How Much Money Do You Need to Be Financially Independent?
The most common rule of thumb is to save 25x of your annual expenses in order to be financially independent, but this depends on a host of factors like your age, other income sources, and spending habits.
How much money do you need to be financially independent?
A lot.
Well, maybe you don’t. I mean, if you don’t spend much, then you don’t need that much.
On the other hand, if you want to spend quite a bit on things like your home, travel, cars, etc., you’ll need a sufficient amount of money to afford it.
You also have to consider the source of the money.
Do you have an income stream like a pension, annuity, or social security that would take the burden off of a nest egg of savings, thus reducing the amount you actually need to have on hand?
Or do you need a large pool of cash invested in assets that can grow and/or produce an income stream for you?
As is the custom in personal finance, it depends on your situation.
Let’s take a quick walk through these considerations and run through a scenario as an example of how one might calculate their own financial independence “number.”
As we walk through this, we’ll operate with a working definition of financial independence (FI) that basically assumes FI is having enough money so that you can pretty much do what you want (like not working again).
You may reach financial independence and decide that you want to keep working. Maybe you don’t want to travel. Perhaps you want to live a minimalistic lifestyle or maybe you want your very own McMansion.
The key theme here is financial independence means you’re in control. You don’t have to obligate yourself or limit yourself because of money.
Let’s get started.
How Much Do You Plan to Spend?
Maybe it’s surprising to you, maybe it’s not, but it always shocks me how few people have a remote clue how much they’re spending on a month-to-month or even annual basis.
There are many reasons knowing your spending level is important, not the least of which is setting a somewhat accurate goal for saving and investing.
Regardless, let me be clear about one thing first: You can’t know how much you need to save if you don’t know how much you’re going to spend.
If you glean nothing else from this write-up, please take that comment with you.
The reason it’s so critically important is the same reason you shouldn’t walk into a grocery store with a nickel in your pocket and expect to be able to buy much of anything.
You probably go to the store often, so you know how hopeless it would be to stock your cupboards without enough money to purchase your most basic grocery needs.
Granted, you don’t stop working and declare yourself financially independent every day, but the same logic applies.
You need to start with the end firmly in your mind if you want to be successful.
So, how to do this?
You need to create a budget.
Instead of walking through that process here, I’d like to refer you to the starting point of our Next Dollar Roadmap. It’s cleverly titled Starting Point: 8 Steps to Creating Your First Budget.
You’ll find information there about not only creating a budget but some useful e-tools that make it a little easier.
Once you know how much you spend each month, you can multiply by 12 to arrive at an annual number which is the unit of measure most people use when they refer to salaries, interest rates, taxes, etc., etc., etc.
So, let’s say you calculate that you need $60,000 to cover your living expenses each year. Does this mean you need a portfolio of assets that produces $60,000 of income annually?
Maybe. Maybe, not.
For most people, even without considering inflation (which we will leave out of this post for simplicity’s sake), your spending will change once you reach the place in life where you can step away from a typical job forever.
For example, will you still have a mortgage? Do you have kids that will be out of the nest years from now? Will you travel more? Less? The same?
All of this should be accounted for as you build your forecast. Don’t panic if you feel a little unsure, just do the best you can for now.
Where Will Your Money Come From?
Now that you have an annual spending target, you need to account for the income you may have that will reduce this number.
For example, most people receive Social Security eventually.
Using our example from earlier, if you have a spending need of $60,000, but receive $30,000 each year from Social Security, the amount of income you need to find each year just got cut in half.
You should also account for income sources like pensions and annuities (not that common) that would bring this number down slightly.
I’d caution you not to include any expected inheritance.
Even if maw-maw has assured you that you will be “taken care of” or even told you the dollar amount you should expect to inherit, no one can guarantee an inheritance.
Maw-maw could live to 100. She could get sued. Her assets could be seized for tax evasion. You could miss an Easter with the family and be conveniently written out of the will.
Any number of things could happen. Do yourself a favor and don’t depend on what you can’t guarantee.
Along those lines…you may not want to rely too heavily on Social Security. At least not as it exists today.
I’ll spare you the details for now, but the Social Security system has some significant solvency issues that must be addressed to stay afloat.
That could mean retirement ages get pushed out. You could get phased out for income or net worth. They could reduce benefits or even increase the taxes paid on them.
There are more questions here than answers which is why I don’t count Social Security in my personal calculations.
(You can read more about how Social Security is a terrible retirement plan here.)
After you’ve deducted these other sources of income from your annual spending number, you’re ready to move on to the next step.
Use the 4% (or maybe 3%) Rule
So, how much do you need in the form of a lump sum of cash and invested assets to cover your living costs?
Most people (financial advisors and planners included) refer to the famous 4% rule often.
In summary, the 4% rule was birthed from a study in the late 90s that showed a portfolio of assets invested in stocks and bonds had a high likelihood of lasting at least 30 years if the withdrawal rate began at 4% and was periodically adjusted for inflation and other market forces over time.
That long sentence doesn’t read like a summary.
Said very simply, the 4% rule says if your withdrawal rate is 4% of your portfolio balance, it will probably last at least 30 years.
Revised for mathematics, 4% is the same as 1/25th which means you can multiply that annual spending need by 25 to arrive at “your number” for financial independence.
Returning to our previous example, with an annual need of $30,000, you’d need a nest egg of $750,000 ($30k x 25) to be financially independent.
For $60,000 annual spend you’d need $1.5MM.
Seems easy enough, am I right?
Well, hold your horses a bit. We need to comment on two major issues here.
First, the 4% rule was for a 30-year portfolio. So, it’s great if you’re 70 years old, but what if you want to be financially independent at 50 or 40?
If this applies to you, you’ll need to adjust your calculations for the extended draw-down period.
I don’t give advice through this website, but personally, I’d adjust my calculation to the 3% (33.3x) rule at age 50, the 2.5% (40x) rule at age 40, and the 2% (50x) rule at age 30.
If you’re trying to achieve financial independence before 30, just keep making your multiplier more conservative but I’d work longer. There are only so many movies to watch on Netflix anyway.
Average J’s Number
Let’s run through a quick example with our friend Average J.
Average J wants to be financially independent but not super rich, just average.
In 2022, the average household in the United States spends $66,928. (In case you’re wondering, this is about $3,000 more than the average income ☹.)
Average J is conservative by nature and wants to be financially independent by age 50, so she uses the 3% rule and multiplies her expected expenses by 33.3.
This gives Average J a financial independence “number” of $2,228,702.40.
Average J can get there by using a host of tax-advantaged retirement accounts and other investing methods, but she will have to prioritize saving to get there.
Err On the Conservative Side
As a word of caution, there is no way to perfectly calculate exactly how much you need to be assured that you have achieved financial independence.
Personally, I err on the very conservative side.
I’ve never heard of anyone complaining about having too much money, so you might as well give yourself some cushion.
After all, you’re basically deciding whether you want to err on having too much when you quit working or having too little. Which one do you think would be harder to live with?
For more about financial independence, may I suggest some enlightening reading about the FIRE movement?
There are many ways to approach financial independence. It’s probably best to learn as much as you can so you get comfortable with running scenarios for your own lifestyle.
Finally, remember that the journey is as or more important than the destination. You are allowed to change your mind and tweak your plans along the way.
