Occasionally, I think back to the time before I had my personal finances together and I’m amazed at how much my life has improved by taking charge of my money. And I still have lots of financial goals that I haven’t yet accomplished.
While there is no single number that I would pinpoint to say that someone is wealthy (or not), the best indicator of wealth may be how far someone is on the path to becoming financially independent.
After all, someone that requires six figures a year to cover their expenses isn’t going to be able to live off a million dollars for very long. In contrast, someone with a million dollar portfolio that spends only $40,000 may have more than to sustain them indefinitely (Mr. Money Mustache, Mad Fientist). They would be arguably better off financially, even with the same amount of money.
Defining Financial Independence
So what exactly is financial independence?
Financial independence means you have sufficient assets and/or passive income (i.e. not wage/salary or active business income) to cover your basic needs for the remainder of your life.
The opposite of financial independence, of course, is financial dependence. This could be dependence on others for financial support or incurring debt to pay for your expenses.
There is no set number that determines financial independence because it depends so much on individual circumstances. However, it is a universal goal that everyone should strive for. At the very worst case scenario, you should save enough for retirement, when you no longer actively work and are relying on savings and other passive income (even social security) for your basic needs.
How Do You Set A Financial Independence Goal?
To quantify financial independence, it is commonly accepted that you need a portfolio that is 25 times your basic expenses. The math behind this comes from the Trinity Study, a research project completed several decades ago that indicates that if you withdraw 4% of your portfolio each year you will most likely have enough to live on indefinitely.
While savings of 25 times your expenses sounds like a lot, don’t forget about the role of compound interest to get you there. It can take a while to feel like you’re making progress at the beginning, but the momentum builds once you’re portfolio grows.
This is yet another reason you need a basic budget (ahem, spending plan). Simply take your annual living expenses, multiply them by 25 and you’ll get your financial independence number. That’s all there is to it.
Let’s go through a quick example.
Betty & Rob currently have $250,000 saved in 401K, IRA and brokerage accounts. They spend $18,000 on housing, $5,000 on transportation, $13,000 on food and $10,000 on other expenses each year. Their total spending is $46,000 annually. So, they would need a portfolio of $1,150,000 to achieve financial independence. This would require them to save another $900,000, some of which would come through their own personal saving contributions and a significant amount from investment gains and income.
I personally like to break my big goals into smaller goals. This is where measuring your progress and making smaller goals comes in.
What Does Reaching for Financial Independence Teach You?
While financial independence is a worthy goal in and of itself, the process will be just as valuable.
Achieving financial independence requires you to:
- Track you how much you are spending
- Live within your means
- Completely avoid consumer debt and minimize mortgage debt
- Set and monitor goals and keep focus on the long-term
I believe that things will only get better for me regardless of what happens to the stock market, the real estate market, or any other market behind my control. I have a healthy emergency fund and am thinking long-term for my investments. Even though I haven’t yet reached financial independence, I can see the benefits already. I have a sense of freedom and an abundance of choices that would be limited otherwise.
When you’re sitting down to set your goals during the new year, don’t forget to include some steps that will help you to reach financial independence.
If you’re just beginning your financial journey, this may just include a small emergency fund and paying off debt.
If you have a strong financial foundation already, you may need to focus on improving your money mindset to keep focused on your goals. You may also need to educate yourself more about how to manage your investments and allocate everything properly between tax-deferred, tax-free and taxable accounts to provide the best overall strategy.
If you’re almost there, congratulations! I’m sure it’s been worth the journey and all the sacrifices you’ve made.
What steps are you currently taking to help you reach financial independence?