It is not uncommon for people these days to work into their 60’s, 70’s and even 80’s and yet there is a big difference between those who choose to work that long and those who have no choice in the matter.
When you know your financial independence number, you gain the ability to benchmark how close you are to reaching your financial goals, as well as, see what you can do to get closer.
Achieving financial independence or financial freedom comes down to three things:
- Establishing enough passive income to cover your annual expenses now and into the future,
- Saving a lump sum of money, typically that gets invested in securities, that can cover your living expenses through regular withdrawals,
- Or some combination of both.
Before you tell me how much you love what you do and never want to retire, please hear me out on this. While it’s great to think positively about your future, I also want to warn you that having the belief, “I never want to retire” is not as helpful as you may think. Far too often people get stuck in this way of thinking and use it as an excuse to not save enough. Just because you feel inspired to keep working now, doesn’t mean you’ll always feel this way.
Plus, we simply don’t know what the future holds and having choices is one of the most beneficial things we can do for our future self. I have never heard someone say that they wished they hadn’t saved money when they were younger. What I do hear people say is they wish they’d spent more on the things they cared most about and less on the things that didn’t matter.
All this to say that I’ve greatly benefited as a result of knowing how much income (and savings) I need in order to support myself and my family now and in the future. Partly because it helps you sleep better at night knowing everything is covered, but more importantly, is this ritual of figuring out your needs can lead to incredible opportunities you may have never dreamed possible.
What I mean by that (while trying not to be way too “woo”) is that what you pay attention to grows and what you ignore doesn’t. While there may be some scientific reason for this, all I know is that my clients tell me stories that were inconceivable until they happened. What all of the stories detail is how once they focused on what they wanted and stopped avoiding the things that mattered, huge financial shifts happened in their lives.
SO, this is why I wanted to share the process below… to give you clarity about your own financial situation so you can have more choices when it comes to the life you are living and creating.
5 Questions to Determine Your Financially Independent Number (Use this worksheet to complete as you go):
1. How much money do you need to live on (now and into the future)?
In order to know how much money you’re going to need later in life, it starts by tracking what you are spending today. Not just what you think you spend but really tracking what it costs for you to live on a monthly and annual basis.
Even if you feel like you have a lot of money at your disposal and no need to track what you spend, I’m going to recommend that at the very least you create a spreadsheet that includes all your regular expenses so you have clarity of what your existing life is costing you. Or, if you prefer, there are many online tools that safely synchronize with your bank and credit cards so that you can pull in that information easily, a few of the tools many of our clients us include Quicken, Mint.com and YNAB (youneedabudget.com).
Reconciling what you spend to your income also allows you to notice where, when and why you are spending what you spend. According to research conducted by ynab.com when tracking their users, the average person saves about $600 in expenses over the first 90 days of tracking spending and $6,000 in the first year alone.
Once you know how much you are spending, you can determine if any of your expenses will go away by the time you retire including car payments, student loans and mortgage payments as a result of paying down or paying off any loans outstanding. A good rule of thumb for using current expenses to anticipate future expenses is to use 80% of what you are spending now.
Throughout this exercise, I will be using a hypothetical example of Julie and Tom who are both 40 years old. Their current expenses are $95,000 a year and when they retire they plan to no longer have a mortgage or any other outstanding debt. When adjusting for the expenses they will no longer have upon retirement, they are expecting to need a minimum of $75,000 a year in combined income to support their current lifestyle.
Go ahead and do your best to calculate the estimated amount of money (based on today’s dollars) you’ll need to live on when you are no longer working. Write that number down on a piece of paper so you can keep track of it as you go through the other questions below.
2. How much will you be receiving in retirement income/pension/social security benefits, if any?
The next step is to determine how much money you’ll need to subsidize what you and, if applicable, your partner will receive from social security and any other pension, annuity or defined benefit retirement accounts you are eligible for (not including 401K or individual retirement accounts).
To determine social security benefits if you live in the U.S., you can start by going to ssa.org and setting up an account if you’ve not already done so. This site will show you what you have earned over your lifetime and paid social security taxes on. The government is tracking these numbers to determine how much money you will be eligible to receive upon retirement depending on the age you choose to start receiving payments.
If you have been a very high earner for more than 10 years, there is a good chance you will be hitting the maximum benefits ceiling provided by the social security administration. If, on the other hand, you have earned low wages, or been self-employed and not paid into social security, you may find that your benefit is very low. It is important to know what you are working with.
With social security, depending on your age, it can be very beneficial to know what you can expect later in life. This information can empower you to make choices about how much you want to be earning (and paying taxes on) so that, if needed, you can increase the amount of money you will be paid through social security. Far too few people know this number and therefore don’t realize how you have the ability to increase your social security payments later in life if you want and need to.
When you are reviewing your personal information at the social security website, you will notice there are significant monthly benefits to wait as long as possible to collect your payments. However, it is not a one-size-fits-all equation and for some people it is far better to begin collecting social security as soon as possible.
Many people, especially those who are healthy in their 60’s, will choose to delay retirement or at the very least wait to begin collecting social security payments in order to maximize the benefits. You can find calculators online that help you weigh the benefits of waiting versus collecting at an earlier age.
Let’s go back to the previous example so you can see why it is important to know how much you’ll receive in social security and how that relates to your overall financial planning.
Let’s say the plan is to wait until age 69 to maximize benefits and in our example this means Julie and Tom can expect to be receiving a combined benefit of $3,600 a month or $43,200 a year. Since they do not have any other defined benefit or pension, they are going to take their expected annual expense number of $75,000 and subtract their expected social security of $43,200 to see that they have a shortfall of $31,800 per year or close to $3,000 a month that they will need to make up somewhere else. Go ahead and write down what you’ve learned by going to the social security administration site.
3. How will you invest now to earn what you need later?
In addition to knowing how much money you will need to have saved up in order to cover the shortfall, you will also need to have an idea of how much you’ll be able to earn on your savings.
So let’s start first by confirming that for Julie and Tom the goal is to have at least $3,000 in additional income coming into their household on a monthly basis by the time they retire (and again, in today’s dollars which I keep mentioning because we cannot know the exact impact of inflation and what things will cost later in life. However, we can make sure that we are investing in inflation-proof assets as much as possible. These are assets that have a tendency to keep up with inflation including stocks and real estate to name a few.)
There are many ways to invest to cover the short falls that social security (and other defined benefit and pension plans) will not cover. These include investing in a balanced portfolio of assets that include stocks, bonds, gold, commodities, currencies and more. Unfortunately the amount of money you can earn on savings is hard to know exactly because no one has a crystal ball about what returns will be on stock and bond investments in the future. Past returns on average have ranged from 5 to 10%, but when adjusted for inflation, the numbers are lower.
One estimate I’ve seen is that it is better to be conservative than surprised later in life. If that is the case, you could use a 3.5% average return on your investments after being adjusted for inflation.
In other cases, you may wish to invest in assets like real estate that provide a solid, steady stream of income as a result of rents being collected. This is where you want to pay close attention to what you find enjoyable and how much work you want to put into managing these assets.
Typically the less involved you are and the more you pay managers to take care of your properties, the less income you will receive. You can also choose between commercial real estate or residential and from there short-term rentals, which are often managed with the help of a site like Airbnb or long-term rentals where you can also get the help of property managers if you don’t want to do that yourself.
Property values, rents and ratios for how much you can expect to receive vary greatly. The point is to do your due diligence and research what options can provide the best solution to meeting your financial needs.
For example, my husband and I have found a way to invest $600,000 into a project that will provide about $80-$100,000 in annual Airbnb income which would more than cover our cash flow needs even if we were to hire people to manage the property which would cost about 33% of that income. Plus what’s also helpful with investing in real estate is the value of the properties can also be increasing to keep up with inflation as you get older. The point is to see how there are many different options to make up short-falls in your income needs but it can take 3-5 years to figure it out and make sure it works for you.
Going back to the case of Julie and Tom, for now they’ve chosen to invest in the stock market and are using the 3.5% average return number to be conservative when calculating how much they can earn on their savings, which means if they were to have a portfolio of $1,000,000, they can expect for it to grow about $35,000 a year when adjusted for inflation.
Take time to consider all the ways you can invest now to create an income stream that meets your financial needs later in life – sometimes it might be a combination of several different investments that add up to the total number.
4. How long will you live?
While it is estimated that the average age for a man to live in the US is 83 and the average age for women is 85 1/2 – it is recommended to estimate that you will live until age 90 to be on the safe side. It is helpful to consider how long your parents and grandparents lived when you think about how long you may live.
For example, both of my grandmothers lived into their late 90’s and so I know that outside of disease and accidents there is a good chance I can expect to live into my late 90’s and am planning my financial goals around that estimation.
In the case of Tom and Julie – they are both anticipating living into their 90’s just to be safe — this means that their retirement funds would need to last them at least 30 years.
5. How much can you withdraw each year for expenses (and have it last 30 years or more)?
There are a few ways to calculate how much you can withdraw from a traditional investment account from year to year and still have it last you 30 years or more.
As we stated before, if you are creating an income stream based on rents being collected through properties you own, you will want to be building in a cushion to afford property management assistance as you age and still be able to meet your financial needs. When you own multiple properties this gets more complicated and so it is something to consider and weigh the benefits to keeping your money in real estate or selling properties and moving money into the stock market later in life. Anything can happen but having a plan is what matters most.
A very popular approach, inspired by the Trinity Study, states that when estimating how much you can take out of your savings on a monthly basis you can use the 4% Rule. The rule says that if you confine your retirement withdrawals to 4% of your total investments per year, you should not run out of money. In this case if you think you’ll need $100,000 a year in retirement income, you’d need to save $2.5 million.
A quick way to calculate how much you need to save using the 4% rule is to multiply your desired annual income by 25. So, if you needed $50,000 a year in retirement, then you’d need to save $1.25 million ($50,000 x 25 = $1,250,000)
A lot of people don’t support using the 4% rule especially in times when bond yields are very low and so when you invest in bonds you want to pay close attention to what you’re using to decide how much you can later take out. It is also helpful to note that in the Trinity Study they were sharing that annual withdrawals between 3 and 4% should be able to last you as long as you need them to. However, to add more clarity (and complexity) it is helpful to share that in the report, they mentioned, “one way to plan for the impact of inflation is to adopt a withdrawal rate that is smaller than the rate of return on the portfolio.”
In the case of Julie and Tom, you can see how if their goal is to only fund their retirement by investing in securities, they would want to save at least $800,000 which is also their financial independence number. AND, should they decide they want to do a combination of other types of passive income investing and security investing, at least they have an idea of how much money they need to plan for.
Here’s a way to figure out your own financial independence number – just copy our Google worksheet here.
Another helpful resource in addition to these five questions you can use to figure out if you will have enough money to retire is a calculator my friend Grant Sabatier created for MillenialMoney.com – you can try it out here. https://millennialmoney.com/early-retirement-calculator/
Be sure to keep in mind…
When you are figuring out your financial independence number it is best to look at your short and long-term goals and consider unexpected expenses that will arise before you retire and also after you retire. The hidden surprises are often what can derail your plans and so the more you consider changes in your situation, the easier it is to plan around them.
Let’s be honest, many people will go through this process of researching options for retirement and come to the realization that the best option is to diversify into other assets, like cash flow real estate, buying a more passive income business, creating a side income based on skills and expertise or something similar to provide an ongoing stream of income that supports them well into their retirement. There is nothing wrong with finding creative ways to cushion your retirement and knowing how much money is enough helps you consider options for the future.
The more thought you put into your options earlier in life, the easier it will be to find solutions.
By knowing your financial independence number you’ll be more incentivized to:
- Contribute to the limits of your employer-based 401K plans especially so you can take advantage of company matching.
- Max out personal IRA contributions.
- Ensure your emergency fund can cover 6-9 months of expenses.
- Save and invest additional money in non-IRA accounts to make up for shortfalls.
- Pay off any existing mortgages on primary and investment/second homes.
- Stay relevant in the employment market or create a business based on what you love to do (earlier than planned).
- Seek business, investing and financial advice oriented to helping you develop multiple streams of income to cover any shortfalls that exist.
- Research real estate properties and how they can help you achieve your financial goals.
- Join a community like Mindful Millionaire so you can learn strategies for spending mindfully, investing in passive income sources and much more.
And even more importantly, by achieving your financial independence number (or at least getting closer to it), you’ll be able to:
- Experience the joys and freedom that comes by knowing your finances are set now and into the future.
- Focus on the impact you’re able to make in the world (rather than having to focus a lot of time and energy on making money).
- Look inside your wallet and know you can spend and give in ways that align with what’s most important to you.
- Participate in helping family members achieve their financial goals.
- Take better care of your mind, body and spirit as a result of having more time freedom.
- Feel a sense of abundance and prosperity in all areas of your life.
- (PLUS!!! I’ll be hosting a free Passive Income Made Easy Bootcamp in September 2021 that you will get notified about when you receive my email updates.)
Planning for retirement can be daunting and yet when you think about it in terms of having freedom and choices, it becomes highly appealing. No matter where you are on your savings journey becoming proactive by learning your financial independence number can be a life changing.
Knowing you’ve got a solid plan in place of how to gain greater freedom will not only help you sleep better at night, it will give you and your family incredible peace of mind. What’s more important than that?
Leisa Peterson CFP® is a money expert, passive income strategist, author and founder of WealthClinic, LLC.
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