For many, the idea of financial independence is something that happens when you’re entering into retirement and is an abstract and far-off concept. Knowing how much money you need to be financially independent can be an intimidating process. How do you calculate this magical number? What do you need to consider? Will I have enough to retire? The whole thing makes many shut down, open up Facebook, and try to escape the feeling of anxiety.
What is Financial Independence?
Financial independence is a simple concept. It means that you have enough wealth to cover your basic costs of living. This means that you are receiving passive income from your assets that is equal or greater than your regular non-discretionary expenses. This can come in many forms, but the most popular income producing assets are your investment portfolio assets (made up of stocks, bonds, commodities, annuities, etc.), a successful business you’ve invested in, and/or cash flow positive rental property.
What does FI Mean to You?
So what does this mean for you? Financial independence for an individual, couple, or family means you do not necessarily have to work to cover your costs of living. It provides greater freedom to do the things that mean most to you personally. You can continue working – because you love your job and not because you have to work. You can quit your job and change careers. You could be a stay-at-home parent and not worry whether the bills will be paid, because your investment savings are working hard for you to generate more income.
Your FI Number
What I like about the FI movement is that identifying your financial independence number is broken down into three simple elements:
- Your Basic Costs of Living: One key part of reaching FI is determining your current and future costs of living. That means you need to have a good understanding of all your costs and determine which costs are non-discretionary and discretionary.
- The Withdraw Rate or Draw Down Rate: The withdraw rate is the amount you can withdraw from your investment portfolio without drawing down on the principle amount of your investments. To put it simply, the interest or profit earned from your portfolio covers all your costs. The consensus within the FI community is if you withdraw 3-4% of the value of your portfolio per year, you will not dip into the principal amount of your portfolio.
- The FI Calculation: So now that you have your current or expected cost of living and your expected draw down rate, you can calculate your FI number. There are two calculations you can use:
1. Total Current Cost of living ➗ Draw Down Rate
2. Total Current Cost of living X 25
Either calculation method will get you to your FI number.
Why Have an FI Number?
It’s important to identify your FI number for two reasons.
- It gives you a goal to work toward. If you do not know what number you are trying to achieve, you will have no way of knowing your progress or whether you have reached that goal.
- It forces you to focus your efforts and find your path to FI. You get to choose and control your FI number, because you can control your expenses/cost of living. By lowering your cost of living, you can get to FI faster and possibly retire early!
My FI Number
With the above formula, I can calculate my own FI number. So let’s use a real life example… me!
Step 1: Summarizing my cost of living (i.e. my expense budget):
Over the past three months, I’ve been tracking our family’s spending using the cash envelope budgeting system. So far we have determined our basics:
|Electricity and water||368|
So now that I know my average monthly costs, we will need to translate this into an average annual cost of living number.
Annual Expenses = $4,238 X 12 months = $50,856
Step 2: Calculate your FI Number
Next, we will need to take our annual cost of living and divide it by our withdraw rate
FI Number today: 50,856 ÷ .04 = $1,271,400
In order for me to be financially independent tomorrow, I would need an investment portfolio worth approximately $1.27 million. Let me keep it real; my portfolio is not even close to half of this amount. Mrs. Prairie FIRE and I have some work to do. But that’s okay! We all have to start from somewhere. Here and now is the best place to start. So onward and hopefully upward!
Understanding Your Future Needs
My goal is to reach my FI number by 2033. Obviously our needs will be different in 15 years. I will be 53 years of age and my two kids, who I like to call my little FIRE starters, will be 18 and 16. It will be a totally different stage in life, with different needs.
Here is what I see changing between now and then:
- Mortgage: Paid off
- Kids: We want to have three little FIRE starters. So in this scenario, one of our children will be possibly heading to university or working, and two will be in high school.
- Health needs: Costs of health will continue to go up for us. Dentists, eye doctors, medication for myself or Mrs. Prairie FIRE, etc. I see these costs tripling over the next 15 years.
- Property taxes: This is guaranteed to go up and I assume by greater than the rate of inflation. I assume a 6% increase in costs year over year.
- Utilities: There is no indicator that the cost of energy will go down, and I make a similar assumption of 6% increase in costs year over year.
- I assume other costs will go up at the same pace as inflation.
Step 1: Projected Expenses in 2033 (assuming 3% annual inflation)
|Total Health Insurance||274|
Annual Expenses = $4,875 X 12 months = $58,500/year
Step 2: Estimated Projected Annual Living Costs ÷ 4% Draw Down Rate
Projected FI Number: $58,500 ÷ .04 = $1,462,500
When I reach this point, it means the following year I can withdrawal $58,500/year and not touch the principal investment. So, say I reach FI in 2033. As long as my portfolio grows by more than 4%, it will never dip below $1,462,500.
There you have it! My personal FI number to work towards. $1,462,500 is a BIG number, but I think it is doable. The next step is to come up with a plan.
What do you think?
I would love to hear from you. Now that you know what information you need and how to calculate your FI, how does it make you feel? What do you plan on doing to reach your goal? Feel free to comment below and contribute your thoughts.
P.S. I know what you might thinking, “But Mr. Prairie FIRE, how are you going to be able to live off just under $60,000/year? It is not enough!” I agree, it isn’t enough for me. I do not plan on retiring at 53, I plan to be financially independent. Financial independence and retirement are not necessarily the same thing. I plan on still working, but can take comfort knowing that all the money I am making past this point is gravy. I will also have the freedom to work less, work for less, or decide to change careers. I will have more options – which means more freedom!