Ahh financial independence (FI)… That moment where you can stop working the 9-to-5 and wake up every morning (or afternoon) doing whatever it is you please. But how do you know when you’ve reached this financial status? Knowing when you’ve reached FI is important because you don’t want to run out of money once you break ties with cubicle nation and you also don’t want to work decades longer than is required.
One method for determining if you have enough to become FI is the moment your passive income exceeds your expenses. Passive income can be things like rental income, dividends, or passive business profits. Tracking your passive income against your expenses is good for investments like real estate but what about investments where most of the return is in appreciation like non-dividend paying stocks?
Luckily there is a dependable rule of thumb called the 4% rule. The 4% rule states that an investor can withdraw 4% of their portfolio each year with a good chance the portfolio will still keep it’s value. I wont go into too much detail on the 4% rule, but if you were interested in learning more about it, here is one of the better articles explaining it. Also, if you think the 4% rule is too conservative or aggressive, then just substitute in the number you are comfortable with like the 5% rule or 3% rule. To give a quick example of how the 4% rule works, lets say your annual expenses are $40k, then you would need $1million ($40k divided by 4% or $40k * 25) to have “enough” based on the 4% rule.
Why the 4% rule is very conservative:
The 4% rule has a few assumptions that make it a very conservative withdrawal rate in my opinion. Why? Because it assumes you will NEVER MAKE ANOTHER PENNY EVER AGAIN. Think about this, it is hard to do. It assumes you will not receive any gifts, social security, inheritances, no income from hobbies or side hustles. Nothing. And the likely hood of you never making another dollar in your life is as likely as a Trump becoming president (oh wait..). Especially when you consider who we are talking about. I mean if you had the drive and were smart enough to save for retirement, then you are also the kind of person who may accidentally make a little bit of money from a hobby or other fulfilling work you become involved in.
But what if my portfolio does exceptionally well or exceptionally poor once you are FI? Well, fortunately the 4% rule is based on the trinity study which looked at the market returns over 50+ years and considered how much would an investor be left with after a 30 year period if they withdrew 4% in any market climate. They found that 95% of portfolios lasted the 30 years with the median (or most probable) outcome being your portfolio would grow 2.8 times the original size! Yes, there were 5% of portfolios that didn’t make it after 30 years, but I’m not too worried about that either.
The reason I am not afraid of being in the 5% group of the trinity study where their portfolio’s get depleted is because I would not watch my portfolio go to $0 without doing something. If my portfolio dipped by even 10%, I would adjust my spending or look for a few months of contract work to replenish it and then reassess. The 4% rule assumes you would have no option but to watch your investments vanish if you were in the unfortunate 5% of their simulation. Think about it, that is like watching your house burn down OVER 30 YEARS and not doing anything about it! This should give you again more security in using the 4% rule and maybe question if it is a little too conservative.
The other half of the equation is to determine your expenses. You must keep in mind that your expenses when you are FI will be different than when you have a job. You will save money on commuting expenses, work clothes, lunches, rent, and travel. Let’s touch on 2 of those that I think are the big ones, rent/housing and travel.
It is likely that you chose where you live based on where you work (or you have a crazy commute which is equally as expensive). And typically housing near good jobs is more expensive than areas that are more residential. Perhaps you would want to continue living where you are, but it is something to think about since housing is usually one of the biggest expenses and you could likely save thousands each year by moving.
I also threw in travel since you will have more flexibility when you travel now (and it’s a popular thing to do once you are FI). You no longer will have to take vacations Saturday – Saturday during peak season where the flights, hotels, and activities are all jacked up. You can now arrange your vacations around the more enjoyable slow months and save half or more.
Adjusting to your after FI expenses will be specific to your own situation and depend on what you want to DO when you no longer have a job. My guess is that your expenses will lower 10%-20%. So for our $40k example, it will be lowered to $36k-$32k. This is great news since this lowers the amount required to have enough by quite a bit:
4% rule with $40k annual expenses: $40,000 / .04 = $1,000,000
4% rule with $36k annual expenses: $36,000 / .04 = $900,000
4% rule with $32k annual expenses: $32,000 / .04 = $800,000
This means our savings goal is $100k-$200k less than we originally thought and can mean we will be FI years sooner than expected (depending on your savings rate). There are some who take this idea to the extreme and take advantage of lower cost of living areas after they break ties with the 9-to-5. For example, a lifestyle that $40k/year could provide in the US is probably similar to $15k/year in SE Asia. And on $15k/year you would only need to save $375k with the 4% rule or about a third of what you would of needed at $40k/year. While living in another country might not appeal to most, it could be a way of fast tracking your way to FI.
This also doesn’t have to go to that level of extreme either. For example, I live in Chicago and the housing is typically 30%-50% less expensive if you live in the suburbs rather than the city. So if you lived in the city because that is where your work was, then moving to the suburbs once you no longer need that job would save you 30%-50% on housing.
If you have other plans once you are FI like traveling the world, then price it out. It probably doesn’t cost nearly as much as you think. I know people who can travel for a year on $10k (it does include sleeping in a tent and hitchhiking) and others who do it for $40k. With the flexibility and control over your time, you will find that it doesn’t cost nearly as much as you thought. Maybe even more important than pricing out how much you think your expenses will be once your are FI, experiment with it!
Experiment with your post FI life before you are FI:
By some of the calculations I did above, you can see that knowing how much your expenses are is a very important factor when it comes to deciding how much is enough to be FI. This is why you will want to experiment with your FI life before you are FI. You will want to do this for 2 main reasons:
1. Get more accurate expense numbers
2. Find out if you enjoy doing the things you wanted to do once you were FI
There are many ways you can experiment with your FI life. Want to travel the world? Take a sabbatical or as long of a vacation as your employer will allow. Want to live in a different location? Rent there for a year first. Or possibly the best experiment you could do is taking a mini-retirement. A mini-retirement is where you take an extended amount of time away from work (3 – 24 months) with the intent to go back. This is a good idea if you have at least a few years of expenses saved and are confident you can enter back into the workforce when you return. No doubt after living like you are FI for 3 – 24 months, you will you have a fine tuned vision of what you want your life to look like after FI and what it costs. Also, I would recommend experimenting more and more as you get closer to the finish line. Your vision will constantly evolve for what you want to do when you are FI, but hopefully experimenting allows you to get a much more accurate number than you started out with and lets you have some fun along the way!
Plan on making some money after FI?:
Do you have a hobby or side hustle that earns some money and plan to continue doing it once you are FI? Perhaps you have a blog, babysit, dogsit on rover.com, tutor, freelance, drive for uber, or have a lifestyle business of your own. Many of these could earn you a good, steady income and will make reaching FI even easier. For example, let’s say that you are a dog lover and dog sit part-time through one of the dog sitting platforms (rover.com, dogvacay.com) which earns you an extra $1,000 a month (or $12k/year). If we continue with the example of our annual expenses being $40k, then how much would we need to be enough for FI? Since our dog sitting earns us $12k a year, our investments only need to cover $28k a year ($40k-$12k). When we apply the 4% rule to that, we would need a $700k portfolio ($28k/.04) compared to a $1 million portfolio ($40k/.04) had we not had the $12k of income. Wow! That’s a difference of $300k which likely means years of working cut off your sentence in cubicle nation.
One word of caution and optimism.
Caution- You will need this income. Meaning if this income source dries up, you will need to find another way to cover the difference or go back to working until you save up another $300K.
Optimism – If this hobby or side hustle is something you enjoy doing, then there’s a good chance this income will grow since you will be able to commit more time to it. This is the more likely outcome.
It is up to you how much of this income you think is reliable indefinitely and the chances it will grow. Perhaps you take a hair cut off the amount you earn from these income sources. For our dog sitting example, maybe you make $12k a year but only feel confident in making $6k a year as an absolute minimum, so you only subtract $6k from your expenses when calculating how much is enough. This will put less pressure on the income source performing and gives you some margin since it is likely that you will earn more than $6k/year anyways.
Where are we at?
Enough = (Annual expenses – Work related expenses – hobby or side hustle income) divided by 4%
Or for our made up example of a pet sitter with $40k in expenses where 10% ($4k) are work related:
Enough = ($40,000 – $4,000 – $12,000)/.04 = $600,000
Flexibility is the key:
Knowing the EXACT amount you will need to support your lifestyle when you are FI is something you will never know. Unexpected things like illness, poor portfolio performance, or financial emergencies often scare people into thinking they will need to work and save forever. Similarly, unexpected gifts, inheritances, exceptional gains on your investments, or hobbies turned into incomes can make all your worrying look silly. This is why it is important to be flexible as life happens once you are FI. If a major setback happens, maybe reduce your spending temporarily or turn on some income stream. Being flexible and open to adjusting your lifestyle through the many financial seasons of life is the biggest security you could give yourself once you are FI. None of the retirement calculators account for you having an income during retirement or lowering your expenses when financial emergencies come up so if you are willing to be flexible and adapt then the chances of the 4% rule failing will quickly become 0%.
For me personally, I think the 4% rule is too conservative. I would feel comfortable with the 5% – 7% rule which would mean saving 15X-20X my annual expenses instead of 25X before declaring FI. This is mainly because I plan on working on other money making adventures once I am FI and feel 15X my annual expenses saved gives me enough room to pursue those adventures with minimal pressure to earn an income. But I’m also flexible and not afraid of going back to a job for a little while longer if things don’t work out.
What do you think? Is saving 25X your expenses enough? Do you think it is too much or too little? Why?