Many of you have likely heard of the FIRE movement, which stands for Financial Independence, Retire Early. However, do you know what financial independence means? I previously published an article about what it means to be financially comfortable, but financially independent takes it a step further. In simple terms, it means that you are no longer dependent on active work to pay for your life expenses and so you are free to retire if you choose. This means that you either have enough passive income to live the life you want and/or you have enough money to retire at your current age. Let’s break this down.
Having enough passive income to live off
Passive income is income you receive without having to actively work. This generally includes interest, dividends, capital gains, and royalties. Some people also include rental income, but I would argue this depends on how involved you have to be in managing your rental properties. This also applies to your investments. If you have to constantly trade to earn your income, then this isn’t really passive income.
Now when I say enough passive income to live off, this means earning enough to cover your expenses. This doesn’t mean your current income level. Anyone pursuing the FIRE lifestyle should be saving a large percentage of their income. That means the money you need to get by is actually far less. Of course, if you plan to have bigger expenses after reaching financial independence or retiring early (for example, traveling more frequently), then you will need to aim for a higher passive income stream.
In terms of investment income, you often hear about the 4% rule, which was derived from research suggesting that you can safely withdraw 4% of your nest egg in the first year of your retirement ($40,000 for someone with a $1 million nest egg) and continue to withdraw that same amount each subsequent year, adjusted for inflation, without running out of money before you pass away. This is a good rule of thumb, but keep in mind that it does not apply to individuals who retire early. It was only tested based on the assumption that your money would need to last 30 years. The earlier you retire, the lower your withdrawals should be. Some people have suggested 3% or 3.5%. This is because you need your money to last longer and there is a bigger chance that you will experience a severe market downturn. If your annual withdrawal percentage is lower than your annual investment return, then you will continue to grow your money even as you live off it.
To determine how large your nest egg would need to be based on your desired annual withdrawal amount, just multiply that withdrawal amount by the inverse of the withdrawal rate. In the case of the 4% rule, that would be 1/0.04 = 25. That’s where the 25 times your salary rule of thumb comes from (although it should really be 25 times your expenses). For 3.5%, that would be 29x, and for 3%, that would be 34x (for round numbers, you can think of 30x and 35x). A nest egg this large should provide you with the passive income you need to live at your current standard of living.
Having enough money to retire
If you have enough money to retire at your current age, then you technically no longer need to work. The amount of money you would need to retire is discussed a bit above, but you can also see How Much Money Do You Need To Retire? for a minimum estimate of how big your nest egg would need to be. Keep in mind this is just an estimate of the minimum, so you may actually need more. Also, just because you have enough money to retire, doesn’t mean you actually have to. There are a lot of benefits to working longer than is strictly necessary. It can allow you to increase the size of your nest egg, letting you potentially withdraw more money and live more comfortably in retirement. It can also help you to weather market downturns more easily. You may also simply enjoy working. However, if you do not like your job, then becoming financially independent is a great opportunity for you to find something else to do that you do enjoy. Why keep working at a job you don’t like if you don’t have to?
In summary, financial independence is when you no longer have to work to maintain your lifestyle. You can rely instead on passive income and your nest egg. Alternatively, some people consider financial independence to be when you can live comfortably without a full-time job rather than without having to work actively at all. This definition would definitely include rental income and active trading. It would also include anyone who can scale back to a part-time job and still get by. To reach this level of financial independence, you would need a much smaller nest egg because you can still earn money from your work to complement your passive income. You could also earn enough from a part-time job that you wouldn’t need to dip into your savings at all. Personally, I find this definition to be a bit silly. It seems to me to be more of a halfway point to financial independence than true financial independence itself. Granted, I may be biased because my wife and I both currently have jobs that are technically part-time but actually take up almost all of our time.
Financial independence means that you are essentially independent from financial worries. This does not mean that you won’t actually worry about money; it means you don’t need to. Letting go of stress about money can be quite difficult. Reaching financial independence can take a lot of time and effort, and the journey will likely require you to think about your finances a lot, which makes it harder to let go. However, I imagine actually doing so would be quite freeing. Once you are free to do as you please, why not free up your mind as well?