When asked about what it means to be financially independent, most people think about retirement and the amount of money needed in the bank and investments in order to be worry-free for the remainder of their lives. For many, this is why we work, why we suffer through a job we may not enjoy. The reward down the road is worth putting up with micromanaging supervisors, unfair office politics, and uneducated clients. The pattern and habit of earning and saving will help us reach the point at which we can lean back, relax, and live off our nest egg until we die.
The key to the above is that nest egg. If it’s large enough, it can sustain any life through its expenses. How large? Traditionally, experts have suggested taking what you believe your expenses would be in a year of active retirement and multiply that by 25. If the result were, say, $1 million, then that is the amount you should have invested in a broad equity index now in order to be able to withdraw 4% this year and adjust that amount for inflation each your for the rest of your life. Theoretically, you’ll never run out of money. If your first year of living off your nest egg won’t occur for another 30 years, you’d want to adjust your first number, what you believe your expenses would be that first year, by estimated inflation. A necessary nest egg of $1 million today could be more like $5 million down the road.
This type of financial independence doesn’t inspire completely security; stock market crashes could wreak havoc on the supposed 4% safe withdrawal rate. That’s why people like Suze Orman, who have millions of dollars to put away, put their own money in bonds — a much less volatile investment option — but need only 2% or less of their nest egg each year to meet their expenses. And Suze hasn’t stopped working; she’s financially independent now but still writes books and speaks publicly.
You don’t have to stop working completely in order to be financially independent. Another approach to financial independence focuses on passive income sources. That’s not much different from the above example of living off your investments; the gains and dividends that the stock market as a whole returns over time can be seen as passive, if not for the fact that you still need to pay attention to your investments and react to the market in some cases. In fact, most of the income sources generally labeled passive and somewhat active. You could create a business like real estate empire, where you could live off the rent income, sourcing all the “hard work” to contractors and management companies. Even reducing your work, you can never be completely hands-free when you run any business.
The key to financial independence may be finding a calling — some type of career you can do — and do well — while earning a living. You may still work for someone else’s company or perhaps build your own company, but the important thing is that thanks to the fulfillment you get from your activities, you may never want to retire.
As flexible and personal as the definition of financial independence is, I can’t imagine a scenario in which someone can be in debt and consider himself financially independent. Being in debt is like having part of your income owned by someone else. You are not free to do what you want with your money because you are obligated to repay a loan of some kind. This includes all the things traditionally classified as “good debt” like mortgages and student loans.
- It means to have a passive income that gives you the freedom to say, “Go to hell!” to your boss (via @rullopat). I prefer tact, but the underlying message is the same.
- Sleeping on a big pile of money, because you’re too rich to be bothered with buying a bed. If Scrooge McDuck were alive today, he’d be smiling.
- Financial independence is being able to do something you want without worrying about the financial consequences. Can be a candybar for some, vacations for others (via @DanielPacker). Anyone can do something without worrying about financial consequences; in fact, that’s how many people end up in debt. The difference is that with financial independence, you know what the financial consequences are, and you know you can handle them.
- There’s being financially independent of others, meaning you don’t need cash from Mom and Dad. Or being independent of finances which would mean that your passive/investment income is greater than your expenses (via @calebhicks) This is a great distinction. You could say the college graduate who finally moves out of his parents’ house is now financially independent, but that’s only one of the first steps.
To me, the core of financial independence is being able to make important life decisions without the constraint of your finances. How do you financial independence, and how do you know when you have achieved it?
I apologize to everyone who left a comment on this article on December 30. I needed to restore a day-old back-up of Consumerism Commentary and all of the comments for about 24 hours were lost.
Updated January 17, 2018 and originally published December 30, 2010.