount of money never plays a part in this plan because money is no longer a factor used for decision making. Yet, every plan includes activities which are fulfilling for the individual and often times involves doing some good for the world.
Your FI Number
Now we have an understanding of what Financial Independence means and I went on a bit of a tangent showing my passion for the FI community. We can now focus on the math behind calculating your FI Number. There are two numbers in the simple equation we use to calculate your Financial Independence Number. First is your annual spending, not the amount you spend annually today, but the amount you will be spending after retirement. The second is your safe withdrawal rate which is a standard number we use 4% (or 0.04 when using a calculator). The Equation looks like this.
The real work is predicting annual spending. The best way to do this is to figure out how much you spend annually today and then remove all expenses that you will no longer have once your net worth is reaches your FI Number. Hopefully in your predictions you don’t have debt obligations and close to $0 for living and transportation. Hopefully there's a permanent solution like a paid off home and vehicle. Start with that annual spending number and through your journey you will find ways to decrease this amount. Your first attempt calculating your FI Number, it's always way bigger than what you will really need, because we over estimate how much it costs to live with no expenses. So if your annual spending number is greater than $50k it’s probably way too much. There are so many reasons why it's high, but for now, let’s just say you used $48k as your annual spending. I picked this number (which is relatively high) because it’s simply $4k/month and it’s on the higher end where I assume most first time calculations will be. Your FI Number will be $1.2 Million according to the formula.
This is honestly not that far-fetched, but for some people, the thought of saving that amount of money in a young lifetime is intimidating and uninspiring without any context. This lesson isn’t the place to explain every detail, but if you are reading this feel free to contact me if you have questions or concerns. What I will do here is give a realistic example of a plan with realistic numbers so you can compare it to your life and see if it makes sense and/or interests you. And this example comes right after another disclaimer.
Another quick disclaimer: Financial Independence is NOT for everybody and this lesson is NOT meant to convert you to my personal finance religion. It is literally only meant to explain one strategy of calculating how much money you may need to retire, especially if you want to retire early. By explaining this strategy, I am also introducing you to a small niche of the personal finance community. If you are interested in hearing more info on this topic, let me know and I’ll provide more info on this topic. If not, take it for what it's worth and move on.
Okay, here’s the example I promised: There is a couple who started working at 25 each make modest salaries of $60k each meaning they each get a check of about $2k twice a month. They are 30 years old and they have just finished paying off all of their debt after 2-½ years. They paid off all consumer debt, student loans, auto loans; pretty much everything except their $2,000 mortgage. Other than their mortgage, their only other expenses are about $500 in utilities, $500 on household and personal items, $500 in groceries and dining out and another $1,000 they spend on fun, travel, and anything else they want. They owe $300k for a 30 year mortgage, but they plan on making double payments to pay it off early which should be done in about 10 years or less. They each have been adding 5% to their 401k for the passed 5 years and getting a full match from their employers. In that time they’ve contributed about $30k each and their 401k’s have each grown to about $50k.
10 years later they have a paid off their house giving them over $300k of equity. Plus their two 401k retirement accounts have over $100k each. That alone puts their actual combined net worth at a half million in just 40 years old. But they don’t include equity in their house in their net worth since they still have to live in their home. They decide to work 10 more years each. They also decided to take the $4k they were using to pay off mortgage to invest in index funds in addition to continuing their 401k investments.
Another 10 years later, they now have invested $480k in which grew to $650,000 throughout that time. Their 401k’s have each grown to $150k which is $300k combined. So now, after only 25 years of working, they decide to retire from their jobs at 49 years old because their combined net worth is $950,000. They can live off of this $950k nest egg for the rest of their lives by withdrawing $38,000/year (about $3,200/month) which will cover their living expenses and add an additional $700/month to travel even more, but they decide doing that for the rest of their life could get boring. So they come up with a plan to teach others about using money to escape the rat race just how they did. And after a couple years of doing this they started earning more money from their teachings than the $38,000 they were already pulling out of their investments. So they actually donate most of their money to help students go to college to pursue careers that actually interest them instead of careers that pay the most. You’d be surprised how many people can say this is their story!
There is soooo much more we could have talked about like creating other passive income so the amount you need to pull from your retirement monthly is less and in turn your FI Number is less. We could have talked about decreasing expenses, increasing saving rate and much more. We could have also gone more detailed in the example giving the couple raises and promotions over time or starting their business before retiring all of which I consider icing on the cake. I think the point is made and there will be more info on this topic and a full course coming on the topic of Financial Independence!