Which Is More Important For Reaching Financial Independence: Increasing Income or Increasing Savings Rate?

Many people think that the primary way to become financially independent is by increasing your income so that you can quickly build up a nest egg. Others think that your savings rate is the most important. The truth is there are pros and cons to both approaches, and the fastest way to FI is by taking advantage of both. But which one is most important? Read on to find out.

What Is Financial Independence?

In order to understand which approach is more important to reach financial independence, we first need to define the term. Financial independence is when you have enough money to live off your investments or passive income without needing to work. You can read more about financial independence here.

Now let’s go over the pros and cons of each approach.

Increasing Income

Pros

  • More money available to budget
  • Unlimited upside
  • No need to reduce quality of life
  • Passive income requires little to no additional work after the initial investment

Cons

  • Generally requires more time commitment
  • Often more stress/pressure
  • Still have to save if you want to grow your nest egg
  • Watch out for lifestyle inflation (spending more money as you make more money)

Increasing Savings Rate

Pros

  • More money saved
  • Less money needed for financial independence (FI is calculated based on expenses)
  • No need for additional work
  • Does not require extra time commitment

Cons

  • Limited upside (can only save so much)
  • May not be able to buy everything you want
  • Have to carefully consider purchases
  • Requires discipline

Which Is More Important?

As you can see above, there are a number of pros and cons to both approaches. The biggest benefit of increasing income is the unlimited upside. There is theoretically no limit to how high your income can go. You also don’t need to reduce your quality of life because, with a higher income, you can keep your current lifestyle and still have more money to spare. However, if you do increase your spending when you increase your income, you may quickly run into the problem of lifestyle inflation. The more money you spend, the more you will need to reach financial independence.

The biggest benefits of increasing your savings rate are that you are saving more money (obviously) and that you therefore need less money to reach financial independence. If you can live off less money, then you don’t need to have as large of a nest egg to be financially independent. The biggest drawback to this approach is that you can only save so much. You cannot increase your savings rate indefinitely. Cutting back too much can also reduce your quality of life.

As for which is more important, I took a mathematical approach to find out.

I started with a control scenario to serve as a point of comparison. Starting at age 30, let’s assume an individual earns $50,000 per year and saves 30%, which comes out to $15,000. This may sound unlikely, but it actually matches my household last year. Assuming that all of the savings are invested with an 8% annual return, and using a 3.5% withdrawal rate to calculate financial independence (rather than 4% because the individual would likely reach FI before normal retirement age), this person would reach FI at 53.

Income$50,000
Savings $15,000 (30%)
Expenses$35,000
FI number $1,000,000
Age at FI53

If this person were to double his income to $100,000 at 35, how would this affect the age at which he reaches FI?

If he were to continue saving $15,000 per year like before, it would take him 11 additional years until FI at 64. This makes sense because after his raise, he began to spend much more money every year, thus increasing the amount he would need for FI. This is classic lifestyle inflation.

Before RaiseAfter Raise
Income$50,000$100,000
Savings $15,000 (30%) $15,000 (15%)
Expenses$35,000$85,000
FI number $1,000,000$2,428,571
Age at FI5364

What about if he were to continue saving 30%, which would be $30,000 now with his higher income? You’d think saving more money would get him to FI faster, but this is not the case. He would actually reach FI at 56, three years later than if he never got a raise. This is because the amount he would need for FI increased with his raise. Rather than living on $35,000 per year, he now needs $70,000. The $15,000 he saved each year before he got the raise is not enough to support his new lifestyle, so he would need to keep saving for a few more years. This is again a case of lifestyle inflation.

Before RaiseAfter Raise
Income$50,000$100,000
Savings $15,000 (30%) $30,000 (30%)
Expenses$35,000$70,000
FI number $1,000,000$2,000,000
Age at FI5356

If the individual wanted to reach FI at the same age as before, 53, he would have to increase his savings rate to 36% after receiving the raise. This is only a modest increase, though it is an increase of $21,000 annually, but the person would still get to spend an additional $29,000 per year.

Before RaiseAfter Raise
Income$50,000$100,000
Savings $15,000 (30%) $36,000 (36%)
Expenses$35,000$64,000
FI number $1,000,000$1,828,571
Age at FI5353

Meanwhile, if he were to continue living on $35,000 per year even after the raise, bumping his savings rate up to 65%, he would reach FI at 44, nine years earlier. You can see how important it is to keep lifestyle inflation under control.

Before RaiseAfter Raise
Income$50,000$100,000
Savings $15,000 (30%) $65,000 (65%)
Expenses$35,000$35,000
FI number $1,000,000$1,000,000
Age at FI5344

Conclusion

Clearly, savings rate is more important for reaching financial independence than increasing income. If you increase your income but do not increase your savings rate, it will actually take you longer to reach FI than if you had never increased your income to begin with. On the other hand, increasing your savings rate will always get you to financial independence sooner. Of course, if increasing your income allows you to increase your savings rate, then this is the best of both worlds and the ideal approach.

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