F.I.R.E 101

This post is designed to give students the basic knowledge to get started on their path to Financial Independence, we will tackle the money, the math, the plan, and most importantly the REASON. To start with we need to define Financial Independence, Financial Independence is when you no longer need to trade time or energy for money. It is when you have saved enough financial capital to continue living the lifestyle you want without worrying about earning money.

The goal is for the money you have saved and invested to be working and providing large enough returns via dividends and capital gains, that you can live off of the interest and never worry about running out of money. There is a lot of debate as to what the actual amount of money someone needs to confidently walk away from their career but for simplicity, we will go with 25 times your current monthly expenses.

This would equate to being able to comfortably withdraw 4% of your account balance every year to live off of. This number has been studied extensively and proven to be the sweet spot. Trinity University did a study of historical returns and back tested the 4% withdrawal rate, they found that it had an almost 100% success rate of insuring that the investor did not run out of money after retiring. The really interesting thing is that in most cases the investor actually ended up with more money than they started with even after they had withdrawn 4% to live off of for 30+ years. So where do we start?

balance business cobblestone conceptual

The REASON– The reason for Financial Independence in my opinion is the most important part because without the why it’s hard to get motivated to even start and really hard to keep going when progress seems slow or setbacks occur.

Everyone’s why will be different depending on their personal beliefs and what is important to them, for me it’s security for me and my family.

Simply saying my why is I want to be rich, is not enough. You need to really define what is important to you and connect your finances to it on an emotional level. I recommend spending time thinking about what a future of financial independence would look and feel like, how would being secure in your future and having the ability to choose to work because you want to, not because you have to feel like?

How would you behave or act if you didn’t depend on a job to pay your bills. What would you do with your free time, how would your freedom affect your family and friends? Once you have written down your WHY and what it means to you then we need to tackle the how.

person writing on white book

The How – The how can be summed up very simply as getting your monthly expenses as low as possible so that you can save as much of your income as possible, so that you require very little income to live off. So if you can imagine paying off your debts and saving 40% of your income, that means you only need 60% of your current income to actually live off. Lowering your monthly expenses, speeds retirement up exponentially as it allows you to save more and at the same time require less to actually live off of. 

The chart below is from the Mr. Money Mustache (MMM) website and does a great job of showing just how powerful a high savings rate can be. It shows that saving 5% of your income takes 66 years to be able to retire, it means you need 95% of your income to pay your bills. On the other hand a 50% savings rate only takes 17 years to reach retirement because you only need half of your monthly income to cover your living expenses.

So let me say this one more time, the lower you can get your living expenses the more of your income you can save to build a money making machine.

              Savings Rate (Percent)        Working Years Until Retirement
5 66
10 51
15 43
20 37
25 32
30 28
35 25
40 22
45 19
50 17
55 14.5
60 12.5
65 10.5
70 8.5
75 7
80 5.5
85 4
90 under 3
95 under 2
100 Zero

I’m sure that many of you are saying this sounds great but who can afford to live off of only 50% of your income, unless of course you make a million dollars a year. Well the great part about this math is that it is all about percentages, so whether you earn $10.00 an hour or $100,000 a year, the math is all the same.

The less of your monthly income you require the more you can save and the sooner you can afford to retire. Honestly if you could live with family or friends for free you could probably retire now.

The first thing to do is to begin tracking your income and expenses and get a clear picture of what you have coming in and what you have going out. If you spend more than you make you have a deficit, if you earn more than you spend you have a surplus. Managing your monthly finances will allow you to better understand where you are, where you want to be, and how to get there.

Remember the earlier you retire the longer you will need to live off of your investments. Interestingly if you can increase earnings and simultaneously cut spending your savings and net worth will start to grow exponentially. Once you start to see progress it becomes really fun, actually it starts to become slightly addictive. Albert Einstein said that “Compound interest was one of the great wonders of the world”, it allows your money to earn interest off of the interest and once you get a decent amount saved your money will start earning more than you do by working, that’s when it gets really fun.

man in red crew neck sweatshirt photographyOkay class, we defined our why, we looked at the math behind how lowering expenses allows us to shorten the time till retirement, and we also know how much we are spending and saving. Now we need to see if the amount we are saving each month will get us to our retirement goals. For me it easiest to work backwards by finding my FIRE number, then we can make a plan and set goals to help us achieve it.

photograph of men having conversation seating on chairSince most of the students are regular W-2 employees, here is my recommendation for where and how to save your money. Start with your companies 401k and put in enough to get the company match, this is like free money and everyone loves free money.

Next let’s move over to a traditional IRA, my personal favorite brokerage is Vanguard and it only takes about 10 minutes to open an account. Currently individuals are allowed to save up to $6,000 per year in an IRA. This money is post tax but you get a credit on it when filing taxes, so you get an immediate tax savings in the year invested.

Once you max out the IRA account, we can move back to the 401k. Maxing out your 401k should be your next goal, all the money put in this account is put in pre-tax and instantly lowers your taxable income. So not only does it lower the amount of taxes you have to pay, it also allows that money to grow tax free as well.

This is especially advantageous for someone who is in a high tax bracket because once retired chances are you will be in a lower tax bracket.

So if you make it to the point that you are maxing out an IRA and a 401k and you still have additional income to invest, I recommend utilizing a taxable brokerage account. These accounts are for post tax income and have no limit to contributions, these accounts don’t have any real tax savings but they allow you to invest in anything you can imagine and as long as you keep the investments for more than a year you benefit from the long term capital gains tax rate.

bank banking business cardsI of course as all of you know believe in paying off all debts and holding at least 2 months of expenses in cash in a savings account. All of these goals can be worked towards at the same time. I recommend paying off any debts with high interest rates and leaving debts associated with appreciating or income producing assets until last.

I would in fact suggest that if the debt is associated with an asset that produces enough income to cover the debt payment that it should be moved to the bottom of the list. Also if you have a stable job and feel secure in it I think the emergency fund can be less of a priority, however you must be able to cover any unexpected expenses that might arise without having to dip into your savings or go into debt to cover them.

This is not only a plan to get you to financial independence but to create generational wealth. Once you have reached what we call critical mass or saved an amount that spins off enough money for you to withdraw 4% to live off of, not only will you most likely never have to work again but you will likely leave the next generation a massive inheritance.

If you couple this with teaching them how to save and live below their means, plus getting them started saving young they will be able to grow that nest egg and change the course of the family tree.

woman man and girl sitting on snowOkay class, this concludes our lesson for the day. Now for your homework, I’d like everyone to write their WHY for financial independence somewhere that you will be constantly reminded of it. Creating that strong emotional connection will help drive you and keep you focused on the prize. If you are interested in getting started by crest a budget and tracking your wealth, check out our new workbook. It’s designed to get you off to a good start and quickly set you on the path to Financial Independence.

Thank you for joining us and remember that we are not licensed financial advisers or tax professionals, please consult with your financial specialist before making any financial decisions.

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