Financial Independence: When Your Income Matches Your Outgo, Without Working for Money

Financial independence is one my favorite topics. It’s something I one day hope to achieve through a variety of sacrifices, such as paying off our mortgage early, building savings inside and outside of retirement accounts, and sticking to a frugal lifestyle.

Saltwhistle Bay Dock and Beach on Flickr by Jason Pratt

The other day a reader asked for clarification on what financial independence meant. Well, I suppose it can mean different things to different people. To me, it means that my savings can be moved to ultra-conservative investments, and still spin off enough money each month to cover my basic living expenses. At that point, I technically do not have to work for money.

Roadmap to Financial Independence

So how does one reach financial independence (FI)? It certainly doesn’t happen overnight. The point where one reaches FI is a function of three things:

  • Diligent Savings. To build enough capital to live on interest and dividends takes years of faithfully saving and investing. We are still in the “capital building” stage ourselves, and invest in a variety of tax advantaged retirement accounts and taxable accounts. Currently, our plan is to max Roth IRAs, invest in my 401k through the match, and with anything left over, build our FI savings capital buying dividend stocks through our discount brokerage, Zecco.com, and tax-efficient mutual funds at Vanguard.com in a mix of stock funds, bond funds and international index funds.
  • Debt Freedom. Reaching financial independence is hard enough, but adding a pile of debt to the mix makes it next to impossible. We have already eliminated all consumer debt (credit cards, student loan and car loans). We’d like to eliminate our mortgage in the next 5-7 years. However, building savings capital and paying off our mortgage early will mean there will be little money for anything else. Which takes us to the third component.
  • Reduction of Monthly Expenses. Saving money every month on regular expenses not only helps increase your disposable income for savings contributions, it’s good practice for living financially independent. It also means in most cases, you don’t necessarily have to become a millionaire to retire. In early retirement, you would need a nest egg of $600,000 to spin off enough money to cover $2,000 in expenses (assuming a 4% return, before taxes).  You would only need $450,000 to cover $1,500 a month in expenses given the same terms. That’s a significant difference in the amount of savings needed to reach financial independence.

Other Sources of Income in Early Retirement

Once monthly expenses have been reduced, and fairly well defined, we can begin to get a good idea of the amount of money we’ll need saved to retire early. But one thing many formal calculators and financial gurus forget to take into account is that most people will not “retire” early at 50 years old and never earn another dime from some type of work. Sure, they may not earn what they made while working full time, but most early retirees go on to work in another field they are passionate about, splitting time between their passion, their family and a hobby or two.

In the example above, if our expenses were $2,000 a month in early retirement, but we were able to earn $500-$700 from part time work, consulting, or something similar, our savings needs would be much lower than if we planned to earn nothing. This often means people can technically reach financial independence much earlier than they previously anticipated.

Do any of you have plans for early retirement? What steps are you taking today to get there?

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