August 8, 2020

How does financial independence work anyway?

If you’ve managed to find your way to this site, then I’m fairly confident you’re at least familiar with the topic of financial independence. If not, no problem. FI can look different to everyone, so even if you’re comfortable with the concept it would be helpful to understand how I view it.

To me, being financially independent means that you have built enough wealth to sustain yourself and/or family for the rest of your life without the need to work for a single dollar in the future. The wealth you’ve accumulated pays for your annual expenses through passive income and meets or exceeds your budget. The most common forms of passive income are investment accounts and real estate, but that’s not to say these are the only two options. The awesome thing about FI is that it’s never too late to start.

So let’s go through a quick example. Let’s say Joe is 25 and lands his first real job in sales. To make it easy we’ll assume he’s making $50,000 per year after taxes, bonuses, etc. Joe was lucky enough to get an athletic scholarship for school so he has no university debt but he doesn’t have any valuable assets right now either. For all intents and purposes his starting net worth is $0. As soon as he starts working he hears about financial independence and starts down that path right away.

Every month he is bringing home close to $4200 but continues to live like he did in college, so he’s only spending about $1500 per month, leaving him with $2700 per month to invest. At the end of the year he has $32,400 saved up. Because he put this money into his investment accounts, he earned 8% on the year, bringing his total closer to $35,000. His annual expenses were roughly $18,000. In one year of work he saved up enough to take two years off. Pretty sweet, huh?

At Joe’s 35th birthday party, he announces he is retiring. Everyone asks, how is that possible?? Let’s look at the numbers. For 10 years Joe has been saving $32,000 and only spending the $18,000 he needed. After a decade of this and a steady 8% return in the stock market, he has built up $500,000. Using the 4% rule (I’ll discuss this more in the future) Joe can withdraw $20,000 per year from his investments for an indefinite amount of time, which is enough to cover all his expenses. Joe has achieved financial independence. Not all that hard, right? And the cool thing is now Joe can do whatever he wants for the rest of his life as long as he continues to live within his means.

It is important when starting this process to set goals and be realistic with yourself. If you know you like to spend then don’t tell yourself you can be financially independent on a stash of $100,000. The other part to think about is having a safety plan. If you continue to work a few extra years to build up your stash to a safe level that’s one option. Another is to buy an investment property that will provide reliable passive income streams in the future. Or if money gets tight, pick up some part time work and use that to cover expenses so you don’t have to sell shares when the market is low. The key is being able to adapt. If you are smart enough to get yourself in the position of being financially independent, you have nothing to worry about moving forward.

One thought on “How does financial independence work anyway?

  1. Brian,

    I’ve been enjoying your website, I hope you keep it up!

    I think you hit the nail on the head with that last line about being able to adapt. While debating about whether or not the 4% Rule is a useful measure or a harmful simplification is interesting at first, eventually it doesn’t really matter.

    I tend to agree that anyone who has the discipline to reach FI, even if accomplished in a decade or less, is experienced enough and has done enough research that they aren’t blindly following some formula they found on the internet. Any “I’m running the numbers and going to quit my job” post talks about the intense deliberation, doubt, and second guessing that goes on when you finally reach that point.

    I’m still early in my FI journey – running numbers in my head based on the 4% rule is a great distraction on the way to work, but the further along I get the more I see first hand the thought, discipline, and planning that goes into buying your freedom.

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