Financial Independence (FI) is the point where investment cashflows cover your basic essential and non-essential expenses.
The term independence is well placed. You are no longer dependent on an employer to cover your essential and non-essential expenses. This is a nice place to be. It increases your freedom.
Your FI point is not based on your age. Rather, it is a portfolio value that can provide sustainable investment income through dividends, realized capital gains, rental income and/or bond yields.
I refer to this portfolio value as your financial independence number.
How Do I Find My Financial Independence Number?
Safe withdrawal rates (SWR) are the key to finding your financial independence number.
The SWR represents the fraction of your portfolio that can be pulled for income each year, adjusted for inflation.
Studies show reasonable SWRs to be between 2% and 3%. I cover the details in my post Safe Withdrawal Rates: Everything You Need To Know.
This post also covers risks associated with various SWRs. Understanding risks is critical to good decision-making. You don’t want to run out of money in the financial independence stage.
Financial Independence Number Example
For example, Fred will reach FI when he has $70,000 per year in investment income. That’s enough to cover all his expenses. After learning about SWRs, Fred determines a 3% SWR will work.
Therefore, Fred’s FI number is $2.33 million ($70,000/3% = $2.33 million).
Alright, that’s enough time spent defining things. Let’s look at ways to accelerate the journey to financial independence.
1. Increase Savings to Invest
Aggressive investing (especially early on) is the best way to accelerate the journey to financial independence. The more money that you can put to work, the better.
For example, a 10% annual return on $10,000 is only $1,000. But a 10% return on $100,000 is $10,000, and on $500,000 it is $50,000.
That’s why your savings rate is the most important factor. It drives the magnitude of compounding and directly drives the speed at which you will reach FI.
There are only two ways to increase savings: increase income or reduce expenses. I built this post to help you determine the ideal balance between expense-cutting and increasing income.
Someone with high income and high non-essential spending would focus on expense cutting. While someone with low income and essential spending would be more effective if they were focused on increasing income. A hybrid between expense cutting and increasing income is often ideal.
2. Invest Early: Maximize Time Invested
I wish I understood the power of time when I was younger. I was building fast cars instead of investing during the longest bull market in history. No longer do I have fast cars, but I do carry the lessons learned.
Time is your friend when investing. It puts compound interest to work in your favor.
Let’s say you invest $10,000 today and achieve a 10% return. Your $10,000 will grow to:
- $11,000 in 1 year;
- $26,000 in 10 years;
- $67,000 in 20 years; and
- $452,000 in 40 years.
Just take a look at Warren Buffett. 99% of his net worth was built after his 50th birthday.
Ronald Read serves as another excellent example. He is a janitor when he died at age 92, his net worth of over $8,000,000 surprised the world.
Compound returns are why you don’t need a huge income to grow wealth. There are plenty of everyday millionaires who got to where they are by making $50,000/year.
The graph below shows how investing $2k per month will grow over time. The earlier you start this process, the sooner compound growth will take you to your FI portfolio value.
3. Reduce Lifestyle Expenses in FI
A $1.33M portfolio is required to fund a $40,000 lifestyle in the FI stage, based on a 3% SWR.
If you want an investment income of $80,000/year in FI, you will need a $2.67M portfolio. A lower FI number is needed to fund a less expensive lifestyle.
Frugal lifestyle habits are forged as you save to invest during your journey to financial Independence. These habits don’t suddenly disappear when you enter the FI stage.
You will naturally become comfortable with a low expense lifestyle and find fulfillment independent of spending. Sustaining a frugal lifestyle after FI will be natural, not difficult.
4. Achieve Higher Returns
Compounding investment returns are what build your nest egg over the decades to reach your FI number. Your savings rate influences how much money you provide to undergo compound growth.
The rate of return determines how quickly these investments grow. Your path to FI will be accelerated with a higher rate of return.
Your long-term expected returns can be tailored by the amount of risk you are able and willing to take. You can read more about investment risk in this post.
Returns From Stocks
This leaves businesses (stocks) and real estate as your source of long-term returns. I won’t discuss real estate here. It is not my area of competence. For example, the S&P500 index has achieved a 10.2% annual return since 1923, including all crashes.
Stocks are not for everyone. You require a long time horizon of 10+ years where you don’t need the money. Plus you need to be able to stomach the ups and downs of the stock market. Your ability to handle volatility depends on your unique risk tolerance. If you don’t have the stomach for the volatility with a 100% stock portfolio, you may need to pad your portfolio with some bonds.
Most investors will have a difficult time beating long-term returns provided by low-cost index funds. The reason is that markets are efficient. Most available information is already priced into stocks. This makes it difficult to beat the market based on skill.
What about mutual funds? Actively managed funds (mutual funds or actively managed ETFs) fail to beat indexed funds over a long-time horizon. Fees are the reason for underperformance. And picking winning funds doesn’t work because past performance does not predict future performance. Fund outperformance is mostly luck, rather than fund manager skill.
5. Optimize Investment Tax Efficiency
Tax efficiency occurs when you locate your investments in a way that reduces the tax owed on investment income. With tax efficiency, you can reduce tax drag and make the most out of tax-sheltered accounts.
Tax efficiency is the least influential on this list when it comes to accelerating your path to financial independence. Plus, the extra involvement with your portfolio can result in emotional decision-making that can hurt your returns.
So, how do you achieve tax efficiency? There are two main areas where you require knowledge:
- Understanding tax-sheltered accounts; and
- Understanding how taxes apply to investment income.
Boring. I know. Time spent learning about taxes will have huge payoffs over the long haul. Boredom is the price to be paid.
Tax Sheltered Accounts
Optimize tax efficiency of investments through the use of tax-sheltered accounts like the TFSA and RRSP in Canada and the 401K, Roth IRA and HSA in the U.S.
How you allocate investments across these accounts is called asset location. This is a great guide on asset location for Canadians. Asset location can be used to maximize your after tax wealth. Tax-sheltered accounts will allow you to maximize after-tax wealth and to make the most out of the compound effect by minimizing tax drag.
The various tax-sheltered accounts have difference but they generally all allow investments to grow tax-free. For example, dividends can be reinvestment without paying taxes, and you can sell securities for a capital gain to re-balance the account without paying capital gains tax.
Taxes on Investment Income
You can only allocate investments across various accounts properly once you understand how dividend and capital gains income are taxed. I built this guide to help Canadian’s learn how taxes apply to investment income.
There are huge tax advantages on investment income relative to regular income. For example, domestic dividends and long-term capital gains are taxed at far lower rates than regular income in the U.S. and Canada. And dividends from foreign stocks and interest are taxed as regular income – they receive no tax benefits.
