3 Ways To Define Financial Independence

retire 3 day weekend not the sameI 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.

AgeFFR needed for Financial Independence
40 and youngergreater than 33
50greater 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?


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Joe started Retire by 40 in 2010 to figure out how to retire early. After 16 years of investing and saving, he achieved financial independence and retired at 38.

Passive income is the key to early retirement. This year, Joe is investing in commercial real estate with CrowdStreet. They have many projects across the USA so check them out!

Joe also highly recommends Personal Capital for DIY investors. They have many useful tools that will help you reach financial independence.
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37 thoughts on “3 Ways To Define Financial Independence”

  1. Financial independence does have a set definition: having enough assets to retire at any time. It’s working because you choose to rather than because you have to.

  2. I’m impressed, I have to admit. Rarely do I come across a blog that’s both educative and amusing, and let me tell
    you, you’ve hit the nail on the head. The issue is something that
    not enough folks are speaking intelligently
    about. I’m very happy that I found this in my search
    for something regarding this.

  3. The dollar amount is different, but true financial independence is when someone can live the lifestyle they want to live without being much concerned about trivial money issues such as 25x expense net worth or 3 to 4% withdraw rate.

  4. Financial independence is not having to work! We’re planning on having a few different rental properties and investment accounts for passive income streams, and I’ll probably continue freelancing since it’s location-independent.

    Great read!! Hope you have a nice weekend!

  5. To me, financial independence is something different than what you are looking at. You are talking mostly about “retirement” independence, i.e. when you can retire safely. Financial independence for me is when you can comfortably not work, and not have to worry about covering your bills for several years.

    Now to go back to your formula for retirement independence, I would say it is something like this:
    (Money you have access to – Taxes, penalties, etc.)/expected yearly expenses (housing, food, travel, clothes, etc.) = life expectancy (ie. number of years you have “left” to live).

    I have a simple spreadsheet I play with. You play with the numbers as constants and you can see how they work for you. Drag the cells in excel down for the number of years you expect to live and here you go. These are just toy numbers because I am at work and don’t have mine w/ me. The columns are the year, how much you have to draw from, your yearly withdrawal, tax hit, how much cash you get from accounts, the market increase for your accounts, any fees, and your new base for next year.

    Base $350,000.00
    Tax 28%
    Withdrawal 4%
    Increase 6%
    Fees 1%

    Date Base Withdrawal Tax Cash Mkt. Increase Fees New Base
    2014 $350,000.00 $14,000.00 $3,920.00 $10,080.00 $20,160.00 $3,360.00 $352,800.00
    2015 $352,800.00 $14,112.00 $3,951.36 $10,160.64 $20,321.28 $3,386.88 $355,622.40

    • I like your formula too. It’s just a bit too complicated for the article. I just wanted a ballpark figure. Your number looks good. The net worth is still increasing. The only problem I see is that you’ll have higher expense some years and it’s tough to figure that into your spreadsheet. When you need a replacement vehicle for example. I guess you can just put in a bigger withdrawal 5 years out or something like that.

  6. I am actually shooting for a hybrid between #1 and #2 and in reality, will have a mix of all three!

    I take my monthly expenses, subtract my passive income, multiply by 12 for my yearly expenses after income. Then, I multiply THAT number by 33.

    I am creeping closer all the time, but definitely have a few years left to build my way there. And of course, once I do hang em up, I will probably end up participating in work that produces income anyway, just because, as you said, doing nothing leads down a dark path.

  7. Great post! Yes work towards active and passive income. Nobody wants to really retire from life. Maybe from a job they hate but not from work. The key is to finding your lifes work that you enjoy pursuing. Think of all the wealthy people in this world that do not have to work but still choose to do so. They do so because they love it. That is what all should strive for. Find a passion that wecan get paid for that provides active income while at the same time doing things to build your passive income. This post pretty sums up some of that philosophy. Thank you for the great information RB40!

  8. The 25x guideline (4% rule) seems to assume that our investments will have to cover the full amount of our estimated expenses for the rest of our life. At some point in our 60’s most of us will start collecting SS and maybe even a pension, reducing the amount that has to be funded from our investments. On the other hand most of us will incur considerable additional expenses over what we spend today to cover health insurance until we reach 65. Also, isn’t the 4% (or 3%) rule the amount you could withdraw from the investment indefinitely? I don’t need it to last indefinitely. At some point I plan to start drawing mine down. And yeah, I’ve told my kids that very last check will probably bounce 😉 Granted, there are lots of assumptions here about future return on investments, lifespan, expenses, solvency of SS, and so on.

    • 25x is just a ballpark figure. Most retirees have way less than 25x and they are making it work somehow.
      It’s just an estimate to see if you should consider early retirement. 🙂
      I think 3% will last indefinitely as long as history holds up. I don’t mind drawing down when we’re over 60, but not before then. Yeah, it’s more complicated, but we just have to adjust as we go along.
      Thanks for your thought.

  9. So–on the rule of 25 factor how would you account for having a DB pension plan in the networth calc? In my case at 55 I have ~$36K a year pension (non-COLA). My expenses will be $70K. 401k is about $700K. I’m pre-tax maxing and 53 now.

    Maybe the answer is to calc this based on me drawing $34K from my 401K (as my remaining expense outside of penion). Cheers.

    • It’s just an estimate so it’s not that accurate anyway. I would take your expense minus pension and use that. You’ll also get social security at some point, right.

      • Good point. One option a lot of folks take at my megacorp is the “accelerated” pension which adds about $5K a year until you get to 62. Then even though the pension goes down like $10k a year for me SS will be $20K at 62 so it would still be a raise–Ha!

  10. I was glad to see you adjust the 4% rule for investable assets, and point out that the success rate is only valid for 30 years.

    We do not have any sources of income other than our jobs, dividends and interest from our investments, and Social Security after we retire. We plan to have 40x our expenses in investable assets when we retire in 9 years. This means we could probably retire sooner, but my wife will only be 49 even at that time, so she will not be eligible for Social Security, nor even able to withdraw from her tax-sheltered retirement accounts without penalty. We also want to be able to financially help our son during and after college. (I do not consider his $200k college fund as part of our investable assets.) So we are working on having a really big nest egg.

    • Wow, 40x is really good. If you can handle working 9 more years, then go for it. That’s being prepared and you won’t have to worry about money again as you age.

  11. Joe for me I believe it is important to strive for all three ways and cover all basis. For example if you can successfully build 10X living expenses, have passive and active income then it just accelerates the entire FI process while being happier.

    • I like that approach. It’s the natural way. You strive to increase both income and net worth, and FI will come naturally.

  12. Joe,

    Great post. Most timely for me as I recently quit my full-time job to pursue writing.

    I can certainly agree with you that there are clear benefits to doing something you enjoy for less money rather than put up with the higher-paying grind for 10-20 years so that you can build enough passive income to live off of.

    However, I think, if possible, the best way to go is to do both. If you can generate enough money to not only eke out a living doing what you enjoy but also see a little extra income which you can invest in assets that produce passive income (be it rental properties, stocks, etc.) then you’re set.

    I really enjoy writing. I have a great time at it, and I’m super blessed to be able to write and inspire people on a daily basis right now. However, passive income is still the dream because there’s no way to know I’ll enjoy writing forever or be able to do it forever. Life can take you in unexpected directions sometimes, and you never know what you’ll be doing a decade from now or what you’ll enjoy doing. Passive income buys you the flexibility and options necessary to pursue whatever you want, regardless of the income you may or may not be able to generate.

    Best wishes!

    • Hey, congratulation! Your passive income is increasing so that’s the good thing. Yeah, making money at something you enjoy is serendipity. I’m sure even if you get tired of writing, you’ll be able to find something else to do. Good luck!

  13. Hi, Joe, I have been following your blog with interest, thanks for the great work! You might like to also note that the funds counted cannot include any money currently in an IRA or 401(k), as these are not available without penalty until age 59-1/2 at the earliest. My problem is that most of my retirement fund is *in* retirement funds – can’t get to it for a long time yet.

    • Amen to this! It’s no fun having your money “locked up” this way and feeling like you have to do without. A great antidote for the automated investor would be to turn off the contributions to the Roth IRA, and set up several great DRIPs for automated dollar cost averaging purchases. Check out the Computershare website, to see how efficient it is and how low the cost can be. You can liquidate a position to access the money at any time. And as long as you meet the taxable income limits, the capital gains tax on the sale of those shares held over a year is ZERO. People may say the market is risky, but I sleep pretty well owning MCD, WAL, PG, etc.!

    • There are many ways to access your retirement funds. You can just pay 10% penalty. Or use the 72t rule. Or use backdoor Roth. I don’t see why we need to ignore the retirement fund. I’ll write more about this next time.

  14. To me, financial independence means not having to work for money. If I get enough income from my investments that I’m able to sit at home and do nothing forever, then I’m financially independent. I, of course, won’t stay home and do nothing… I’ll at least go to the beach.

  15. I think I will continue that tradition of evaluating my financial independce goals every July 4th! I’m what feels like as far away from this goal as the actual independence day July 4, 1776, hope that’s right, no history book used.

  16. I heard once that a person can consider themselves financially free/independent/secure when their money makes more for them in a year than they make for themselves in a year. That always has struck a chord with me and is something I’m shooting for. That seems similar to your thought at the end about income from other sources covering your living expenses.

  17. I think you slipped backwards in defining Financial Independence by Cash Flow, when you conclude that you will ultimately see an increase in net worth. If you’re strictly defining success by the cash flow, then an increase in net worth represents “lazy capital” in the form of equity that should be recycled to another cash flow-positive asset.

    I absolutely agree about Financial Independence your own way. We all need to be more creative for ourselves. I used to think that “getting ahead” meant keeping the nose to the grindstone for that next promotion and 8% salary bump. Nope! It means using the resources you have (time, money, energy, skill) to develop additional cash flow. You don’t get rich at work; you get rich at home. The Rich Dad Poor Dad books made a tremendous difference for me. I also credit and recommend Richest Man in Babylon for starting my family out on the right path.

  18. I think “Financial Independence” might be a bit of a misnomer, because we are all “dependent” on our finances. It took me a while to get this into my thick skull, and that’s the problem. Some of us take longer to come to that realization than others.
    I like the term “Financial Security”. That would be, having enough money to enjoy life and not outliving your money. I know it’s probably just semantics.
    How many of us truly enjoy our work and don’t just work at the job we took to make ends meet? I feel confident saying that is true of most of us.
    The trick is getting to the point in your life where your acquired skills in that thing that truly makes you happy allow you to generate an income. At that point you might consider yourself Financially Secure. Who knows? Depending on your level of enjoyment you might consider it passive income.

    • I like Financial Security. Your point about earning income doing the thing you enjoy is right on. It’s serendipity if you can make it happen. Most of us don’t enjoy our job and only do it for money. That’s not a good way to go through life.

  19. I think counting on active income is a bit of a chance. I think financial independence is being able to say no to work you don’t want to do, have time to do, or are not excited about. When that active income becomes boring/too much work/etc, if you’re dependent on it to survive, you can’t just quit – the same as if you were working a 9-5 job. Yes, you may be able to do something else for active income, but the fact remains that you still have to do *something* to earn that active income.

    I think it’s more of deciding how *demanding* you want your active/passive income to be. Most of us will still have to “actively” manage our portfolios until the day we die, but that’s 20 minutes a week (maybe?). Others are OK with landlording and property management. Still others want to continue a hobby to make some extra money. I don’t think there’s a “right” answer, just the right answer for each person.

    • Even if I get bored of my current work, I’d be able to make money doing something else I like. I have to do *something* to earn that active income, but that’s really for the best. I will never be completely passive anyway. I agree that everyone will have to find their answer. I think shooting for 100% passive income isn’t good, though. It will make life too passive.

  20. To me, financial independence is all about being able to afford to do what I want to do. That isn’t to say I can buy a private jet and an island, but rather have the freedom to work (if I even want to) at a job that I truly love, regardless of the pay.

  21. “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.”

    I agree it is a good thing and just because we’ve retired from traditional jobs doesn’t mean every way we earn income should be passive. We can still “work” and make good money.


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