Path to Financial Freedom: Achieving Independence Beyond the 4th of July

As we celebrate Independence Day, it’s an ideal time to reflect on the concept of independence in various aspects of our lives. While political and personal freedoms are often at the forefront of our minds, financial independence is another critical aspect that can profoundly impact our quality of life. Financial independence can mean different things to different people, but at its core, it represents the ability to live comfortably and sustainably without being reliant on employment income.

Defining Financial Independence

Financial independence is a personal milestone that varies significantly from one individual to another. For some, it means retiring early and traveling the world; for others, it might mean having the flexibility to pursue a passion project; work less hours in a more desirable job or career, but still work; or spend more time with family. Here are a few examples of what financial independence could look like:

Early Retirement: Being able to retire before the traditional retirement age while maintaining a desired lifestyle.
Career Freedom: Having the financial security to change careers or start a business without the immediate need for income.
Work-Life Balance: Reducing work hours to part-time or freelance work, allowing more time for hobbies, travel, or family.
Peace of Mind: Simply having enough savings and investments to cover all living expenses without financial stress.

Calculating Your Path to Financial Independence

Achieving financial independence involves careful planning and understanding how much money you need to support your desired lifestyle. Here’s a step-by-step guide to help you determine your financial independence number:

1. Determine Annual Expenses: Calculate your annual living expenses. Include all necessary costs such as housing, utilities, food, transportation, healthcare, and discretionary spending like travel and entertainment. Keep in mind that when you retire you may actually spend more on things like vacations and traveling, or increased healthcare costs as you get older.

Example: If your annual expenses total $60,000, this is the baseline for your calculations.

For simplicity you're going to use the higher number of either the current or future living expenses. There is a method that adds up all your living expenses for each year from now through the rest of your life, then takes inflation into account, and discounts back to how much you need today with a given return over time to cover all your living expenses. That is much more complicated, though.

3. Account of Taxes: If you'll be earning income from your investments to pay for your living expenses, you'll owe some taxes on those earnings. If you manage to earn all long-term capital gains, then your tax rate may be only 15%. However, it could be a mix of long-term capital gains and short-term capital gains with other income at ordinary income tax rates. You'll want to add a meaningful effective tax liability assumption. This can be done by taking your inflated living expenses and dividing by your assumed effective tax rate. Let's say you've determined 20% to be your overall effective tax rate with a living expense of $80,000.

Example: $80,000 ÷ (1– 0.2) = $100,000
0.20 is used for the 20% effective tax rate. We divide the amount of money needed by 100% minus 80%, thus the "1–0.2)

3. Determine Safe Withdrawal Rate: A widely used method to calculate the amount needed for financial independence is the 4% rule. This rule suggests that you can safely withdraw 4% of your investment portfolio annually without depleting your savings over time. Lately the 4% rule has come under scrutiny, with many economist and financial planners suggesting the safe withdrawal rate should be lower to account for potentially poorer market performance and/or increased inflation over the long-term. The new rule could be 3.5% or even 3%.

Example 1: If you need $100,000 per year, using the 4% rule you would divide your living expenses by 0.04 (4%) to find your target savings amount: $100,000 ÷ 0.04 = $2,500,000

Example 2: If you need $100,000 per year, using the 3% rule you would divide your living expenses by 0.03 (4%) to find your target savings amount: $100,000 ÷ 0.03 = $3,333,333

According to the 4% rule, you would need $2.5 million in savings and investments to generate $100,000 per year. If using 3% instead of 4%, you would need $3,333,333 to generate the same $100,000 per year.

Investment Performance and Adjusting for Inflation

One important factor not taken into account with the above calculations is inflation. Ideally any earnings or gains from the investments would exceed whatever the inflation rate is. This isn't always the case with all investments, and especially when there is a downturn in the markets that causes all investments to decline in value (like in 2022). Therefore, a good rule of thumb is to aim for investments that assume a return that exceeds the rate of inflation. For example, if you assume inflation is going to on average be at the Federal Reserve's target of 2%, you would want investments that return at least 2%. Generally, it's recommended to account for the possibility of a higher inflation rate, such as 3%. In that case you would want investments that return at least 3%.

Even better would be to aim for investments that return at least the amount that you're withdrawing from your accounts for the investments or inflation, whichever is higher. For example, if you're using the 4% rule and assuming an inflation rate of 3%, you would aim for an investment return of 4%.

The Role of a Financial Planner

Embarking on the journey to financial independence can be complex and challenging. This is where a financial planner can provide invaluable assistance:

Assessing Current Financial Situation: A financial planner can help you understand your current financial health, including income, expenses, debts, and assets.
Estimating Living Expenses: A financial planner can assist in accurately estimating your living expenses both before and after retirement, considering factors such as inflation, healthcare costs, and lifestyle changes.
Developing a Financial Plan: A financial planner can create a comprehensive financial plan tailored to your goals, outlining steps to achieve financial independence. This includes budgeting, saving strategies, and risk management.
Investment Strategy: A financial planner can help develop an investment strategy to grow your savings, balancing risk and return based on your time horizon with financial goals.
Continuous Support and Adjustment: Financial planners provide ongoing support, adjusting your plan as needed to stay on track with your goals and respond to life changes.

Financial Freedom is Journey that Requires Planning

Achieving financial independence is a journey that requires careful planning, disciplined saving, and smart investing. This Independence Day, take a moment to envision what financial independence means to you and start laying the groundwork to make that vision a reality. With the guidance of a skilled financial planner, you can navigate the complexities of financial planning and work towards a future of financial freedom and peace of mind.

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This content is developed from sources believed to be providing accurate information. The information in this material is not intended as investment, tax, or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. Digital assets and cryptocurrencies are highly volatile and could present an increased risk to an investors portfolio. The future of digital assets and cryptocurrencies is uncertain and highly speculative and should be considered only by investors willing and able to take on the risk and potentially endure substantial loss. Nothing in this content is to be considered advice to purchase or invest in digital assets or cryptocurrencies.