Planning for Financial Independence

The Financial Independence / Retire Early (FIRE) concept has been gaining a lot of traction lately and we’re huge advocates of the movement. What would you do if you didn’t need to work for a living and could choose an alternate path on how you spend the majority of your waking hours? Would you volunteer at your favorite organizations? Spend more time with friends and family? Travel the world? Launch a side business based on a favorite hobby?

Save enough money, invest wisely, reach financial independence and the choice is yours. Continuing to work is always an option, but the beauty is — it’s an option! By making conscientious lifestyle decisions during core working years, FIRE devotees are able to call it quits on their day job several years or in some cases, decades, early.

What is Financial Independence?

Financial Independence is when you have accumulated enough wealth that you no longer need a traditional income stream (i.e. a full-time job) to support your desired lifestyle. Income from investments and/or other passive income streams (rental properties, royalties, passive business income, etc.) provide enough continuous and stable revenue to fully support your planned living expenses. Your money is making money, so you don’t have to.

Once you’ve hit the threshold where your investment returns and passive income surpasses your planned living expenses, you are financially independent.

How much money do I need to become Financially Independent?

Quick Answer: A minimum of 25x your planned yearly expenses

Now let’s break that down.

The “4% rule” or “Safe Withdrawal Rate” is a staple in the FIRE community. The basic premise is that you can withdraw 4% of your investable assets every single year for the rest of your life (with inflation taken into account!) with an extremely high probability that you’ll never run out of money. In fact, your portfolio is likely to grow over time.

Following the 4% SWR, if you have $1 million in investable assets and assume an inflation rate of 3% per year, you can withdraw $40,000 the first year, $41,200 the second year, $42,436 the third year, etc. The increase in the withdrawal amount each year allows you to maintain your standard of living as prices for goods and services gradually rise over the years due to inflation. In years when the stock market is performing poorly, withdrawals may exceed 4% of the principal amount, but in years when the market is doing well, the withdrawals will be less than 4% of the principal and your portfolio will grow above $1M. Historically, the stock market has averaged inflation-adjusted returns of 7% through dividend distributions and stock growth.

Please note, that while net worth is a fantastic metric, only investable assets or income-producing assets (like rental properties) should be taken into account for Safe Withdrawal Rate calculations. Your home value may be a large contributor to your net worth, but unless you are planning to sell it and invest the proceeds, it doesn’t count.

Now there is obviously some risk involved in this method, but for a 30-year retirement, a 4% withdrawal rate is extremely conservative. For those considering a longer retirement period, you can certainly target a slightly lower Safe Withdrawl Rate to reduce risk. Bill Bengen, who conducted extensive research on this topic over the past few decades, first proposed this theory in 1994. He recently hosted a Reddit Q&A and offered this in-depth response:

“The “4% rule” is actually the “4.5% rule”- I modified it some years ago on the basis of new research. The 4.5% is the percentage you could “safely” withdraw from a tax-advantaged portfolio (like an IRA, Roth IRA, or 401(k)) the first year of retirement, with the expectation you would live for 30 years in retirement. After the first year, you “throw away” the 4.5% rule and just increase the dollar amount of your withdrawals each year by the prior year’s inflation rate. Example: $100,000 in an IRA at retirement. First year withdrawal $4,500. Inflation first year is 10%, so second-year withdrawal would be $4,950. Now, on to your specific question. I find that the state of the “economy” had little bearing on safe withdrawal rates. Two things count: if you encounter a major bear market early in retirement, and/or if you experience high inflation during retirement. Both factors drive the safe withdrawal rate down. My research is based on data about investments and inflation going back to 1926. I test the withdrawal rates for retirement dates beginning on the first day of each quarter, beginning with January 1, 1926. The average safe withdrawal rate for all those 200+ retirees is, believe it or not, 7%! However, if you experience a major bear market early in retirement, as in 1937 or 2000, that drops to 5.25%. Add in heavy inflation, as occurred in the 1970’s, and it takes you down to 4.5%. So far, I have not seen any indication that the 4.5% rule will be violated. Both the 2000 and 2007 retirees, who experienced big bear markets early in retirement, appear to be doing OK with 4.5%. However, if we were to encounter a decade or more of high inflation, that might change things. In my opinion, inflation is the retiree’s worst enemy. As your “time horizon” increases beyond 30 years, as you might expect, the safe withdrawal rate decreases. For example for 35 years, I calculated 4.3%; for 40 years, 4.2%; and for 45 years, 4.1%. I have a chart listing all these in a book I wrote in 2006, but I know Reddit frowns on self-promotion, so that is the last I will have to say about that. If you plan to live forever, 4% should do it.

In case you’re curious (and love math), his book is Conserving Client Portfolios During Retirement by William Bengen and here is a link to a short whitepaper he wrote on this topic.

Quick lookup table on target FI numbers with a 4% withdrawal rate for various spending levels:

Target Financial Independence Numbers

How do I know how much I’ll be spending each year after I quit my job?

This is likely the toughest part of the equation, due to a few factors:

  1. People are notorious for underestimating how much they spend.
  2. Health Insurance and Taxes need to be part of planned spending.
  3. Large and sometimes unexpected expenditures need to be accounted for (new car purchase, medical emergency, major house repair, etc).
  4. Your lifestyle (and therefore expenses) may change as you transition into retirement.
  5. Inflation and market returns may vary.

Ready to start tackling these unknowns?

Track Your Current Spending and Create a “Now” Budget

Whether you are planning for FIRE or not, knowing your current spending is critical for financial success. Chances are, you’re spending more than you think you are. Start tracking your spending and understand where every dollar is going. Once you understand your baseline, including strengths and weaknesses, you can start planning for the future. Learn how to create a budget here.

Determine Your Desired Lifestyle and Create a Retirement Budget

Once you have a solid grasp on your current spending, sit down and start thinking about your desired lifestyle and future spending. Chances are your retirement lifestyle is going to vary from your “working 40+ hours a week” lifestyle and your spending will change accordingly. Are you targeting a bare-bones retirement or a more luxurious one? Food for thought:

  • Do you plan to make major changes to your lifestyle?
  • Are you planning on earning any side-income during retirement?
  • How will you fill your free time when you are not working every day? Activities and socializing often cost money.
  • What expenses will go away? Childcare, college savings, mortgage principal and interest, retirement savings?
  • What expenses will be new? Higher travel budget? Expensive Hobbies?
  • Will you be supporting any additional family members?
  • Remember to account for large, intermittent expenses.
  • Estimate health insurance costs.
  • Take inflation into account. If you are planning to retire in 20 years, the costs of goods and services will be more than it is today.
  • Tally up all expenses and determine how much needs to be set aside for taxes. Will you be withdrawing from taxable or tax-advantaged accounts?

There are a number of retirement planning calculators available online, so do a search and play around with a few of them. One of my favorites is Personal Capital’s Retirement Planner — it lets you vary a number of factors, including inflation rates, one-time spending events, additional income in retirement, etc. and automatically accounts for taxes. Take a peek at Personal Capital’s free finance tools here.

For additional information, Early Retirement Now has an extensive guide on safe withdrawal rates, so definitely check them out.

Is there a risk I will run out of money?

There is always some level of risk, but the research and application behind the 4% SWR strives to provide an acceptable level of risk to allow for much greater reward. There’s a risk the stock market will not perform at the same levels it has over the past 10 years. There’s a risk you or a close family member will need extensive medical care. There’s a risk a zombie apocalypse will occur and the entire economy will crash. All of these risks exist whether you are working, retired at a traditional age or retired at age 40. Good personal finance habits and a solid understanding of your financial situation will help you weather those storms and come out ahead.

There are a number of ways to mitigate these risks:

  • Be conservative in your retirement spending estimates. When estimating what your future expenses will look like, incorporate cumulative inflation and round up a bit.
  • Build flexibility into your planned retirement spending. Plan a good amount of discretionary spending into your retirement budget. If there is a significant downturn in investment returns or you are hit with a major unplanned expense, have the option to live on a smaller budget for a few years. It is a higher risk scenario if you have no flexibility to reasonably cut expenses and must withdraw exactly 4% each year to meet your basic living needs.
  • Consider earning a little income during retirement. The 4% SWR model assumes no additional income in retirement. Early retirees have many opportunities to earn a little side-income, especially in their younger years.
  • Do not count Social Security earnings in your FI calculations. Reserve this potential future income as a safety net and do not use it in your FIRE calculations or utilize a reduced amount.
  • Do not count inheritances in your FI calculations. Plan based on the money you have in your possession now and be pleasantly surprised if additional money is added in the future.
  • Understand that nothing is set in stone and you can revise along the way. Decide that you want to increase your FI number to support a more lavish retirement? No problem. Keep on working and earning!

I’ve got my Financial Independence Number, now what?

Start saving, investing and dreaming of the future! Set financial priorities that focus on the highest rate of return. Revisit and revise your FI plans every few years, especially as you approach retirement. Your situation will evolve over time and so should your retirement plan.

Bottom Line: Determine the lifestyle you want and then save for it.

4 comments

    1. Happy Holidays to you too!!

      Yes, we are planning to pay off our house prior to FIREing. Our mortgage is our biggest recurring financial obligation ($1,800/month) and by paying it off, we’ll only have a $500 – $600 per month obligation to cover property taxes. It will add a lot of flexibility to our budget.

        1. No specific pay down plan yet — we still have a few more years ahead of us 🙂 We’re several years into a 20-year mortgage and will probably increase payments that last 2-3 years before retiring.

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