I know it’s not quite Independence Day yet, but we’ll be out of town camping, so it’s better to get this one out earlier rather than later. I’m really looking forward to camping at the beach for a few days.
As the 4th of July approaches, it’s a good time to contemplate the state of your financial independence. Heck, I’ll make it a tradition to talk about financial independence every year around this time. It’s time for celebration and it’s also a good reminder that independence is a goal worth struggling for. What would you do if you didn’t have to worry about money? Would you continue to go to work or would you do your own thing?
It’s too bad that most people don’t know about financial freedom. When I was young, I thought financial independence is only for the rich folks. Now I know that it’s possible for the middle class too. Financial independence often means different things to different people and it can be difficult to measure progress on this journey. How do you know if you’re getting close? Let’s take a look at some common definition and see how we measure up.
Financial Freedom by net worth
First up is the method of accumulating a big nest egg that you can draw from for the rest of your life. This is one easy way to check if you’re close to financial independence. First, figure out your net worth. That’s the value of everything you own. Then divide it by your annual expense. If this number is 25 or more, then you’re close to financial independence. You can withdraw a fixed 4% from your asset, adjust for inflation every year, and your portfolio should last the rest of your life (Trinity study.)
Actually, there are a few things wrong with this formula. Net worth isn’t really a good indicator because it includes your home, cars, furniture, and other depreciating assets. You can’t generate income from those items unless you sell them. Let’s use the investable asset instead of net worth. Investable asset is just how much your investments are worth. Investable assets include stocks, bonds, CD, cash, investment properties, and more. Your primary residence and other personal property are not a part of your investable asset. Investable asset tells you how much money you have available without having to sell your personal properties.
Financial Freedom Ratio (FFR) = investable asset/annual expense
If your Financial Freedom Ratio is 25 or more, then you’re getting close to financial independence, with a little caveat. It also depends on your age. The 4% withdrawal rate is quite safe if you’re 60 and will spend a normal amount of time in retirement. I’m 40 and I think it’s pretty risky to withdraw 4% at this age.
|Age||FFR needed for Financial Independence|
|40 and younger||greater than 33|
|50||greater than 28|
|60+||greater than 25|
A 3% withdrawal rate is much safer for a very long retirement. Of course, this is just an estimate so you can see where you are in your financial independence journey. Some of us will have higher expenses in the future, so you might want to take that into account as well. Most households don’t have anywhere near 25x their annual expense when they retire, so if you do, congratulations!
Financial Independence by cash flow
Another good way to define financial independence is having enough passive income to pay your living expenses. This is a bit different than FI by net worth. Some people don’t have a huge net worth, but they have plenty of passive income. If your passive income covers your living expense, then you’re very close to financial independence and working is optional.
Some passive income sources
- Rental real estate – Depending on the location, you might be able to have positive cash flow without much equity.
- Trust fund – I don’t know anyone with a trust fund. I’m assuming that it’s not part of your net worth, but it does help with your monthly cash flow.
- Royalties from intellectual property – apps, books, music, and other intellectual properties can bring in passive income.
- Business earning – A self sustaining business that brings in positive cash flow. Is this just a pipe dream?
- Interest from bank account.
- Dividend and interest from your investments.
- Pension and social security benefit.
I think a rental property is probably the way to go for regular middle class people. In the right location, you can get positive cash flow without having to invest a lot of money. In the first few years, your net worth won’t increase much. In the long run, your net worth will greatly increase as the mortgage reduces and the property price improves.
You can measure your progress by calculating the percentage of expense that your passive income covers. When you cross 100%, then you have arrived at financial independence.
Financial Independence your own way
Financial independence by the 2 measures above is very difficult to achieve. Most households have nowhere near 25x their annual expense. Generating enough passive income streams to cover your monthly expense is probably even more difficult unless you’re really good at it. Is there a way to make financial independence a little easier to achieve? Sure, here is my definition of financial freedom.
RB40’s Financial Freedom – Income from sources other than your full time job covers your living expenses.
Yes, this is cheating a bit because the possibilities are endless for non job income. Why limit yourself to passive income? Active income is a good thing so why shouldn’t it have a role in your financial independence journey? All of us worked for many years and we’re not going to simply turn off our brain when we reach financial independence. Even passive income involves work. You have to trade and manage your stock portfolio. Rentals can be a headache even with a property manager. Income from intellectual property will usually decrease if you don’t market it. Nothing is completely passive anyway.
The key is to make money while doing something you enjoy, at a level that you won’t get tired of. For me, that’s blogging a few times a week. My online business isn’t adding much to my net worth, but it does bring in some income every month. Blogging isn’t passive at all, but I enjoy writing and it doesn’t feel like a job to me.
You don’t want to be completely passive anyway. That’s the express train to depression. If you’re stuck in a job that you don’t like, then one way out is to find a way to make money at something you enjoy. Combine that with some passive income and suddenly, you’re a lot closer to financial freedom. A little active income goes a long way in retirement.
Make your own choices
Financial Freedom means you can make your own choices. You can work on your own projects and you don’t have to worry about getting laid off. Anyway, I think everyone should know that financial independence is reachable and it’s worth the struggle.
What does financial independent mean to you? Do you think active income has a role in financial independence?
For 2018, Joe plans to diversify his passive income by investing in US heartland real estate through RealtyShares. He has 3 rental units in Portland and he believes the local market is getting overpriced.
Joe highly recommends Personal Capital for DIY investors. He logs on to Personal Capital almost daily to check his cash flow and net worth. They have many useful tools that will help every investor analyze their portfolio and plan for retirement.