Regardless of the current state of your finances or how your career has progressed, true financial independence is something that appeals to all of us. Who wouldn’t want the ability to choose when and where you work rather than being forced to work out of need?Retirement and financial independence can seem a million miles away in your 20s or 30s, but achieving financial independence, or FI, at a young age is possible, and many people are actively working toward that goal.
What is financial independence?
Financial independence could mean many different things, but here, we’ll be talking about accumulating enough money that you no longer need to work. You may choose to continue working, so retirement and financial independence are not necessarily synonymous.
The Trinity Study found that 4% is a safe withdrawal rate, and this has become a cornerstone of the FI community. That means that if you can live for a year on 4% of your investment portfolio, you’ve reached financial independence. For example, if you spend $50,000 a year, you would reach financial independence with $1,250,000 ($50,000 x 25 years).
Keep in mind that this is a general definition. The goal of pursuing financial independence is to gain freedom over your life and to feel free from the stress and worry of money. A simple formula alone can’t dictate when you feel true freedom over money. Your goal for achieving financial independence could be higher or lower.
Getting started toward financial independence
Now that we’ve covered what financial independence is, let’s take a look at how to get there.
Know your ‘why’
First, you need to understand why you want to pursue financial independence. Do you want to get out of a career that you don’t like? Do you want to be able to travel the world? Do you want more time with your family?
There is no right or wrong reason, but you should think about your own motivation because it can have a big impact along the way. Pursuing FI will require some sacrifices and it’s much easier to make those sacrifices when you realize why you’re doing it.
Calculate your annual spending
Before you can know how much money you need to save to reach financial independence, you’ll first need to know how much you spend each year. If you don’t know how much you spend each year, you can use things like your credit card and bank statements from the past year.
It’s also a good idea to start tracking your expenses on a regular basis to make sure you know exactly how much you’re spending.
Calculate your FI number
Once you know how much money you are spending, you can calculate your “FI number.” The calculation is simple. Just multiply your annual spending by 25 to get your FI number.
However, you should also consider coming changes that could affect your spending. For example, if you’re planning to have kids in the future, you should expect that your expenses will increase. If you’re spending $40,000 a year now, your true FI number is higher than $1 million ($40,000 x 25) because of this.
Increase your savings rate
Your savings rate is the percentage of your income that you have left after paying taxes and all other expenses. If you’re currently making $60,000 and saving $6,000 a year, you have a savings rate of 10%.
Many financial experts recommend that you should have a savings rate somewhere around 15%, but that advice is based on a plan that involves working until you’re 65 years old. If you want to reach FI earlier, you’ll need to increase your savings rate. Many people who are pursuing FI are able to reach a savings rate of 40% to 50%, or even more.
Don’t be intimidated if you’re nowhere close to that number right now. This is something that you can work on continually by finding more ways to cut expenses or by increasing your income.
→ Cut monthly expenses
When you’re looking for ways to increase your savings rate, take some time to evaluate all of your recurring monthly expenses. Reducing these expenses will allow you to save each and every month, and the cumulative impact of a few small changes can be a big increase in your savings rate.
Some recurring expenses like cable, expensive wireless service, insurance premiums, as well as memberships and subscriptions can usually be reduced if you’re willing to shop around and consider making some sacrifices.
→ Establish good spending and savings habits
At first, finding ways to save might seem difficult, but you’ll quickly develop some good habits that make it a lot easier going forward.
If you want to make the process more fun, you could take a money saving challenge that gives you some added motivation to save as much as possible. Once you get into the habit of regularly looking at your finances, you’ll find that saving money is easier and more a part of your normal life.
→ Increase your income
Reducing expenses should be one of your goals, but the other way to increase your savings rate is to make more money. Many people in the FI community use a side hustle, or second job, as a way to make extra money.
Another major benefit of a side hustle is that you can continue to do it (if you want to) after you retire from a traditional job. Many early retirees use this as a way to earn some income and to do something that they enjoy.
This extra income can also help to essentially reduce your FI number. For example, if you need $40,000 a year to live and you’re able to make $15,000 a year from a side job (and you’re going to continue making that much in the future), you’ll only need an additional $25,000 to cover your living expenses. That reduces your FI number from $1 million ($40,000 x 25) to $625,000 ($25,000 x 25).
Of course, that isn’t the only option for increasing your income. You may be able to get a raise at your current job by developing some high-income skills, getting a promotion, or taking a higher-paying job. Additionally, you can invest in various income-generating assets to increase your savings rate.
Have an investment plan
All of that money that you’re saving will need to be invested. There are a lot of different approaches that you can take. Most people who pursue FI take a simplified approach using investments like index funds, which are some of the best investments for young adults and others alike due to their low costs and diversification.
From here, you’ll want to start tracking your net worth on a regular basis so you can see where you stand and monitor your progress.
Don’t stop here
Although this covers the basics steps for getting started on your journey toward FI, you’ll want to keep learning and improving your financial literacy. This is a long-term journey that requires significant commitment, but those sacrifices will pay off when you gain control over your life instead of being controlled by money and work.