Financial independence has a unique definition, depending on what stage you are at and what your goals are. What you choose to do with your financial freedom can change how much you need and how fast you can accomplish that goal. Do you want to quit your day job, start a small business, volunteer your time, travel the world, financially contribute towards something you’re passionate about, or something entirely different? It’s a process and the stages of financial independence build on each other as you grow.
Stage 1: Debt Free and Security
If you asked me in 2009 what financial independence was, my definition would have been the ability to cover the basics- to feel secure. At the time, I was staying in school to avoid student loan payments, and had no line of sight to a job that would make those payments feasible. If you find yourself in this situation, you sometimes will need to make painful cuts to your spending habits, get rid of your debt (ie: sell it), or increase your income.
I was extremely thankful that my degree had a great return on investment, meaning that my expected pay with my degree is really good compared to the investment that is needed to get that degree. However, many people invest money into an education that doesn’t provide that increased pay, making it extremely challenging to pay off any loans taken to obtain that degree. If you bought a car or house you can no longer afford, you have the ability to sell those items, but if you spend money now on a degree you can’t afford to pay for later, you can’t simply sell it to someone. Education and learning can increase your income, but it is extremely important to account for the expected return on that investment, both of your time and your money.
Whether you increase your income or reduce your expenses, it is critical to contribute as much as you can towards you debt principle, reducing the amount you are spending on interest. If I took 20 years to pay off my student loans, I would have paid almost $50,000 more in interest. By contributing more each month, I not only paid off my loans in 8 years, but I saved a significant amount of money. While it is ideal to pay extra on your highest interest rate loans, many people follow Dave Ramsey’s method where you pay off the smallest debt first, building your motivation to pay off larger debts.
Stage 2: Supplement Your Income
I will never forget the day I paid off my student loans. It was a huge sense of relief to be rid of what felt like a second mortgage. I still carry some debt (my car and my house), but I have built up enough wealth to pay off this debt if I chose to. At this stage in my life, financial independence means being able to build enough wealth to supplement my income. I have no intentions of leaving my work, but the idea of being able to supplement part of my income with investments provides the freedom to potentially work part time, work a different job that my pay less, or increase my contributions towards a charity with that supplementary income. Whether you want more time to volunteer, spend time with family, or just enjoy your passions, building your wealth so that your money is working for you is the common goal.
How much you need will be dependent on your unique situation. You’ll need to think about how much you want to make through traditional income, and how much you’ll need to support your lifestyle. The less money you are dependent on, the less you’ll need to accumulate, or the less you’ll need to make through traditional income. Similarly, the more money to maintain your ideal lifestyle, the more money you’ll need to make through your traditional income or the more wealth you’ll need to have accumulated.
My goal is to build enough wealth that I could bring in about $2,000 a month in supplementary income. I know from my previous lifestyle that I could live on this, but ideally I would still bring in some level of income to maintain my current lifestyle, or leverage that additional income to contribute to organizations I am passionate about. In a previous post, I covered the Rule of 25, where you need to accumulate 25 times your desired annual income, assuming you see a return of 7% (3% for inflation and 4% for your income). Assuming the rule of 25, I need to accumulate $600,000 for this to be a reality. This would theoretically allow me to withdraw 4% of that nest egg annually, or $24,000 per year without ever reducing the amount of that nest egg.
Stage 3: Replace your income
In this stage of financial independence, you eliminate the need to work for income, and can completely live on your investment gains. Some people may still decide to work, but the difference at this stage of financial independence is that the decision to do so is completely optional.
You may decide to volunteer, stay home with your kids, pursue hobbies full time, or anything else that you choose to do so with an abundance of time. You may even travel more or full time, assuming you can do so on your current budget. For many people who strive for financial independence, the ability to retire early and live completely on your investment gains is the traditional definition of financial independence.
Similar to the prior stage, the less money you need to maintain your lifestyle, the lower your nest egg needs to be. Let’s say that you currently make $60,000 per year, or $5,000 per month. If we apply the Rule of 25, this would suggest that your nest egg needs to be 25 times your annual salary, or $1.5 Million. However, if you can reduce your lifestyle so that you only need to make $40,000 per year, your nest egg could reduce to $1 Million.
Stage 4: Accumulate Wealth
At this stage of financial independence, you have not only built enough wealth to cover your income to support your current lifestyle, but you have more than you need to be happy. If you achieved stage 3 and continued to work, reduced your annual expenses, or the markets have performed really well, you may find where your nest egg continues to grow because you are spending less than you are gaining.
Let’s say that you’ve accumulated $1.5 Million, but you only need $40,000 annually to live well. If you see 7% return on your nest egg in one year, your accounts will grow $105,000. Assuming inflation is 3%, then you still will gain $60,000. With the excess $20,000, your investments are continuing to grow faster than you are spending them. Maybe your investment performance is better than you expected, but you keep the same withdraw limit, allowing you to accumulate the difference. Unfortunately, the opposite is also true, which may push you back to work for a period of time until things stabilize out, so it is wise to keep the extra during a good year versus allowing yourself to spend more.
Achieving financial independence where you not only can replace your income, but your nest egg continues to grow, even after you withdraw your living expenses is the ultimate level of financial independence. This will give you more confidence in your ability to live on your investments for many more years, ride the ups and downs in the market, or provide flexibility for increased expenses such as medical care or increasing your lifestyle. Personally, at this stage of financial independence, I would be enthusiastic about finding ways for this additional wealth to benefit my community and our society.