Whether you are planning for retirement, early retirement, or want to know what it would take to stop working, your financial independence number is the amount of money you need to maintain your lifestyle without a paycheck.
To be sustainable, your savings and investments will need to produce returns that can support your lifestyle without being depleted. Therefore, your financial independence number is the total assets you need to live without withdrawing more than 4% a year.
This approach is designed to permit you to maintain your standard of living indefinitely. However, before we dive into the formula, it’s essential to establish what financial independence means to you and why you want to pursue it.
Build a Life You Want
Financial independence and time freedom are worthy goals. They help you clarify your expenses, income needs, and savings plan. However, rather than putting off happiness until this big goal is achieved, make enjoying your life and fulling your purpose part of the plan.
You may not have as much time to relax, travel, pursue creative projects, spend time with loved ones, or do whatever you enjoy while working and saving for the future. Still, just as you are establishing solid money habits that will sustain you, you also want a reasonably balanced lifestyle that nurtures you.
We all know someone with plenty of money who is miserable anyway because they never learned how to enjoy life. There is no point in arriving at financial freedom sick, injured, bitter, or burned out.
Good money habits paired with positive lifestyle habits are the best avenue to achieve financial independence and love it when you get there.
Ready to map your road to financial independence? Schedule a no-obligation conversation with the Lake Hills Wealth Management team to see how we can help.
How Do I Calculate My Financial Independence Number?
The first step to calculating your financial independence number is to quantify your monthly expenses. This number should include your mandatory monthly bills such as food, utilities, real estate taxes, and discretionary costs like travel, dining out, and shopping. Don’t create a budget based on the easiest, smoothest months you’ve lived. It’s better to account for the unexpected and be prepared to adapt to changes when necessary.
When looking at your monthly expenses, it’s wise to go back a couple of years to account for all the things you purchase. Include gas, travel expenses, Christmas and birthday presents, subscriptions and memberships, community events, real estate taxes, and personal care costs.
Calculating your financial independence number is straightforward once you have established the income you need. However, the best formula for you to use will depend on the age you will achieve financial independence and a couple of other factors.
Achieving Financial Independence Young – Create Passive Income
If you start this process very young and plan to retire unusually early, for example, in your 30s, 40s, or early 50s, you will want to build enough passive income through your investments to support your lifestyle while accounting for healthcare costs without the use of Medicare and Social Security. You could have 50 years or more of retirement, and the economy and marketplace will undoubtedly go through many changes during that period, so any withdrawal strategy will likely cut you short.
In this case, true financial freedom will mean passive income to cover your expenses, and your financial independence number will depend on the income you receive from your investments. Your goal is to live off your assets’ income without running out of money later in life. Be realistic, account for all current and future expenses, market fluctuations, inflation, and consider an Adaptive Investment Strategy. [Link to Pillar Page]
The Conservative Calculation – 3%
Suppose you are retiring early and do not have any other reliable sources of income, for example, a livable social security payment or a spouse’s pension. In that case, you may want to plan for conservative withdrawals at 3% a year.
The conservative calculation for your financial independence (FI) number is:
FI number = your yearly expenses / 3%
For example, if your annual expenses equal $150,000, the formula would be:
150,000/.03 = 5,000,000
So, with 5 million invested, you can retire and safely withdraw 3% a year.
Although a conservative calculation, this simple formula does not account for inflation and will vary depending on the rate of return of your investment portfolio. It is an excellent rule of thumb, but it is worth speaking with a financial advisor to work out the specifics of your plan.
The Standard Calculation – 4%
The standard calculation is still relatively conservative and remains a rule of thumb for many financial planners. You may feel comfortable using the standard formula if you:
- Retire in your 60s or 70s
- Own your home
- Are well-insured
- Are entitled to reasonable social security income, or
- Are otherwise insulated from risk
The standard calculation for your FI number is:
FI number = your yearly expenses / 4%
For the same annual expenses of $150,000, the formula would be:
150,000/.04 = 3,750,000
So, with 3.750 million invested, you can retire and safely withdraw 4% a year.
If your annual expenses are closer to $200,000, you need 5 million saved.
200,000/.04 = 5.000,000
Naturally, if you want to spend more, you’ll need to save more, and if you can manage on less, you don’t need as much invested to retire.
Knowing your FI number can be motivating and help clarify saving and investment plans as you navigate toward it. Many people are inspired to realize they can potentially retire early.
At the same time, it’s wise to recalculate your FI number every six months to a year as the circumstances of your life shift. Your FI number is a general guideline designed to help you identify a goal.
How Do I Achieve Financial Independence?
While a small percentage of people strike it big or accumulate significant amounts of money very quickly, for most of us, the adage ‘slow and steady wins the race’ is key to achieving financial independence.
Depending on where you are starting financially, your plan may begin with paying down debt and ramping up your investments. Alternatively, it could be time to tailor your portfolio strategy to mitigate risk and maximize returns.
Wherever you are on your path to financial independence, the guidance of a fee-only, fiduciary financial advisor can help you formulate and stick to your goals. If you would like to find out what it will take to achieve your financial independence number, feel free to contact our team at Lake Hills Wealth Management.