Okay, so in my last post I talked about calculating your savings rate and how that can help you determine how many years you’d have to work and save in order to retire or become financially independent.
Hopefully that led you to wonder “Wait, so how much money do I need to reach financial independence?” And the answer to that question is, predictably, that it depends.
It doesn’t depend on how much you currently make, though. It depends on how much you spend.
Understanding that the amount you need to retire is based on your spending and not your income is super important.
Many online “retirement calculators” will calculate your retirement figure based on your income and then add in estimated raises to project your income at the ripe old retirement age of 65. If you’ve ever typed some numbers into one of these retirement calculators before, it may have given you something like $2-$6 million, especially if calculating as a couple.
The reality is a little brighter and a lot more within reach.
Once you know how much your annual expenses tend to be each year, there’s a quick way to determine a ballpark figure for reaching financial independence. To find that figure, you just multiply your annual expenses by 25 (we’ll talk about why, and the assumptions made in this equation down below).
Calculating for Financial Independence
So, if your life costs $30,000 each year you’d need $750,000.
If your annual expenses are $40,000 each year you’d need one million dollars.
And if you spend $65,000 each year, you’d need a little over $1.6 million.
One million dollars is still a lot of money, but it’s a lot less than $3 million, and actually not a wildly unreasonable amount for a couple each making moderate salaries to save in about 20 years, thanks to compound interest (I know, you think I’m losing it, but stick with me for a few more articles).
Now, you might be wondering…
Well, it doesn’t work if your money is just sitting in a savings account being annihilated by inflation. But, if that money is primarily invested in low-cost index funds (with a small percentage in bonds), it’s fairly safe to assume that you could withdraw 4% of your investments each year (or your annual expenses) forever, and never run out of money.
You see, the 25 times your annual expenses equation is really the inverse of the 4% rule of thumb.
The 4% rule is based on the Trinity Study. The Trinity Study was a 1998 study that analyzed what percentage of investments a person could withdraw annually, throughout all investing timelines, and not run out of money. It found that 4% was a safe withdrawal rate, with a success rate of over 95%.
That’s because when you have your money invested in low-cost index funds you can fairly reliably expect an average annual return of 7-8% over the long haul. If you then account for a 3% inflation rate each year, that safely leaves you with 4% of gains that you could withdraw without ever touching your principle (the money you originally invested).
So, what this means, is that once you have 25 times your annual expenses invested, you’ve essentially bought a money-making machine. You’re financially independent and no longer are required to work.
Obviously, the exact amount you’d need to save will require a little more number crunching as your post-work expenses might look a little different.
It might go up because you’re paying for health insurance since you won’t have it through your employer. Or, it might go up because you plan on fostering kids. Or, it might go down because you no longer have commuting costs or need to buy professional clothing. Or your kids will be out of the house. Maybe you move to an area with a lower cost of living since your location is no longer dependent on your job. Or maybe you travel full time.
Your number is going to be personalized to you and your ideal situation.
Your safe withdrawal rate will also depend on your asset allocation, your comfort level with risk, your adaptability, and other passive income streams. Some folks who are a bit more conservative in their planning aim for a 2.5% safe withdrawal rate, others 3.5%, while others feel perfectly comfortable with 4%.
The point is to play around with it and get a ball park figure. It’s fun to dream up different scenarios and come up with an actual number. Even if it’s not exact, it will make the prospect of retirement or financial independence more real and tangible. Which in turn might help motivate you to start saving and investing!