If you are tired of the mainstream message of retiring at 65 to then enjoy your life, you have probably heard of the FIRE movement. For those that are not aware, FIRE stands forFinancial Independence, Retire Early. (If you question why you should pursue FIRE, check out this post.)
However, before we get to FIRE, let’s discuss what financial independence (F.I.) is and how to calculate our independence number.
What is Financial Independence?
Jim Rohn, former international business speaker, quotes financial independence as “your ability to live on the income of your personal resources”. In other words, you are financially independent when you have accumulated enough resources to live the life that you want without exchanging your time for dollars.
There are two ways to achieve financial independence – through resource accumulation or passive income streams.
The resource accumulation method determines how much you need to save and invest before you can live off your income without working.
The passive income method determines how much you need through multiple streams of income to cover your monthly expenses.
To accelerate the process, you can combine both methods.
This article will teach you how to calculate your financial independence number and provide an example of how many income streams you may need from the passive method.
Disclaimer: This article is available for educational purposes and not presented as financial advice. Please work with a financial advisor if you want more detail guidance on your specific situation.
What is the 4 percent Rule?
According to Investopedia, the 4 percent ruleis a guideline many financial advisors use to calculate how much a person can safely withdraw from their retirement account annually to cover their monthly expenses.
The rule states that you will be able to use 4 percent from your investment accounts without reducing the principal balance. This means your withdrawals are from capital gains and dividends.
Again, this rule is a baseline to gauge what you need.
4 Percent Rule Calculation
To calculate your financial independence number using the 4 percent rule, you need to determine what your monthly expenses are and multiply that by 12 to get your annual costs.
After you calculate the annual costs, multiply that number by 25.
For example, if your expenses are $4000 a month,
$4000 x 12 = $48,000
$48,000 x 25 = $1,200,000
This means, you will need to accumulate approximately $1.2 million dollars to become financial independent.
Keep in mind, that the $1.2 million is driven from your expenses. This amount is completely up to you. If you want to enjoy a more lavish lifestyle, then increase your annual expense budget and multiply that amount by 25. If you want to live on the bare minimum just to stop working, decrease your annual expense amount and multiply by 25.
However, be careful when reducing your expenses to the lowest possible amount because while your lifestyle may not change, there maybe unexpected life events and cost increases due to inflation.
The Challenge with the 4 Percent Rule
While this theory has proven to be successful, the economic environment has changed since this theory was first published. As Maurie Backman, a writer for Motley Fool, describes in her articlethere are three issues that surround this rule:
- The theory assumes that your investment portfolio is a mix of at least 60% stocks and 40% bonds.
- Interest rates were previously higher than in recent years which means bonds would have performed better than in the current market.
- Since the 4 percent rule anticipates that retirees will only withdraw the capital gains and interest, but they could potentially withdraw more if they wanted to draw down the principal.
Passive Income Method
The passive income method is much more straight forward. You only need to calculate what you anticipate your monthly expenses to be.
Next you will create passive income streams that meet that amount. Some examples of multiple streams could be:
- Investing in Real Estate
- Selling your expertise through e-books, hardcopy books, and courses
- Selling products on Amazon and E-bay
- Earning Dividends from Stock Investments
- And so much more!
One example is to use cash flow generated from a rental property portfolio.
Using the previous scenario of $4000 monthly expenses; if you generate $300 cash flow per property, you will need ~14 rental properties to meet your monthly expenses.
$4000 / $300 = 13.33 (Round up to 14 to be safe)
Keep in mind that the $300 cash flow is available after all other expenses are paid to manage the rental property to include mortgage, taxes, maintenance, etc.
In this scenario, you will need to own 14 properties and technically you have enough cash flow to cover your expenses and be financial free.
Of course, you can still work if you choose, but now it’s a choice rather than a need.
Just a note about passive income: All passive income requires some level of work to start and maintain it so it is not 100% passive. However, the beauty is that the level of work dramatically decreases once the assets starts generating income.
Final Thoughts
Calculating your financial independence number should be one of your first actions when establishing your financial goals.
Once you have a F.I. number, determine what age you want to achieve this goal.
Lastly, select which path you want to take (resource accumulation and/or passive) and develop a plan.
Action – Calculate your freedom number today.