Financial Freedom Formula
There is a rather simple calculation that will help you determine where you need to be in order to achieve financial independence. Consider this a computation of your financial freedom number that will provide the knowledge you need to help answer a number of questions, including:
- How long until I can achieve FI (financial independence)?
- Is there a specific savings amount I should target?
- Is financial freedom really something that I can attain?
Interested? Yes, I thought so. Let's get straight to the good stuff.
Simple enough, right? To further clarify, here is some added detail behind each item listed in the calculation:
- LIVING EXPENSES = Annual living/spending needed for you and/or your household (requires a knowledge of your annual household budget)
- PASSIVE INCOME = Annual amount of passive income expected to be received (if any) through real estate or other investments by the time you reach FI (financial independence)
- PAID OFF DEBT = Current annual debt payment amounts (mortgages, loans, etc.) expected to be eliminated by the time you reach FI
- X 25 = Simple multiplication of your adjusted annual living expense by 25 (to have your proposed nest egg at the amount where a withdrawal rate of 4% will account for these adjusted annual living expenses)
- NEST EGG NEEDED FOR FI = Cumulative dollar value of portfolio/investment assets required in order to be financially independent (aka, your financial freedom number)
But just to make sure we're crystal clear, let's run through an example of how this works by using the following hypothetical inputs:
- Annual household spending needs = $75,000
- Passive income/year (to be received by FI) = $20,000
- Mortgage payments/year (to be paid off by FI) = $15,000
Under this scenario, we have the following calculation:
$75k - $20k - $15k x 25 = $1 Million
In other words, this household would likely need to make sure they have $1 million in total portfolio/investment assets saved before they should consider themselves financially independent. Upon achieving this $1 million mark, they could expect to safely withdraw 4% (or $40k) from the $1 million nest egg each year (while also adjusting for inflation) without the money running dry.
Of course, there are other variables that can come into play to alter this formula. For instance, if a person plans to work part-time or start a side-business for the remainder of their days, the nest egg required would be reduced since additional income will being generated. This means less would be required from portfolio investments each year to account for living expenses. Also, plenty of people like to be conservative with their financial planning assumptions. For these individuals, it might make sense to boost the size of the nest egg needed by 10% or more than the formula suggests. These types of tweaks will vary per each unique situation.
Have you taken the time to mark where you are in your journey towards financial independence? If not, go ahead and run the numbers to see where you stand. Just knowing this marker will allow you to strategically plan for an escape from the rat race. And yes, it is something that you can attain!