Financial planning tends to focus on retirement planning — that holy grail where we ride off into the sunset (literally, to some beach chairs) and never work again while living comfortably off of retirement plan savings and income. Retirement planning is a nice ideal and important, but there can be much more to financial planning than preparing for our last 25 to 30 years. A broader financial planning discipline may have more appeal to you — financial independence.
It’s fairly self-explanatory: The concept is to reach a point where your financial assets can support your living expenses, so you no longer need to work or depend on earned income. Essentially, your time is your own.
Shifting from retirement planning to financial independence helps move the financial concept from a daunting, long-term goal to a process with benefits along the way. It also addresses those blessed people who love their businesses or jobs. In those situations, a full-stop retirement date may not have an appeal, but they still want the freedom to work when, where, and how they prefer — in other words, independence.
What steps can you take to start the road to financial independence?
Let’s start with the foundational equations of finance. For annual income, savings equals income minus expenses, and for financial position, net worth equals assets minus debt.
In the annual income equation, expenses and savings deserve equal attention. The rule of thumb is that you can safely withdraw 4 percent of your investment assets each year, make increases for inflation, and still have assets remaining after 30 years. By inverting the 4 percent withdrawal rule, you should target accumulating 25 times your annual living expenses (e.g. $60,000 annual spending x 25 = $1,500,000 target investment assets).
It is important to dial in your spending number to provide an accurate, realistic target. I advise my clients, regardless of income level, to establish some sort of budget plan. Knowing expenses allows the opportunity for review and adjustment. There are articles that extol the benefits of cutting out Starbucks coffees, but the real focus should be paid to the big three — home, vehicles, and food. Making conscious decisions like staying below the housing cost guideline (housing costs less than 28 percent of income) and making reasonable vehicle purchases help keep expenses at a moderate level and allow for increased savings. Another important factor is avoiding lifestyle creep, in which expenses instead of savings grow with income.
The traditional retirement savings target is 10 percent to 15 percent of annual income. That savings rate over a career should ensure that you can retire and maintain a similar lifestyle in retirement. A 15 percent savings level should be the baseline, with increases shortening your time to financial independence.
There are people who take it to another level, such as the FIRE (Financial Independence, Retire Early) movement that aims for a 40 percent to 50 percent savings rate. Prioritizing savings to that level may not be practical or feasible, but anything over 15 percent will accelerate your timeline and immediately impact your financial position.
There is a hierarchy of savings that helps maximize efficiency while taking advantage of the tax code. After reserving an emergency cash fund (three months to six months worth of living expenses), prioritize savings to 401(k) or 403(b) plans that offer a matching contribution. Next, target any higher-interest loans (anything above 6 percent). Then, contribute to health savings accounts and Roth IRAs if you are eligible. Last, save to brokerage accounts up to your targeted savings rate.
Saving is simple. Sometimes all you need is the right advisor in your corner to assist with an individualized plan that you can follow. With these tips and a little guidance, reaching financial independence is possible, regardless of your age and salary. Plan now and enjoy your freedom later.
Tim Ellis, CPA/PFS, CFP, is senior investment strategist and wealth strategist for Waddell & Associates. He can be reached at tim@waddellandassociates.com.
