Financial independence (FI) versus retirement
When I finished graduate school I knew I had to learn something about finance. I bought the obvious, “Personal Finance For Dummies” by Eric Tyson. It turned out to be a great starter finance book. From this book I set a goal of being able to retire in 20 years. It seemed a pipe dream at the time. In retrospect if I knew then what I knew now, I would have set the goal of 15 years. After a lot of reading and podcasts I have come to understand that retiring to a life of only leisure is probably not for me, I’d like to have a creative outlet that earns money. Don’t get me wrong I like leisure, just not 100%. So for me the goal is financial independence (FI), not retirement.
Why get FI?
Work can be unpredictable. One day things are going great, then next you get an email from your Boss saying “Can you meet this afternoon, we need to make some changes and it will include (fill in the blank – really bad stuff)”. Or maybe you’ve been working very hard for 20 years and you start to run out of gas, it happens. Or maybe you have a serious health issue. The bottom line is things can go bad fast, and very unpredictably. It’s nice to have financial security.
FI also improves the dynamic at work. As you start to reach FI your philosophy at work changes. People who are not close to FI and have large mortgages often don’t speak up and don’t take risks. Being close to FI can give you the freedom to do the job the way it should be done.
Notice the word freedom in the previous sentence. FI is freedom. Once you are FI you are no longer a wage slave. You have choices. This is the main reason to be FI, to increase your freedom. Who doesn’t want to have more freedom?
Freedom, here I come, let’s get FI
Below are 5 major steps to FI. If I could go back in time I would have educated myself about these steps and made them a major priority. There are also links to resources to get you started.
- Reduce expenses and spend thoughtfully. Money is just a way to trade your skills and efforts for goods and services you need. If you think money is bad or something you should not think about, then you really are not valuing your skills and efforts. So as money comes in, it’s important to make sure you are getting value for every dollar that goes out. Don’t trade your life energy for consumer goods that you will seldom use and will end up in a landfill in 10 years. Do spend on life experiences and things you truly value and will ‘move the needle’.
- Have a high savings rate. You may read that you should save 10-15% of your salary for retirement. I suggest a better approach, save at least 50% for FI. This may not be possible when you are just out of school, but it should be a goal to get there. As you get closer to FI some people even get to 75%. The time to FI is directly related to your savings rate. At 10% you have 51 years till FI, at 15% you have 43 years, at 50% you have 17 years and at 75%, 7 years. Having a high savings rate means being creative and really stretching a dollar, but it can be fun.
- Invest wisely. Ok this is obvious, but here’s where many people go wrong. They offload the understanding of investing to someone else or just go with the recommendations of their 401k pamphlet (like I did). My belief is that everyone should have a thorough understanding of investing. It’s about valuing your own time and effort. This means learning the basics and reading at least 2 books on personal finance/investing. There are many excellent resources available. Investing includes understanding 1) different asset classes like equities, bond funds and cash, 2) your risk tolerance and determining an appropriate asset allocation, 3) the powerful effect of expenses including mutual fund expense ratios on your timeline to FI, and 4) how to construct an investment policy statement that will guide you through good markets and bad. Go forth and educate yourself.
- Minimize taxes. I learned the hard way there are a lot of strategies that can be used to minimize taxes. I am not talking about sketchy tax deductions. I am talking about straightforward approaches like maximizing your 401k/403b and other mechanisms including 457 and health savings accounts (HSAs). For some people it is possible to contribute to a 403b, a traditional IRA, a 457 and a HSA. Justin at the Root of Good blog shows how his family was able to have income of $150,000 and pay $150 in taxes. While not everyone can save that much, many people can improve their tax efficiency. There are also approaches like tax loss harvesting and tax gain harvesting. If you don’t know what these are, you may be missing out on major tax savings. Another example is rolling over money from a 403b or traditional IRA to a Roth IRA in years where you don’t have much income. Finally, structuring your portfolio for tax efficiency is important. Unfortunately some of this is quite complicated and requires quite a bit of reading. But it can really pay off.
- Understand how to sequence withdrawals. If you can optimize how you will withdraw funds once you are FI, you can reduce the $ number you need to reach FI. This is a highly individualized process and there is a lot to learn. For example understanding how to optimize social security (SS) can have a major impact on your finances. For many couples having the higher earning spouse delay taking SS until age 70 can have a major impact.
If this seems overwhelming, don’t worry it’s doable. Just get started. I have put them in the order I think is most important. And nowadays there are incredible resources of which I have listed my favorites. If you are at the beginning of this journey it seems to go very slow at first. But some steps synergize with each other. Reducing your expenses allows you to contribute more to your tax deferred accounts and have a higher savings rate. This in turn allows you to minimize taxes. As your assets grow, your journey to FI speeds up. “The most powerful force in the universe is compound interest” – Albert Einstein. So get FI!