The goal of this post is to provide an introduction to the keys of FI. It is my hope that you use this as a launching point to dig deeper into the study of financial independence. In my experience the more you learn, your motivation will increase. And you will find the strategies that work best for you and those you can adjust or drop. It is a personalized journey. Here I’ve gathered the topics that have helped me the most.
Know your FI number
Many in the FIRE community point to the 2012 post by FI blogger Mr. Money Mustache: The Shockingly Simple Math of Early Retirement. It’s the one that convinced me FIRE was achievable. Pete created a two-column table showing savings rate % and corresponding years to retirement. It shows the most important factor in your FI path is the gap between your income and expenses – your savings rate. I have visualized the relationship between Savings Rate and Years to Financial Independence below:
As you dig into the assumptions in Pete’s article, you discover it is based on a 4% rate of withdrawal in retirement. Originating from the Trinity Study. Published in 1998 by a trio of professors from Trinity University in San Antonio, Texas. They used historical market returns from 1926-1995 to test the following:
Five different portfolios:
· 100% Stocks
· 75% Stocks and 25% Bonds
· 50% Stocks and 50% Bonds
· 25% Stocks and 75% Bonds
· 100% Bonds
Computing success rate for retirees in each of the 70 years for 4 different rolling periods:
· 15 years
· 20 years
· 25 years
· 30 years
They found a 75% or greater stock allocation sustained the 4% withdrawal rate more than 90% of the time for the rolling 30-year periods. Withdrawing 4% of the initial portfolio and increasing by inflation each year. The 4% safe withdrawal rate was born. Many have strong convictions about the 4% withdrawal rule in favor and criticism. I’ve taken the approach to use it as a rule of thumb, providing an approximate portfolio target. It may not be perfect, but for motivation and planning purposes I’m comfortable with it. Realizing once we get closer to FI, we can adjust and adapt the plan.
The beauty of the 4% rule is simplicity. To get your target, multiply your annual expenses by 25 and you have your portfolio goal.
Having a target should motivate. I know it did for me. With a target, increasing retirement contributions is more exciting. I’ve used a couple techniques for motivation.
Goal – reach a 25% savings rate of gross household income. Popularized by The Money Guy, if you reach and maintain a 20-25% savings rate you’ll be in great shape in a couple decades. And they’re right. Especially if you build this savings habit in your 20s. By the time you’re deep into your 40s you’ll have built your Money Machine to work harder than you. Portfolio gains will exceed your annual contributions. And will at some point reach the level of your annual income. Compounding is on your side.
Another way I focus on saving is analyzing in-the-moment spending. Advertising has trained us to spend quick. And it’s so easy to buy. To make quick judgements, I use my true hourly income rate. You find it by adding all the time associated with getting to and unwinding from your job. And adding all the ancillary work expenses: commute, attire, food, events etc. Taxes come out too. Once you have your true hourly rate, you can use it to measure purchases in relation to time. Asking, how many hours will this item cost me? Realizing that time is the most valuable resource we have.
More about True Hourly Rate
This lesson has taken me a while to learn. We focus our energy on the wrong things when it comes to investing. I’ve spent time in deep analysis trying to beat the market with individual stocks, options or sector funds. Trying to find the next opportunity or avoid the next pitfall. All along I should have focused on increasing my savings rate. I can spend that time in other ways trying to either increase income or reduce expenses. Those actions will have a much greater return than trying to outmaneuver the market. These days, I’m ok with getting market returns in index funds for the majority of my assets.
Read more about Investing Simply through index funds.
Control the Big Three
Setting a fixed monthly expense too high impairs your savings rate. My recommendation is to keep this under 25% of your net income each month. Banks will approve a much higher ratio – 28% of gross income before taxes, health insurance or retirement contributions. It’s ok to own a nice home as long as you don’t create a situation where you can’t invest 20-25% of your income because of it. For deeper analysis – Buying a Home – Which Ratio is Best?.
Vehicles are wealth destroyers. They depreciate in value and strain monthly cashflow. New cars are the worst. With average monthly payments in the mid to high $500s, not only do they depreciate fast, but that is money you can’t invest now. It’s especially draining if you get two of these wealth destroyers going at once. My recommendation is to go drastic and cut deep. Buy a vehicle with great reliability ratings and drive it into the ground. Find one about 5 years old that has already depreciated 40%. And if your car payments exceed your investing each month, fix this immediately.
You have tremendous ability to influence your effective tax rate. Let’s assume a couple invests in tax deductible 401ks. And they’re in the 22% marginal tax bracket – with household gross income between $80k – $171k. They go FIRE crazy and each max out 401ks ($22,500 each). By investing the 45k, they save $9,900/yr. in Federal income tax. Or put another way, the IRS just gave them an immediate 20% return on those contributions.
Another big factor is state income tax. If you find yourself in a state with high income tax rates (California has a top bracket marginal rate of 13.3%!), consider leaving that state. With all the remote work possibilities, there has never been a better time to consider this.
Read deeper into reducing The Big Three
Cultivate inexpensive hobbies
I challenge you to pause right now and write down 10 things you enjoy doing, with others or alone. Next, review your list and categorize each as high or low cost. I predict at least 50% of them cost very little or nothing. And if none fall into that category, you have an assignment. We need ways to relax, express creativity and connect with others. And how you spend valuable free time is key to your FI equation in two important ways.
- Expensive hobbies that reduce your savings rate slow your path to FI. And you can find other activities on your list that cost less and provide similar satisfaction.
- You will need to fill your time during your FI years. And you might be able generate some income from your hobbies. That is a true FI move. Doing something you otherwise would and getting paid for it.
Read more about how to Entertain Yourself, thoughtfully.
Acquire Memories not Stuff
The most important resource is time. I aspire to spend it creating memories with people I love. They could be simple memories. Gathered around a board game, enjoying recreational sports together, coffee and conversation, or a walk. Or they could be more adventuresome created during travel. Regardless, our shared memories enrich, whereas excessive stuff detracts from our lives.
There’s the initial expense of the items. And if we place greater importance on the items than our relationships, we are going down a bitter path. 3 Ways Stuff Traps Us and How to Escape.
Read more about defraying the cost of travel while creating memories with those your love: Disney on a Dime
Maximize Income from Your Career
We spend more time working than on anything else. I have come to a couple conclusions:
- Enjoy it as much as possible. Analyze your skillset and interests. And pursue a path in those areas. Temper your passion with practical analysis and end-goals in mind. If it’s financial independence, basket weaving might not get you there. There’s a wide variety of careers that can provide enough income to reach FI. Take a path that enables you to enjoy the journey, but also enables you to reach the destination.
- Maximize income from your 40+ hour workweek. We only have so many years our bodies and brains can work and you never know when they might fail you. Make the most of those years. Be so good at your work that you consistently earn pay increases. Learn in-demand skills that enable you to apply for other positions with better income prospects. Be so essential that your employer will do everything possible to prevent you leaving.
I’ve noticed that as your personal finances improve, your work influence, confidence and performance improve too. You’re less fearful of losing your income, more outspoken and empowered. And you have less personal finance stress weighing you down mentally.
How to Analyze Your Personality and Goal Formation techniques
Enjoy the Journey
Once you commit to this goal of early FI, you might pursue it at the expense of other areas of your life. Health, relationships, etc. Keep in mind financial independence has milestones along the path. I encourage celebration in achieving them. And as you move through the milestones, you gain stability at each level. Many different FI personalities have defined them, so with some variations. Here’s my list.
Starting at $0
You have eliminated all your high interest rate consumer debt. Opinions differ on whether auto and student loans (low interest rate debt) should be paid before moving through FI milestones. I say you can pay that off as you go as long as the payments don’t exceed what you’re saving for retirement each month. If they do, you should consider getting your full employer match and then pay those off to free up cash flow. Your goal is to get to 20-25% savings rate as fast as possible.
3-6 months of living expenses
Big milestone. The first 100k is the hardest to accumulate. Because you’re doing the heavy lifting by investing the majority of this. Your portfolio has not yet picked up enough momentum to roll on its’ own.
Parachute money – 2-3 years of expenses saved (retirement, brokerage, bank savings combined). Gives you the confidence to know if you had to leave your job for any reason, you’d be ok, until you land the next one.
The point at which you could stop investing and allow your existing portfolio to grow on its’ own. And you’d still reach FI at a more traditional retirement age, like 65 or 67. It’s empowering because you can take a lower paying job and still reach financial independence. As long as you leave what you already have invested alone. To calculate your progress, you can use this calculator.
- Input your current portfolio value
- $0 for Monthly Contributions
- # of years to traditional retirement (I use age 67 because that’s when I’m eligible for full social security)
- assumed interest rate (I use 7% or 8%)
See where that value falls in comparison to your FI number goal discussed in Rule #1.
Halfway to your goal. 12.5 times your annual expenses. Common misconception is that it takes the same amount of time to make it to Half FI as it does to FI. The 2nd half of the journey is much faster due to compounding growth of your portfolio. The speed of the snowball is moving fast at this point.
You have enough to cover your expenses if you cut out your discretionary expenses. You could choose to cover those with a side hustle or part time job. Sometimes called Barista FIRE. Popularized by the idea of working at Starbucks part time for health insurance.
You’ve reached it! 25 times your annual expenses.
There are a couple other nice signposts along the way, that didn’t make the milestone list.
- A year in which you see your portfolio gains exceed your contributions. Likely you will reach it some year between Parachute Money and Coast FI.
- A year in which your portfolio gains exceed your salary. You should see this somewhere between Half FI and Lean FI.
You can meet each of the milestones within 5 years, so they’re easier targets. Also, hitting them is cause for celebration. Who doesn’t love a great party?
Share Your Why
This information unlocks something that can change your life. Now, share what you’ve learned. People struggle with personal finance, and it doesn’t have to be that way. You can help those you care about onto a better path. And you don’t have to go through extraordinary lengths to share your message. It can be as simple as, “have you heard about financial independence?” That’s how it all started with me.