Today is 4/25/2019, which is being celebrated as the first annual Financial Independence Awareness Day by some of the personal finance bloggers in the Twittersphere. Ty Roberts from CampFIREfinance put out a call for posts about Financial Independence, to be shared on 4/25. He chose 4/25 for folks to think about the 4% Rule and/or 25x your annual expenses. This is a common metric for planning for traditional retirement and is based on the Safe Withdrawal Rate from the Trinity Study.
In this post, I want to talk about two different types of financial independence: the first being a more common perception of being financially free from your parents and family, with the second being the Financial Independence movement that today’s articles are mostly written about.
First financial independence
I am probably not wrong to assume that when most Americans think of the term “financial independence,” they are thinking of being able to stand on your own two feet financially. No more help from mommy and daddy to pay for groceries or tuition, utilities or rent. No longer participating in the “Family plan” for your cell phone coverage.
Strangely enough, I just gained this first kind of financial independence a few days ago. I stepped off the family share plan that I had been a part of since 2002 with a switch from Verizon to Google Fi (affiliate link) to be on my own plan. Lest it seem like I’ve been a freeloader from age 19 to now 36, I have been making periodic payments towards the family cell phone bill for years, infrequently. As the data hog of the family, I was a big reason my parents had to keep their existing plan that racked up over $220 each month. I wanted to make sure I covered a fair share of the total bill. But as I researched my options, Google Fi made sense for me in my area. My family lives in rural Indiana, where Verizon has – by far – the best coverage.
I may have considered myself financially independent of my family since graduating from college in 2005, but there were lingering examples for financial assistance provided to me. The largest assistance was when I lost my job in 2009, and my parents allowed me to move back into my childhood bedroom, live rent free, and I didn’t even have to buy groceries! Another example was an INTEREST-FREE LOAN from my grandmother to buy my first car in 2012, pictured below. Until then, I had been driving the car my parents bought me in college, when I had totaled the prior car they’d bought me. A final example was a result of living the aforementioned 1,100 miles away from “home;” my parents and grandparents would take turns purchasing my airline tickets to fly home for holidays like Thanksgiving and Christmas.
I would not have survived the Great Recession without the financial support of my parents. I moved back home to Indiana and took a job making $11/hour. Basically, I spent every cent from my paychecks to keep my mortgage current on my townhouse in Florida. The interest-free loan of $20k was in 2012, and my grandma requested that I hold off on paying her back until my student loans were completely paid off – then she forgave $15k of the $20k loan, so I was able to pay her back in early 2015. My foray into travel hacking solved the airplane ticket issue, since I can now tell them all that I essentially fly for free now.
Striving for Financial Independence (FI)
Now that the family cell phone plan monkey is off my back, I can fully concentrate on reaching FI. Financial Independence in this sense is the ability to live off your invested assets causing mandatory full-time work to be a thing of the past. For those who haven’t read the Trinity Study, it concluded that a retiree can initially withdraw 4% of the portfolio balance, and then increase withdrawals in subsequent years by the rate of inflation, and never run out of money. This strategy was determined to be ~98% safe over the 100+ years they had studied, so it stands to reason that many retirement strategies are based upon this quick and dirty rule of thumb called the 4% rule or 25x your annual expenses.
I’m a single guy and aim to spend roughly $30,000 per year. The 4% rule would say I need to have an initial retirement balance of $750,000 to be able to safely withdraw 4% (adjusted for inflation) each year in retirement. I’m currently spending more than that per year, while I send extra funds towards my mortgage that I want to have paid off in its entirety before my 43rd birthday in 2025. So once the mortgage payments (and extra principal payments) are gone, my expenses will decrease by about 20-25%, back down into the range of $30,000 per year.
The problem with using current expenses to plan for your future life is that the cost of your life can change drastically through the years. For example, my employer currently covers the lion’s share of my medical expenses, which will not be extended to me as a retiree. That’ll result in a big increase in my health insurance and medical costs.
Ways to strive for FI
There are various methods to achieve Financial Independence. You can be a real estate investor, putting up with tenants and maintenance issues in order to achieve a steady stream of rental income to cover your life expenses. You can invest in stock and bond index funds, which track the broad markets and aim only to keep up with a given index. Cautious investors often like dividend stocks, which often generate consistent monthly, quarterly or annual payments as a sort of profit-share for stockholders of the company.
One of the easiest and most tax-efficient ways to invest for your future is in a retirement account. These are typically offered through your employer and will sound something like a 401(k), 403(b) or 457(b). The huge benefit of these pre-tax accounts is that your money goes into your retirement account even BEFORE you pay Uncle Sam! You are legally reducing your adjusted gross income in the current year to be able to save for future you. That’s a pretty awesome incentive that Uncle Sam provides to encourage you to invest.
Another entity that may be encouraging you to invest in your future is your employer itself. This will typically come in the form of a matching percentage of your own contributions into the retirement account. For example, if you contribute 3%, your employer contributes 3%, and suddenly you have doubled the amount of money that you’d saved on your own. The use of automatic payroll deductions to fund these accounts is another huge hurdle overcome because your employer is providing a necessary service of sending the money to the retirement plan provider on your behalf.
Individuals can set up retirement accounts on their own, outside of the employer plans in the form of an Individual Retirement Arrangement, or IRA for short. These accounts can be funded up to $6,000 in 2019, and you can choose either pre-tax or post-tax accounts, which each have their own set of benefits. The pre-tax version is called a Traditional IRA and works like the 401(k) type of plans described above. But a Roth IRA is money that you’ve already paid taxes on, so the money can grow and be tax-free upon withdrawal. Some people like to reduce their current tax bills and will opt for the Traditional IRA. Others are concerned about tax rates going up in the future, or believe they’ll be making more money in retirement which would mean a higher tax bracket upon withdrawal, so they opt for the Roth IRA.
Self-employed individuals have the option of setting up a SEP IRA, Solo 401(K) or and Individual 401(k). These are less common, so I won’t be covering them here.
After filling up the approved retirement account buckets with the awesome tax advantages, you still may want to save for other expenses in the future. A good place for those funds is in a brokerage account, where you can buy individual stocks, bonds, REITs or mutual funds. These accounts do not get the tax advantages described above but can be worth exploring for their own tax advantages. For example, Long Term Capital Gains are shares held for more than a year and are currently taxed at 0% and 15% depending on which tax bracket you fall into. Short Term Capital Gains are securities held for less than one year and are taxed at normal income tax rates.
There’s a place for savings accounts and checking accounts in your plan for Financial Independence, but these shouldn’t be too big of a part of your plan, as you will lose out of accumulated gains through “cash drag.” Cash drag is a reduction in your overall portfolio growth percentage because the cash is sitting in an account earning basically nothing, or at best, barely keeping up with inflation. Cash can be a strategic part of your portfolio during times of high volatility, and leading up to and into your withdrawal phase, but it shouldn’t be a large part of your holdings unless you are saving up for a down payment on a house or other type of rental property. Fortunately, high yield online savings accounts have begun to return to the marketplace after about 10 years hovering just above 0%, so it is possible to achieve 2.20 to 2.45% for your emergency fund cash.
Financial Independence is most definitely not a get rich quick scheme. It requires diligence and a consistent effort to make sure lifestyle inflation is not creeping up on you with every raise, bonus or windfall that happens during your working career. But the effort will pay off as you earn your freedom from the workplace and earn the ability to stop working a 9-5 job, if that’s something you wish to do. I know that’s a peace of mind that I can’t wait to realize.