Financial independence is having enough wealth such that you no longer have to work for money. You become financially independent when your wealth's assets produce enough income to cover your expenses.
For example: If you have $500,000 in assets and your assets produce $20,000 per year (4% of your total assets value) and your expenses for the year are $20,000 or less, then congratulations, you are now financially independent. Your assets are producing more income than you spend in a year.
Everyone has a different financial independence number. Some people want to have a more lavish retirement and therefore will need to save more money. Some people want to retire as soon as possible and are more willing to cut back some expenses. The key to financial independence is how much money you spend. The more you spend, the more you will need to save. The less you spend, the less you will need to save.
You need to save at least 25 times your annual spending.
Why? In 1998, three professors at Trinity University released what is now called the Trinity study. The study looked at a number of different stock/bond mixes of portfolios and their withdrawal rates from 1925 to 1995 in periods of 15 to 30 years. The study concluded that if you withdrew no more than 3-4% of your investment portfolio every year, then it would be extremely unlikely that your portfolio would run out of money. Thus, from this study, 4% became known as the safe withdrawal rate.
Therefore, withdrawing 4% of your investment portfolio every year should cover your annual expenses. Since this is 1/25 of your portfolio, then as a general rule, your portfolio must be at least 25 times your annual spending in order to retire.
Some people might be more conservative and go with a 3% withdrawal rate. That decision is up to you. However, keep in mind that the Trinity study did not assume the following:
With some of these assumptions in place, we do not have to be so conservative with our safe withdrawal rate and can use the standard 4% safe withdrawal rate.
An important factor to financial independence is your savings rate, which is how much of your income you can save. The more you save, the quicker you will reach financial independence. Take a look at Mr. Money Mustache's article on The Shockingly Simple Math Behind Early Retirement. Assuming a net worth of zero, if you save 50% of your income, you can retire in 17 years. If you save 75%, you can retire in 7 years. If you can save 85%, you can retire in 4 years.
Before we get started, we're going to assume a simple scenario: you don't have an emergency fund, you have some sort of debt (credit card, student loans, house, etc.) and you have no investment accounts.
Your first step should be to track every single dollar you are spending and earning. It will be very difficult to get a good grasp on your finances without knowing exactly what your accounts look like now and where your money is going. If you are looking for an automated approach, Mint.com is an excellent website to link to all of your accounts and pull your financial data automatically. However, I highly recommend using YNAB (You Need a Budget), which will require manual entry of every transaction in your accounts. Alternatively, you can manage this manual process with custom spreadsheets. I recommend doing this process manually (YNAB/spreadsheets) over automatically (Mint.com) as you will know where every dollar is going instead of being merely told where it went after the fact.
Once you are tracking every dollar, you should be able to easily spot where your money is leaking into unnecessary expenses. You should next create a budget, starting with a list of your essential expenses: housing, utilities, food, etc. Then starting listing your non-essential expenses: hobbies, alcohol, vacations, etc. Then you need to set aside a set dollar amount for each of these expenses, essential and non-essential, and try to not go over that monthly alloted amount.
Your objective is that you want to reduce your expenses such that your monthly income is greater than your monthly expenses. You will then take this left over money (income minus expenses) and place it into your soon-to-be created emergency fund, debts, investment accounts, etc. It is very important that you try to stick to your budget and to reduce and remove any expenses that are not necessary, at least temporarily until you are out of debt, if not permanemently (if you wish to achieve financial independence sooner).
An emergency fund is an important initial step to take. With your budget in hand, you should now know exactly how much your monthly expenses are. Now you need to save your excess monthly money (income minus expenses) into an emergency fund account. This account should be a cash account at your local bank or an online bank. The importance is that the emergency fund should be easily and quickly accessible during an emergency. Do not worry about trying to earn much interest on an emergency fund account. Think of it as a self-insurance against future unexpected expenses from emergency situations, such as non-regular car repairs or an emergency veterinary visit.
Start by saving up enough money to cover one month's worth of your budgeted expenses. With this money set aside, if something comes up in the near future, then you won't have to worry about adding more debt to your credit cards due to an unexpeceted emergency. Instead, you pay for that emergency with your saved cash on hand and then re-build your emergency fund for the next inevitable emergency down the road.
Once most of your debts have been paid off, you can expand your emergency fund to the typical recommended 3-6 months worth of expenses. The number of months to save is ultimately up to you and how risk averse you are. Some people save up to a year's worth of expenses (meaning they could possibly go without a job for up to a year!). I would not recommend more than a year's worth of cash in an emergency fund, as you will eventually be placing your excess saved money into an investment account, which is absolutely necessary to become financially independent.
This page is maintained by Bryan Denny. I am a software developer who is trying to achieve financial independence. I created this page as a starting point for others who are interested in doing the same thing.
This page is for informational purposes only. I am not a financial professional. See a professional for financial advice. I am not responsible for your decisions. Please take some time before you make any financial decisions.
This page is still under development. Have a suggested change? Make a pull request on GitHub!