How to Achieve Financial Independence: Beginner's Guide to Early Retirement
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Start Your Journey to Financial Freedom: Simple Steps to Take Control
Disclaimer: This is an educational post that aims to increase financial literacy by explaining good practice concepts around personal finance. At the end of the post, we also recommend a few books that go into some of these concepts further. However, the reader is ultimately responsible for implementing the ideas that are of interest.
What Is Financial Independence and Why Is It Important?
Have you ever daydreamed of achieving financial independence, a place where you are financially secure and free to spend your time as you wish? In a previous book review post, we found that only 15% of people worldwide feel engaged in their current jobs, highlighting a rise in job dissatisfaction and a growing interest in achieving financial independence. In light of these statistics, a 40-hour work week may not be everyone’s first choice if an alternative were possible. Perhaps they would opt for a shorter working week, or might not even choose to work at all for their current employer and pursue some other creative endeavor instead. Some may truly love their current job, but nevertheless may want to have the freedom to take a two-year travel sabbatical. Others may simply wish to allocate more time to their friends and family. Reaching financial independence gives you the freedom to choose when to retire and stop working on your own terms–it is up to you to decide whether age 55 or 67 is appropriate.
This is why mastering personal finance management is crucial for those pursuing financial independence and early retirement. Ultimately, achieving financial independence allows you to build the life you truly want with financial freedom. It’s not just about saving money but about gaining financial freedom and the possibilities for early retirement that come with it.
The core strategy for achieving financial independence involves maximizing savings and making smart investments, allowing you to live off passive income without relying on traditional employment. For most, financial independence is achieved at retirement, but with proper planning, early retirement is possible.
How does achieving financial independence contribute to a better quality of life? Having as much agency as possible over your life is an important component of living well. This has to do with making decisions that affect your lifestyle overall as well as the small choices you make every day.
This post is aimed at those who are just starting out on their journey–to set them down the right path. We provide simple actionable tips on how to get going, and how to consolidate basic financial habits.
Photo by Dan Meyers on Unsplash.
How Do I Calculate My Financial Independence Number?
Creating a roadmap to financial independence involves a simple calculation of two key numbers: your total income (including take-home pay and side income) and your total expenses. These two data points are used to estimate your savings rate and your financial independence number.
First, we need to figure out your “financial independence number” (henceforth, FI number). Your FI number represents the total net worth required to stop relying on traditional employment over the years in order to be independent from mandatory employment. If you wanted to quit your job tomorrow, you could in theory do so once you reached this number.
What Is the 4% Rule and How Does It Impact Early Retirement?
To calculate your financial independence number, multiply your annual living expenses by 25. This in turn comes from the commonly used “4% rule”, based on research by William Bengen. The 4% rule is a popular guideline among retirees to estimate the amount they can safely withdraw annually from their retirement investment portfolio without running out of money.
There is certainly a lot of nuance around using this rule. Different experts advocate for other safe withdrawal rates (e.g., using 3% or 3.5% instead of 4%) or for a different, more dynamic withdrawal strategies that are aligned with how well or poorly their investments are performing. However, for the financial novice wishing to get their finances in order all of this is just distracting. At this point in the journey, we just need to have a ballpark estimate of where we need to go and start taking steps to get there. This isn’t a get-rich-quick scheme, it’s a patient, long-term approach to financial independence. There will be plenty of time over the years to learn about safe withdrawal rates.
In this post we will use as an example €2,500 of monthly expenses**. An individual or a family spending this amount is looking at an FI number of €750,000 (€2,500*12 months*25). This is their preliminary, ballpark number that they should set their eyes upon in these early stages of the journey. The idea is that with this value invested in a diversified stock market portfolio, you would be able to safely withdraw €30,000 (i.e., 4%) each year to cover your yearly expenses–and to adjust it upwards each year to account for inflation.
** Please feel free to adjust this number depending on your cost of living expenses and location.
How Can I Track My Monthly Expenses for Financial Independence?
As shown in the example, accurately calculating your monthly expenses is an essential step to determining your FI number and achieving financial independence. Mastering this crucial step is essential for making progress on your journey to financial independence and achieving your financial goals. Surprisingly, many people lack a clear understanding of their monthly budget and overall spending habits, sometimes because their costs vary substantially throughout the year. Others might have a ballpark understanding of their annual spend, but may greatly overestimate or underestimate the amounts they are spending in specific categories.
Use an expense tracking tool, such as an Excel sheet or a budgeting app, to monitor your monthly expenses over the course of the year. Any other medium that works well for you is also fine–even paper. The important thing is that the method is simple and easy to understand. We will refer to this as your monthly tabulation; at the end of each month you should have listed every single expense you incurred in together with its value. As explained further on, this exercise will be very valuable to identify the areas you may be overspending on and determine where the low hanging fruits are to speed up the timeline for achieving financial independence. While tracking monthly expenses might seem tedious initially, it’s far more draining to spend over 10 years in a job you dislike, delaying your journey to financial independence. Over time you will be extremely grateful for engaging in this exercise.
If you’re looking for a quick estimate of your financial independence number go ahead and work backwards using the information found on your bank accounts. In most cases, you will only need two items to figure this out: 1) how much income has entered each month over the course of the year (add it up) and 2) what is your net worth change over the same time period (to figure out your annual expenses). Using annual data will give you a more accurate picture than evaluating a monthly timeframe, since there might be several large one-time expenses throughout the year that you want to account for.
Why Is Savings Rate Crucial for Financial Independence?
With this data, you can calculate your savings rate—a crucial factor that determines the speed at which you achieve financial independence and early retirement. The savings rate can be calculated on a monthly or annual basis and is the amount of savings divided by your net take home pay. Following the example above, if someone with €2,500 monthly expenses has a €4,000 euro net salary, their monthly savings rate would amount to (4,000-2500)*100/4,000=37.5%.
You can use various online financial independence calculators to map your path to early retirement and see how changes in your savings rate impact the timeline to reaching FI. According to this FI calculator, a 30-year-old without any savings at the start of this process could still reach financial independence (i.e., €750,000 invested) in under 16.2 years if they maintain their savings rate of 37.5%. This modelled pathway, depicted below, assumes a conservative 5% return from your portfolio and a modest annual income growth of 3%.
Modeled path to FI from engaging-data.com.
The person in the example above could retire at age 46, nearly 20 years ahead of most, covering their €30,000 annual spend. What’s your FI number, and how soon can you achieve financial independence and be free from mandatory work? Go ahead and play around with your own data using this free online tool. Don’t be discouraged with this initial assessment, this is just the beginning of the journey and there are lots of steps we will take to improve this baseline scenario.
What Tools Can Help Me Reach Financial Independence Faster?
Using these financial independence tools along with your monthly expense tracking can be an empowering step toward early retirement. For instance, if we identify that €300 of our €2,500 monthly expenses comes only from eating out at restaurants, we can explore what impact cutting the bill in half would have on the FI timeline. As observed in this modelled scenario (figure below), incorporating this small change (-€150 per month) reduces your FI journey by one year. Relatively small cuts have a surprisingly large reduction in the FI timeline for two reasons: you are able to save more each month and your target FI number is reduced, i.e. you need less to be free.
Modelled path to FI from engaging-data.com.
If going to restaurants truly brings you joy and you are satisfied with the tradeoff of working an extra year, by all means continue to eat out. However, most of us can identify very low hanging fruits in our monthly tabulation that have little or no impact on the quality of our day to day life, but that can considerably speed up our journey to FI. Once you have all your recurrent and non-recurrent expenses in front of you, it is like a lightbulb switching on–you will want to cancel the €40 euros subscription you barely use, you may prefer to have one tv/entertainment subscription instead of three, or you may be inclined to check whether you can get better offers for you utilities bill, your phone and internet expenses, etc. For ideas on how to shorten your path to FI focusing on food, read our post “The top 20 money-saving food hacks to help your budget in 2023”. These simple, effective tips can significantly shorten your path to financial independence without sacrificing your quality of life.
Remember, the opposite is true: each time you increase your monthly costs, it hurts your FI number in a non-linear way–it takes more time to save the same amount and the amount saved (i.e., your FI number) needs to be larger to accommodate for a higher future monthly spending.
How to Evaluate New and Existing Expenses to Reach Financial Freedom
This creates a very powerful tool for the evaluation of daily purchases. Next time you are at the store and want to buy a €75 pair of shoes (just because they look nice, not because you really need them), ask yourself–am I happy to work an extra half a year for these shoes? After all, these impulse buys tend to be recurrent.
In our examples, increasing out monthly costs by €75 or €150 euros meant working half a year and a full year more, respectively. Ask yourself each time you buy something: is this worth delaying my freedom by X years? Am I happy to sit at my desk for an additional year to fund this lifestyle? Or as Vicky Robbin, author of “Your Money or Your Life” eloquently put it: “did I receive fulfilment, satisfaction, and value in proportion to life energy spent?”
Start paving your path to freedom. Photo by Nick Fewings on Unsplash.
What Are the Next Steps on My Financial Independence Journey?
Stay tuned. After introducing the concepts of financial independence, FI number, savings rate, monthly tabulation or expense tracking, we will continue to cover more topics related to pursuing financial independence in a series of personal finance posts. This will include information related to analyzing “the big three” (transport, housing, food), “staying the course” with index fund investing, avoiding lifestyle inflation, or how to start out and automate your investment portfolio. We’ll also explore the importance of tracking your progress and staying up-to-date with financial education to accelerate your journey to early retirement. The more you are willing to stay up to date with financial concepts, the easier, quicker, and more enjoyable this journey will be.
Enjoyed this post? Don’t miss our insights on reaching your first $100K investment milestone and mastering the 4% rule to achieve financial independence.
