There has been a movement in the last decade that challenges the traditional idea of “retirement”. The idea prioritizes saving money earlier in your career as apposed to saving a little over time with the end goal of achieving a nest egg that will allow you to live out the rest of your life without the need for earned income.
Having enough money in your bank account or invested in assets such as real estate or stock allows you to live your life without the need for earned income is true financial independence.
Lets take a look at how traditional retirement works:
First, you get an education (or learn a trade), find a good job, set aside a small amount of your paycheck in a retirement account such as a 401k, and retire at the age of 65 to live out the rest of your life on your retirement savings and social security. This is not a terrible plan and has worked out well for a majority of the middle class for decades. This is a perfectly good plan for many people.
However, if you desire the freedom to live life on your own terms (without being tied to a job later in your life) there is an alternative plan many people are pursuing and often referred to as Financial Independence. A similar movement is also called FIRE (Financially Independent Retired Early) - we'll go over the difference in a minute.
The ability to reach Financial Independence (and/or retire early) essentially comes down to having enough assets (savings/investments/real estate/businesses) and/or passive income to live your life without the need for a job or earned income.
Ideally you will craft a plan to build both a large nest egg (savings) and assets that will supply you with passive income for the rest of your life. Let’s break how to obtain them.
First, the nest egg.
Having enough money in your bank account to live the rest of your life may seem like an impossible task. However, when you use the phenomenon known as compound interest, your money will add up quickly. Compound interest is created when the interest you earn on your money starts earning interest on itself. A quick example: If you invest $5,000 into a stock index fund that has an average return of 10%, and add an additional $100 every month for 10 years, you will have a balance of over $34k. In total you would have contributed $17,000 of your own money and your interest would have earned you $17,000! In 10 years, you doubled your money.
How do you know how much money you will need to save?
There is a simple calculation that some financial planners use to get a ballpark number of how much money you will need to save in order to live out the rest of your life: The 4% Rule. Essentially this rule of thumb says that you can safely withdrawal 4% of your invested balance each year and your account should last at least 30 years. Of course this rule will be different depending upon your needs, location, and lifestyle.
Here’s a simple example: If you have $1,000,000 invested in a balanced portfolio, you could safely withdrawal $40,000 per year to cover your expenses. Ideally your portfolio should grow greater than 4% and you will never run out of money. There are many variables to consider such as your investments, your lifestyle, your health, and where you live, but this gives you an idea of what you will need to reach financial independence.
Next, Passive Income
Another important part of reaching financial independence is having passive income. What is passive income? Passive income is any income that you earn without physically trading your time. Common types of passive income include real estate rentals, dividend paying stocks, or a business that operate without you. Passive income is the holy grail of financial independence – the ability to earn money while you sleep, spend time with your family, and take vacations is the ultimate life hack.
What is the difference between Financial Independence and FIRE?
Essentially Financial Independence and FIRE are the same idea - acquire enough money so that you no longer have to work a traditional job.
The traditional FIRE folks plan is to work a high paying job, spend very little money, invest 50-70% of your income into a balanced set of index funds, and quit your job when your investments return enough to cover your living expenses (4% rule). This is a great lifestyle if you have a high paying job, start saving and investing at an early age, live a modest lifestyle, drive an old car, and don't enjoy daily trips to Starbucks.
There is also a new hybrid version of Financial Independence that trades sacrifice for hustle. Instead of skipping coffee and driving a 10 year old Honda, these folks are focused on earning extra money from side hustles and passive income. The idea to invest money remains the same, however higher priority is given to building assets.
So how do I achieve Financial Independence?
Financial Independence starts with a plan and requires commitment, hard work, and time.
The goal is to prioritize earning, saving, and investing your money starting TODAY. Time is the greatest ally in building that nest egg and portfolio of assets. Focus on earning as much money as you can through your full time job and side hustles. Put as much money as you can into long-term investments and utilize tax advantaged accounts such as you 401(k) and IRA.
There are an endless amount of strategies to help you earn, save, invest, and stash your money to achieve financial independence. The Afford is dedicated to helping you achieve Financial Independence so subscribe to get our content delivered directly to your inbox.