Financial independence is achieved the moment your investments start paying more than your expenses — and you get there by doing two things:
- Cutting costs.
- Earning more.
After you pass that magical threshold, you’re “free.” Free from having to work for a living. Free from having to worry about paying rent on time. Free from…well, a TON of other financial obligations.
And the best part: You don’t have to wait until you reach “retirement age” to do it. There’s a massive community of people who devote themselves to the pursuit of financial independence before they even turn 50 — and achieve it.
Sounds great, right?
Well, it can be. But it has to be done correctly. And that means different things to different people. What people don’t realize when it comes to financial independence (FI) is that it often comes with a purported one-size-fits-all drastic lifestyle change — one that might not always be the best for you.
That’s why you get threads like this on /r/financialindependence.
While we do think that some FI people take it way too far (being ultra-frugal, working jobs they hate, etc) and we don’t agree with every tactic they take, we think it’s AWESOME that people want to pursue a financial plan that helps them live their own version of a Rich Life.
That’s why we talked to two experts who have achieved FI about what it’s really like and what systems they used to get there.
- Physician on FIRE (PoF): A part-time doctor whose financially independent lifestyle has allowed him to spend more time with his family and help others work towards financial independence as well.
- The Mad Fientist: For him, financial independence was always about one thing: Freedom. Now that he’s found that freedom, he wants to help you get there too through his website.
Before we jump into the nitty-gritty of financial independence, it’s important to make a distinction between it and its close cousin, early retirement.
Financial independence (FI) vs early retirement (ER)
Early retirement: Being able to retire before you turn 65 (the age Medicare kicks in).
Financial independence: Not having to work anymore. It doesn’t mean you necessarily need to stop working once you achieve FI.
You can be FI and still work. But you can’t have ER without the FI. Got it?
“To me, it’s all about options,” PoF says. “You can choose to work in a different field, volunteer more of your time, work part-time, or not work at all.”
While you don’t have to retire early when you’ve reached financial independence, many dedicate themselves to the pursuit of both through a lifestyle called “FIRE” (financial independence/retire early).
And people who practice FIRE follow a very important framework in order to set their goals: The 4% Rule.
Using the 4% Rule to set a goal
“You can find out how much you need to save using the 4% Rule,” Mad Fientist says.
The 4% Rule is known as the safe withdrawal rate, or the amount of expenses you should be able to withdraw from your savings each year when you retire without touching the principal. This number is based on a study from Trinity University that determined 4% is a good rate to withdraw per year for around 30-year retirements.
So how do you find out how much you need to save? Do two things:
- Find out how much you spend yearly. This includes everything that you might possibly spend in a year including rent, utilities, groceries, gas, etc.
- Multiply it by 25. Or however many years you aim to retire for.
This will give you enough expenses to withdraw 4% for years and years to come.
Here’s a handy chart to show you how much you’ll need to save based on possible yearly expenses.
HOW MUCH YOU NEED TO SAVE
Using the above information coupled with your annual after-tax income, you’ll be able to come up with an annual savings rate (i.e. how much you need to save each year).
Luckily, you don’t have to strain too hard with back-of-the-napkin math to figure it out, as there are a bunch of retirement calculators online. This one is my favorite. It outlines exactly how many years it’ll take to save depending on your savings rate.
Play around with the calculator until you’ve come up with a savings rate that works for you. After that, you’ll know exactly how much you should be saving every time you get a paycheck.
And we’ll show you how to automate your finances later so your money is invested passively.
If you’re looking for expert advice on savings rates, both Mad Fientist and PoF have solid suggestions for savings rates though:
“In terms of the percentage, I suggest you save 65% of your after-tax income,” says Mad Fientist. “That may seem like a ton — but it’s possible. I averaged around 75% to 80% when I was saving.”
Meanwhile, Physician on FIRE suggests you should actually save about 50% of your income to go towards your goals.
No matter what you choose, outline how much you want to save each year, as well as a rough target date you’ll achieve financial independence.
“When pursuing FIRE,” PoF says, “keep in mind that you’re locking yourself into the same lifestyle as when you reach financial independence. [So] if you’re making too many frugal choices that don’t jive with your persona, start living the way you want to and base your FI target on that.”
Should you try to live as frugally as possible and minimize your expenses, or would you be remiss if you couldn’t take part in the finer things in life?
Luckily, there are two communities that embrace FIRE in different ways that can help you decide: leanFIRE and fatFIRE.
leanFIRE vs fatFIRE: Which way should you choose?
Though they sound more like weight loss supplements or descriptions of my latest mixtape than systems for financial independence, there’s no need to be intimidated by them.
“LeanFIRE and fatFIRE are just terms for how much you plan to live on when you retire,” the Mad Fientist says. “There’s no ‘better’ way. Just test out your spending until you find a method that works for you.”
While both have the same goal of achieving financial independence, aspects such as how much you spend, save, and even quality of life can be affected by which approach you choose.
This approach requires you to have a low spending rate each year (typically less than $40,000/year).
“To be leanFIRE is to subsist on a comparatively low level of spending — much like most of us did in college,” PoF says.
This means adopting a frugal lifestyle and sacrificing certain “luxuries” like cars. It can even determine the places in the world you can live in (it’s easier to live cheaply in Norman, Oklahoma, than NYC for instance).
However, that doesn’t mean it’s a miserable life. “Jacob Fisker of Early Retirement Extreme lives a happy leanFIRE existence,” PoF notes.
On the other side of the coin, there’s a FIRE movement that aims to keep up the benefits of financial independence while still retaining a life of semi-luxury: fatFIRE.
FatFIRE is the system of financial independence that allows you to live a more “high-class” lifestyle. But it takes longer to complete.
“FatFIRE is to be financially independent on a more typical level of spending,” PoF says. “I’d say to qualify as ‘fat,’ your anticipated spending should probably be somewhere north of the national average.”
According to PoF, that’d be an annual spending rate of around at least $80,000. “That lends itself nicely to a round number of $2 million saved to have a budget with a 4% annual withdrawal rate,” he says.
This is the practice that PoF embraces — and his reason might convince you to pursue the lifestyle as well.
To achieve fatFIRE status, though, you’ll need a higher rate of saving and earning — which we’ll show you how to do.
How to reach financial independence
Remember, financial independence is about two things:
- Cutting costs.
- Earning more.
There aren’t any slick tactics or sexy ways to go about this. It’s just a matter of setting the right goals and working hard to achieve them. If you’re willing to do that, you can become financially independent.
BUT FIRST, you need to figure out how much exactly you need to save in order to set a goal. This will give you focus when it comes to approaching saving as well as let you know when exactly you’ll be able to reach FI.
A lot of us tend to DREAD the idea of cutting costs — and with good reason. Thoughts of not being able to go to your favorite fast food restaurant or your father yelling at you when you change the thermostat just a fraction of a degree often crop up.
But Mad Fientist suggests you focus on paying for the things you love and cut out all the rest.
“Scrutinize and be conscious of your spending,” he says. “If you see a nice BMW you think you want consider one thing: You could have the BMW or you could be a year closer to not having to work for anyone ever again. Framing it that way helps. It’s not like you’re saving. You’re working towards your financial freedom.”
Conscious of your spending. Conscious…spending…
Conscious spending allows you to know exactly how much money is in your bank account to spend without you worrying about having to make rent and pay the bills, because it’s already been done for you.
How? Through automated finances. This is the system where your paycheck automatically divvies up and transfers to where it needs to go as soon as you receive it.
Here’s a 12-minute video of Ramit explaining exactly how to do it.
NOTE: If you’re pursuing financial independence, you’re going to want to adjust the percentage of money you put away in savings when you implement your plan. You can choose to save around 65% like Mad Fientist suggests, or you can choose to put half your paycheck into your savings like PoF encourages. Or you could go a different route. It’s all up to you and your savings goals.
Using a conscious spending plan also allows you to not sweat the small things you like.
“Realize that the small stuff is just that — small stuff,” PoF says. “The biggest expenses are the big stuff like housing, transportation, and travel. Don’t rent or buy too much home, spend too much on a luxury auto or lengthy commute, and learn to be comfortable at a Comfort Inn.”
Remember: cut things you DON’T care about, to focus on the things you do. Don’t just indiscriminately cut everything.
You can also learn to cut costs by leveraging retirement accounts that give you amazing tax advantages.
If you want to find out more about awesome accounts like the Roth IRA and 401k be sure to check out our articles on the topic:
- The world’s easiest guide to understanding retirement accounts
- 401k: The single best way to grow your money
- 4 keys to early retirement
But for now, I want to talk to you about an account with fantastic tax leverages you might not have heard of before: health savings accounts (HSA).
According to the Mad Fientist, HSAs are “tax-advantaged savings accounts available for people who are enrolled in high-deductible health insurance plans.”
He continues, “HSA account holders can contribute pre-tax dollars to the account and can then withdraw money from the account, tax free, when paying for qualified medical expenses.”
So you contribute tax-free money AND withdraw tax-free money.
I think Duke Nukem has something to say about that:
As of writing this, you can contribute $3,400/year for individuals and $6,750/year for families to an HSA. By maxing it out each year, you can reduce your taxable income by $3,400.
In 2018, the contribution limits for both individuals and families will go up to $3,450 and $6,900 respectively.
Sure, you can’t take the money out other than to pay for certain medical expenses — but when you turn 65 you can without incurring any penalties.
That means all that tax-free money is yours, effectively lowering your taxed income over your lifetime by $3,400/year.
“You should do all that you can to legally reduce your tax burden,” PoF explains. “If you max out your workplace retirement accounts and an HSA [Health Savings Account], you can deduct a significant sum from your taxable income. There’s only so much a wage earner can do, but do all that you can to pay the least and save the most.”
Once you have your retirement accounts set up and you’ve taken steps to cut costs, it’s time to take my favorite step: Earning more money.
Earning more money
Earning more money allows you to increase your savings AND speed up your financial independence goals.
“Don’t be satisfied with the status quo,” PoF says. “Look for opportunities to moonlight. Don’t be afraid to start a side hustle or entrepreneurial venture.”
We worked on something for you that can help you do just that:
The Ultimate Guide to Making More Money
This guide will give you the exact systems you need to help you earn extra income on the side and eventually achieve financial independence (if you want it).
You’ll find our tactics to:
- Create multiple income streams so you always have a consistent source of revenue.
- Start your own business and escape the 9-to-5 for good.
- Increase your income by thousands of dollars a year through side hustles like freelancing.
Download a FREE copy of the Ultimate Guide today by entering your name and email below — and start your financial independence journey today.