I’ve been writing about our path to financial independence (FI) for a bit. In this post, I’ll explain what financial independence is, the different stages of FI, and which stage we’re at.
So what is financial independence, or FI? It’s when your portfolio reaches 25 times your annual expenses. That is also known as the 4% rule based on the 1998 Trinity Study. The study tested how likely your portfolio will survive a 30 year period based on how your portfolio is allocated. It also takes inflation into account. Once you hit this magical 25x your annual expense number, you’re essentially at FI.
Some people think 4% is too aggressive of a withdrawal rate, especially for early retirees. You could choose to withdraw at a lower rate, say 3.5%. That also means you need to increase your FI number to 28x annual expenses (1/3.5%=28).
Personally, our FI number is calculated based on the 4% rule. The reason is that I may continue to work on other ventures, as I don’t see myself sitting still once we hit our FI number. That means we may not be withdrawing all our annual expenses from our portfolio, but instead supplementing it with earned income.
Road to FI
Reaching FI is a marathon. And I hate running. So I need some pitstops on the way to FI. In other words, there are a few stages to reaching FI. To me, these are:
- reaching 0 networth (if you start from having some debt)
- getting out of the paycheck to paycheck cycle
- reaching $1000 emergency fund
- 3-6 months of expenses saved in an emergency fund
- maxing out your Roth IRA for the first time
- Half FI
- Full FI
Reaching 0 net worth
This is typically where most people start. They have some credit card debt or loans, and if they don’t have any savings or investments, their net worth is essentially negative. The most important thing you can do at this stage is to get rid of the loans by paying them down. This is especially important if the interest rates of your loans are more than 7%. The reason is that compound interest is working against you if you have loans with such high interest rates.
Some suggestions on getting out of debt is to list out all of your debt and their interest rates, and either do the snowball or avalanche method.
The most mathematically correct way is to do the avalanche method, which is to pay the loan with the highest interest rate off first. Once you’ve paid that off, you rollover its minimum payment (plus whatever else you can throw at debt) to the loan with the next highest interest rate.
The snowball method is psychologically better. You list your debt from smallest to largest amount, and pay the smallest loan off first. Then you roll over the minimum payment and anything else you have extra to the next smallest loan. Seeing your loans paid off quickly can give you the motivation to keep going.
Getting out of the paycheck to paycheck cycle
Once you’ve paid down most of your debt, it’s important to get out of the paycheck to paycheck cycle. To do this, you need to know your expenses vs income. If possible, list out 3 months worth of expenses and average out the cost of each line item.
The easiest way to get out of the paycheck to paycheck cycle is to reduce your expenses, aka live below your means. That’s why the next step in the FI process is to evaluate how much each expense is worth to you.
Do you really need to live by yourself if it costs you 40% or more of your net income? Can you get a roommate, or move somewhere cheaper? There are ways to reduce your expenses, but only if it’s no longer valuable to you. For us, that meant reducing our rent by moving somewhere cheaper, cutting subscriptions, lowering our phone bill by using Mint Mobile in gradschool, and calling providers to lower our monthly bills.
Another option is to increase your income. This is more difficult since it either involves negotiating your salary at your current employer, finding another job with a higher salary, or getting a second job or side hustle. But, as your income increases, you need to actively work on preventing lifestyle inflation. Otherwise, you’ll end up in the same place: living from paycheck to paycheck.
Reaching $1000 emergency fund
Once you’ve reduced your expenses and/or increased your income, you now have some freed up cash flow to start saving. The first step that most people should do is save up $1000 as an emergency fund. About 56% of Americans cannot cover a $1000 emergency expense. This causes people to use their credit cards as an emergency fund. What happens when people use their credit card and cannot pay it off in full? We end up back at step 1, trying to get back to $0 net worth. That’s why it’s important to get out of the paycheck to paycheck cycle in order to free up some cash flow and build up your savings.
Let’s say you have $50 freed up each month from your budget. To reach $1000 in emergency fund, it will take you $1000/$50=20 months to save up that emergency fund. If you want to speed things up, you can sell stuff that you no longer need, reduce your expenses more, or get a side hustle.
3-6 months of expenses saved in an emergency fund
The next step is to increase your emergency fund to about 3-6 months worth of required expenses. By required expenses, I mean bills you definitely have to pay like your rent, utilities, and grocery bills. Not money for takeout or going out to eat, buy clothes, or get that new iPad. This emergency fund is solely used for when shit hits the fan, for example, if you get fired or laid off from your job. Job hunting can take a couple of weeks to a few months. This emergency fund can help you while you’re unemployed and looking for the next gig.
Saving up this large of an emergency fund is difficult. It took us several years to even get to six months. We did that by first calculating how much necessary expenses we have, and multiplying that by 3 to 6. I suggest people start with a 3 month emergency as that’s an easier goalpost to reach. But, once you do reach that 3 month emergency fund, the next step is to try to increase it to 6 months.
Maxing out your Roth IRA for the first time
A Roth IRA is a great retirement account that you can use to invest your money in. If you have earned income that falls below a limit, you can contribute up to the IRS max of $6500, or to the max of your income, whichever is lowest. That is $541.67 a month of after-tax money you can put towards retirement each year.
There are many benefits to a Roth IRA. You can take your contributions out at any time, so some people use it as their emergency fund. But, I don’t recommend taking your contributions out as you cannot put it back in that year once you’ve hit your max. The money you’ve invested grows tax free, so once you retire, you don’t have to pay taxes on your Roth earnings.
It’s also easier for people to max out the Roth IRA, since it’s a lower max amount than say, a 401(k), which has an annual contribution limit of $22500 as of 2023. Some people also do not have access to a 401(k) if their employer do not provide it. That’s why I advocate for everyone to open a Roth IRA
If you do have access to a 401(k), you should contribute enough to get your employer’s match, as that is part of your compensation package. Otherwise, you’re literally telling your employer you don’t want your full salary.
Once you’ve maxed your Roth IRA for a couple of years, you’ll reach the stage where you have 1 times your annual expenses invested. For us, that’s approximately $54000 in investments. The 4% rule says we can basically withdraw $2160 each year, indefinitely, without running out of money. If only we could live off of $2160… Alas, the FI journey continues.
After a few years of compounding, you’ll reach 2xFI. This is approximately when your investments will be able to cover about 1 month of expenses forever (4%*2*annual expenses=approximately 1/12 * annual expenses). For us, this is when our investments reach our first $100k.
CoastFI is the stage of FI where you do not have to contribute anymore money to investments, but you are still able to reach financial independence at normal retirement age of 67. You would only need to make enough money from your day job to cover your expenses from that point on. Some people decide to stop investing and let compounding do the rest, while still working their day job to over their expenses.
CoastFI is easier to reach if you start investing early. If you started later, you have less time working in your favor, so your CoastFI number increases. A great calculator can be found here.
We calculated our number based on the following assumptions: we will have social security covering parts of our expenses, so our annual expenses that needs to be covered by our own investments is $40000; we assume a 10% nominal rate of return. At my current age and net worth, we’ve basically hit CoastFI.
But, depending on the nominal rate of return you choose, that CoastFI number can be higher. For more conservative estimates, some people use 7%. In that case, we are 10 years from CoastFI. So still a long way to go, depending on how pessimistic we are about the financial market.
At half FI, you have 12.5x your annual expenses invested. For me, it’s hard to imagine having this much money invested. Luckily, compound interest will work in your favor. Once you hit 100k net worth, the compounding really starts to kick in effect. You’re likely to reach 200k in the next 2-3 years, maybe sooner, if you keep investing. And once you reach 200k, 300k is even faster.
Once you’ve reached half FI, reaching full FI will be in your reach. At this stage, you’ll have 25x (or more) of your annual expenses invested. You are fully financially independent, and you can decide to stop working, or to pursue other ventures.
We’re at stage 7-8 in the financial independence marathon, based on our projected annual expenses of $54000. This number can obviously change, as we buy a house or have a kid (or kids) in the future. The next step in the process for us is half FI, which is still quite a few years away. It’s hard for me to imagine reaching that point. But, a few years ago it was hard for me to imagine reaching $100k in investments. So we keep on chipping away at the goal.
I’d love to hear from readers. Are you working towards financial independence? What stage of FI are you in? Is there anything you can suggest to others as they embark on their path to FI?
One thought on “The stages of financial independence”
Thanks for breaking it down!