Achieving financial independence can seem like a daunting and impossible goal if you have too little income or too many expenses, no investments, or significant debt. I recommend creating interim milestones that you can accomplish on the road to financial independence so you can acknowledge the progress you make over time. An easy way to do this is to understand the different levels of financial freedom. I’ve seen articles measuring varying levels of financial freedom. I personally have measured my performance against five levels and I recommend you do the same:
This is the first level I measured and that you need to get to as you march towards financial freedom. It basically means your income exceeds your expenses and you are not dependent on the charity of others and you are not adding debt to support your lifestyle.
I became financially solvent in 1998 after graduating from college and securing my first job which paid me about $38,000 per year. $38,000 per year is not a lot of money but I always made sure my monthly income exceeded my expenses so I could save and move towards the next level of financial freedom.
This is the next level I recognized on my journey towards financial freedom and it means your financial basics are in order. In this level you have an emergency fund and you do not have consumer debt that you do not pay-off in full every month. So you really accomplish two things to get to this level:
- Emergency Fund – Basically, this means you have saved 3-6 months of your monthly expenses in case something unexpected happens that causes you to need a decent lump sum of money. It could be unexpected medical or housing bills, a car problem, etc. If you are saving 30%-50% of your after-tax income (as I suggest) then you should be able to have an emergency fund in less than a year. I do agree with having this fund (and replenishing it if ever used) because surprises happen. I had an emergency fund set-up by 2000, a little over two years after I started working.
- No Consumer Debt – To me, this basically means no debt besides real estate debt. This means no credit card debt that you cannot pay-off in full every month, no student debt, no personal loans. Even if you can afford the interest payments on consumer debt you haven’t reached this level until this kind of debt is paid-off. Why? I believe it is because if something happens to your income the consumer debt is still there and the monthly interest payments are still due. There is no underlying asset to generate cash to pay the interest on that debt or to pay-off the debt. That’s not good. I’ve never gone into any significant consumer debt but there were a few times I had a car loan. I paid-off those loans as fast as I could and loved the feeling of having extra money to save after those loans were paid. Have a few hundred dollars each month helped me accelerate my ability to fund things like a down payment for a property or buying stocks.
This level is a good milestone to achieve because it requires having investments in place that can pay for your basic living expenses. The first two levels discussed were all about having some income, setting aside some savings, and reducing your debt. You achieve financial security when you have investments that can pay for your basic living expenses. Basic living expenses mean your expenses related to shelter, food and basic transportation (it doesn’t mean travelling abroad, vacation homes, luxury cars). It is a significant achievement because it means if you lose your income for a significant period of time you could pare down your expenses to the bare minimum and be okay financially. Some people who do not want a lot of material possessions would consider achieving financial security their ultimate financial goal because they want to enjoy other things in life sooner rather than later.
You should set a goal that approximates achieving financial security for you. For me, I set a goal of having a net worth of $1 million and it was at this point where I felt financially secure. I assumed that I could meet my basic living requirements at $40,000 per year with $1 million in net worth. I achieved this $1 million goal in 2014 and it was probably the most significant milestone for me on my way to seeking financial independence because it was a symbolic victory and I felt like I had real momentum towards achieving financial freedom.
When you reach financial independence your investments can pay for your current lifestyle. There are different ways to measure financial independence but the two most common ways are (1) using the 4% rule put forth by the Trinity Study to determine how much money you need in your investment portfolio to cover at least 30 years of expenses without running out of money and (2) where the passive income generated by your investments can support your current lifestyle. This level of financial freedom is what a lot of people want to reach before they quit their jobs.
I recommend using the 4% rule to set a goal that you can work towards to meet this level of financial freedom. Using the 4% rule, a person needs 25 times his/her annual expenses in an investment portfolio to achieve financial independence. For me, this meant $2 million in investments and I achieved this goal in March 2019. However, my wife and I have since set a goal of $100,000 in annual passive income in order to declare that we as a family have achieved financial independence. We are still working towards achieving this goal. You can see our progress in our Quarterly Updates.
The Financial Hybrid
Before I move on to the last phase that you should consider on your journey to financial freedom I want to discuss how my wife and I are approaching this journey after we reached a certain point.
If you are married or with someone for the long-term, you may get to a point where you could pay for your current lifestyle if one of you stops your job/career but the other person continues to work. At this point, you should consider whether it makes sense to have both people continue to work or should one person step down from their job to focus on other goals.
My wife and I made the decision that I would be the one to stop working last year after we met our initial financial independence goals. We knew that in the short-term it would significantly reduce our earned income but we saw a lot of benefits, including:
- Our kids are at the ages where they still love being with their parents and they can benefit from a father that is there to guide them on a more consistent basis.
- We had historically not done a good enough job of investing in assets that generated significant passive income and with the extra time I have I can convert more of our investments into cash generating assets.
- I have always wanted to do something like Fire Mountain and since I had other goals already in mind I was ready to jump in and add meaning to the next phase of my life.
- With my background I could easily find part-time or consulting work in the future to bring in temporary extra income. In fact, I currently teach one class at a local university to bring in some extra income to pay for our expenses.
A generation ago families with kids would commonly have income from only one parent supporting the family. Today, dual income families consist of over 60% of all families. At the same time, more people want to achieve financial independence and retire early. There are a lot of benefits to starting as a dual income family and then transitioning to a single income family at some point. Usually, one person wants to do other things with their life besides working while the other person still wants to work for reasons besides bringing in income. It can work out nicely if everyone is aligned.
Okay, here is the stretch goal for me. At this point, the income from your investments can support a generous lifestyle, usually more than your current lifestyle. A lot of people will not focus on this level of financial freedom either because it’s not a priority or because the amount to get to this level seems unattainable. You need to decide if you want to include a financial abundance goal as part of your journey or if reaching something like financial independence is your ultimate goal.
I do have a goal that approximates financial abundance for my family – it is $5 million in investments that generate at least $200,000 in annual passive income. I am not sure if we will get there and twenty years ago it would have seemed impossible. However, we are over half-way there and I think it is possible to get there over the next 10-15 years with a little luck and a little compounding.
Your Next Steps
These levels of financial freedom can serve as a measuring stick regarding your own journey to financial independence. I recommend taking a few steps using the information from this post. First, be honest with yourself and identify where you are regarding your own financial freedom. You might be farther along than you realize or this exercise might serve as a wake-up call. Next, determine your ultimate goal for your financial freedom journey. Is minimizing expenses and have enough to cover the basics or is it retiring without sacrificing your current lifestyle? Finally, set interim goals based on the levels that are between where you are now and where you want to end up and then hold yourself accountable and celebrate when you hit these goals.