Wondering what life outside of work feels like? Perhaps it’s easier to dream about than it is to do the work to get there.
It is difficult to become financially independent without having a plan, but determining your financial independence number, decreasing expenses, increasing savings, and investing the rest, make it easier to become financially independent. Also consider starting to invest early, mitigating or eliminating fees, and utilizing tax advantaged accounts.
Having a plan to achieve the life you want to live is vital. Adhering to a few basic financial strategies along the way will make it easier for you and will help get you there faster.
Is it Hard to Become Financially Independent?
Have you ever come to a fork in the road where you can turn either right or left? Which way do you go? Well, if you don’t have an idea of the place you want to go, it doesn’t really matter which path you choose.
The road to financial independence is difficult if you don’t have a clear path of where you want to go. To help make your journey to financial independence possible, begin by calculating your financial independence number. All you need to do is divide your annual expenses by your withdrawal rate (4% as a rule of thumb).
Annual Expenses: $50,000
Withdrawal Rate: 4% (which is 4 / 100, or 0.04)
Calculation: $50,000 / 0.04 = $1,250,000
Your financial independence number: $1,250,000.
That’s the number you’ll need to have saved in order to retire and live off your investments.
Knowing your number is a good start. From there, you’ll need to figure out how to save that amount of money. You can begin by decreasing your expenses overall. Doing so will enable you to save more each month, allowing you to reach financial independence more quickly. If you find you’re able to comfortably live off of less money, you might even be able to reduce your FI number.
Increase your savings each month by spending less or earning more. The simplest strategy to building wealth is spending less than you earn. Striving to increase your income will also provide quicker returns to your savings rate so long as you continue to manage your monthly expenses. As your income grows, your monthly spending shouldn’t – don’t inflate your lifestyle. Find the proper balance with your spending level so that everything you purchase contributes to your overall wellbeing.
Continue the pattern of saving, increasing your income, and investing until you reach your financial independence number. The hardest part about becoming FI is setting your goal and developing your plan. Once you’re able to get a clear idea of your goals and plans, all you need to do is begin. Over time, you’ll find that becoming financially independent isn’t as hard as beginning the path to get there.
How to Make it Easier to Become Financially Independent
Once you’re on your way to becoming financially independent, there are a few ways to make the climb up your financial mountain even easier.
Start Investing Early
Let’s imagine that two friends graduated college and entered the workforce at the same time. Friend 1 decided that she would save and invest $500 every month until she was 35, then stop saving. Friend 2 decided that she would spend all her money during her twenties, and start saving once she turned 30. Friend 2 saved and invested $500 every month for the next 35 years. At age 65, who do you think will have more money? The answer may surprise you.
Amount Contributed: $90,000
Total investments at age 65: $1,150,524
Amount Contributed: $210,000
Total investments at age 65: $830,839
Note: assumed 7% annual rate of return on investments
Friend 1 contributed $120,00 less and spent 20 years less doing it, but still ended up with more money!
The idea here is that the earlier you can invest, the better. The magic of compound interest is the key strategy behind making your money work for you. Instead of having you work for your money. It’s not always about working harder, but working smarter. Front-load your investments as much as you can as early as you can to make your journey to financial independence as quick as possible.
Mitigate or Eliminate Fees
When it comes to your investment accounts, it’s vital to keep your fees low. You can check your investment fees by looking at your investment statements and the prospectus of the funds you invest in. You’ll want to look for the fee percentage that you’re charged to have someone manage your investment, as well as any administrative fees.
The same magic of compounding illustrated in the previous example of Friend 1 and Friend 2 works against you in the case of fees.
By age 35, she’s contributed $90,000 and has $151,141 in her retirement account. She doesn’t add another penny for 30 years and receives an average annual return of 7%. By age 65 she’ll have $1,150,524 in her account. Now, let’s take a look at her account based on potential fees:
If she were paying 0.5% in fees, she’d have $999,720 in her account.
If she were paying 1% in fees, she’d have $868,067 in her account.
If she were paying 2% in fees, she’d have $653,223 in her account.
An extra 1.5% will cost her an additional $346,497 in savings!
The higher the fee, the more your money negatively compounds. If you’re paying more in fees, there’s less money that your investments have to grow. A meager 2-3% may not seem like a lot right now, but it adds up year over year. You don’t want to come to the age of retirement only to find that you’re $500,000 poorer because of negatively compounding investment fees.
Utilize Tax-advantaged Accounts
Warren Buffet, one of the richest men on the planet, has said that he pays a lower tax rate than his own employees. This is because of how he utilizes the tax code to his advantage, much like many of today’s wealthy people do. It’s just as important to leverage the tax advantages available to you as well.
One of the quickest ways to build wealth is to utilize tax advantaged accounts like an IRA or 401(k). These accounts allow you to contribute or withdraw your money tax-free. A traditional 401(k) or IRA allows you to contribute money tax-free until you withdraw it at a later date. That means you’ll have more money to compound over time. A Roth IRA or 401(k) is taxable up front (meaning you pay taxes on the money you contribute) but can withdraw it tax free. Additionally, employers will sometimes match up to a certain percent of your contributions – and that’s free money! Depending on your investment strategy, you can set yourself up to let your money grow tax free, or plan to withdraw your investments at a lower tax rate than your current one. Regardless, leveraging your tax advantaged accounts will help you become financially independent.
Overall, the road to financial independence can be a lot of work. A few simple strategies can help make the journey easier, but the most important thing on your path to wealth building is to make your plan, set your goals, and begin climbing.
Climb on, FinBase.