When I heard the term “financial independence” earlier in my life, here is what I heard: “wealthy.” I equated being financially independent with being wealthy. And “wealthy” was not a word I ever considered as a possibility for myself.
“Wealthy” was a person who was born into money.
“Wealthy” was a person who inherited money.
“Wealthy” was a person who started a successful business.
“Wealthy” was someone who made the rules. Who could fly off to a remote locale and sip cocktails on the beach while yelling into his cell phone “BUY! BUY! BUY!”
That is not, however, what “financially independent” means, especially as it has been defined by the many bloggers out there who have achieved it. Sure, some of them saved up millions of bucks, but some of them decided that saving up $200,000 would be enough. The deciding factor? How much money it would take to cover all of their expenses for a year. Someone who has a lot of expenses would need to save up millions of bucks. Someone who has very (VERY) low expenses could do it on only $200,000.
Being “financially independent” only means having enough money in savings/investments to support your annual expenses, for the rest of your life. That doesn’t mean that you have to literally save a year’s worth of expenses multiplied by the number of years left in your life though, thanks to a beautiful thing called passive income.
Let’s talk for a minute about orange trees.
When you are saving money for the future, the money you are saving is like the tree. The tree is called your principle. And when oranges grow on the tree, those are the passive income. Other than to plant your tree in some good soil in the right climate, you don’t have to do anything to get the tree to make oranges, it just does. You want to live on the oranges. Not tree bark.
If I have $100,000 of principle (the tree) sitting in the bank generating 1% returns per year (the oranges), then my $100,000 has just grown by $1000. If I could live off of $1000 a year, then BOOM! I’m financially independent. See how that works?
Of course, I’m not sure anyone in the United States could reasonably expect to live off of $1000 per year. But if I want to live off of $40,000 per year, then I would need to make sure I have enough principle invested that is growing by a large enough amount that I can live off of it every year.
I want to live off of $40,000 per year. That’s a lot of oranges.
I have $400,000 invested. That’s a moderately sized orange tree.
My $400,000 is growing by an average of 7% each year. Do I have enough?
7% of $400,000 = $28,000
Nope. My $400,000 earning an average of 7% per year is not enough to meet my expenses of $40,000 per year.
I now have two choices.
Choice #1: Lower my expenses (eat fewer oranges)
Could I possibly live off of $28,000 per year? If so, then maybe this would work for me. This is the reason why frugality is such an important subject among those pursuing financial independence. Many people achieve FI through living frugally and lowering their expenses.
If this is not my cup of tea, I need to move on to the next option.
Choice #2: Save more money (grow a bigger tree, or plant more trees, and produce more oranges)
Let’s pretend that I’ve now saved $600,000, and it is also growing by an average of 7% every year. Would that be enough?
7% of $600,000 = $42,000
YAY! I DID IT! I’M FINANCIALLY INDEPENDENT!
Well, maybe. You’ve got the main idea, but there’s something else to consider.
If your money is growing by an average of 7% per year, and you are living off of 7% per year, maybe there are some years when your money is earning LESS than 7%. That would be like a late frost one year that froze your money tree and it didn’t produce as many oranges that season.
If your money is earning less than 7% but you are withdrawing all of that for your living expenses, then guess what? You’ve just dipped into your principle (the base $600,000) and eventually, you will run out of money. You are cutting branches off of your orange tree.
Don’t despair! There is still citrus in them thar trees!
It might seem obvious, but here it is. Withdraw LESS than the growth rate of your money (pick fewer oranges). If it is growing by an average of 7%, and you withdraw only 4% each year to live on, then you can safely say you are financially independent. Within the FI community, 4% is often known as the “safe withdrawal rate” (SWR).
Okay. I have $600,000 invested, and it’s earning an average of 7% per year ($42,000).
But if I can only withdraw 4% safely, that means I can only use $24,000.
Now you know the drill:
Choice #1: Lower expenses
No. I’ve already planted a garden, have a freezer full of roadkill and and take cold baths in the river. I know where this is going…
Choice #2: Keep saving
Back to the orange grove to plant more trees, Pa.
You can do it!
I’m not knocking on frugality. Really. But I will have more to say on it sometime.
- The 4% Rule: The Easy Answer to “How Much Do I Need for Retirement? (Mr. Money Mustache)
- Safe Withdrawal Rate for Early Retirees (The Mad Fientist)
- Stocks — Part XIII: The 4% rule, withdrawal rates and how much can I spend anyway? (jlcollinsnh)
- Financial Independence (good old Wikipedia)