This article is about how I measure progress toward financial independence (FI), which I consider a prerequisite to my early retirement goal.
The terms financial independence and early retirement are often used interchangeably. I consider them different.
Financial independence is a financial milestone. Retirement is when I’ll stop working completely.
I plan to reach financial independence before early retirement. That’s my own F.I.B.E.R. movement, not to be confused with the F.I.R.E. movement.
Financial independence is achieved by:
- building enough passive income to cover annual expenses, or
- building a lump sum of savings and investments (the FI number) to cover living expenses in perpetuity, or
- some combination of #1 and #2.
Using passive income involves building a portfolio of real estate, dividends, business income, or other income streams to cover living expenses. Ideally, these income streams are outside of retirement accounts so they are easily accessible before age 59 1/2.
The FI number is about building a lump sum of money that equals 25 times your annual expenses. So if you spend $60,000 per year, your FI number is $1.5 million.
In the calculation of my financial independence number, I use a combination of both the amount earned through sustainable passive income streams and the lump sum of all of our retirement accounts.
Why I Started Measuring my Financial Independence Number
When I devised the F.I.B.E.R. movement, I realized that didn’t have a financial independence number or retirement savings goal.
Early retirement, for me, is the point when I will stop working for good. No side business, no consulting, no moonlighting at Costco for health insurance. Nada.
My early retirement goal is age 55. That’s an age, not a lump sum of money.
When I reach financial independence, I plan to keep working.
I intend to be fully ready to retire both mentally and financially by age 55. But the viability of that plan needs to be validated with numbers beyond my forward 12-month investment income (F12MII) calculation. That number doesn’t account for savings in my retirement accounts.
I track investment income (aka passive income or F12MII) meticulously every quarter. But my quarterly reports only include taxable investments. It has nothing to do with our retirement savings in my employer-sponsored 403(b) and several IRAs which make up the bulk of our net worth.
In order to know when we’ve reached financial independence, I need to measure all the relevant numbers.
The FI Number
The FI number is based on a study done back in the 1990s called the Trinity Study regarding safe withdrawal rates from retirement savings. This is commonly referred to as the 4% rule (of thumb).
The math says, in general, and after a slew of assumptions, adjustments, and simulations, that if a properly invested retiree spends just 4% or less of their total retirement nest egg per year, they can draw down their savings at their current spending rate (adjusted for inflation) for 30 years before they run out of money.
This works great if you retire at 65 because you’ll have enough to live until 95, which covers most people.
Early retirees, aiming to retire under the age of 60, or much younger, utilize the rule of thumb to declare financial independence.
But if a forty-something retires using the 4% rule, 30 years of spending money may not be enough.
And it assumes spending stays the same, only rising with inflation. It may very well increase due to unforeseen circumstances.
However, there are many solutions to help you outlive your savings beyond 30 years, including:
- spending less than 4% per year
- earning a higher rate of return (than the assumption)
- saving more than 25x annual expenses
- earning some other kind of supplemental income
- creating sustainable income streams from which the principal is not withdrawn.
Over a 30-year period, positive additions to any of these factors goes a long way, extending the longevity of the retirement nest egg.
You often see young people on popular online news outlets claiming to be “retired” young and confidently. The reason they so confidently retire is the exhaustive research and testing that’s been done on the merits of the 4% rule.
With thousands of variables and endless scenarios, the 4% rule has been tested, retested, challenged, strengthened, weakened, and counter-argued to death. Perhaps because people stake much of their financial future on the concept.
All you need to know is it’s fine as a rule of thumb. But I’m not staking my entire financial future on it.
Why I Combine Passive Income and FI Number
The math and back-testing of the 4% rule are sound and it’s especially effective if the early retiree aims to create a bit of wiggle room to account for “sequence-of-returns risk”.
Sequence-of-return risk is essentially the risk that the stock market will tank shortly after retiring. For example, if you need $1.6 million to retire, you’d hate to see the market fall 30% the year after you call it quits. You’d only have $1.12 million left for the next 29 years.
Even so, for 95%+ of the 30-year periods dating back to the 1920s, the math still works.
Anyways, my strategy goes a step beyond saving a lump sum and withdrawing that money for the rest of my life.
I create sustainable income streams through investing.
Instead of drawing down the principal of these investments, I plan to let them ride well into retirement, and perhaps to my death bed.
If I can create enough investment income that consistently grows above the rate of inflation and covers a solid portion of my living expenses, I can tap less of my retirement savings and reduce sequence-of-return risk. Retirement savings will continue to grow tax-deferred for longer, compounding into a more sizable nest egg.
I hope to use that money for luxury travel in my old age. But it’s also marked to cover health expenses, assisted living needs, family in need, and to leave to my family after I’m gone.
The more sustainable income streams you can create (lowering your FI number), the faster your retirement savings will lead you to financial independence.
The main point of today’s article is to show how I calculate my FI number after accounting for taxable passive income.
How I Measure Progress Toward Financial Independence
Now that that’s all out of the way, let’s get to the calculation. I’m not going to share our personal numbers because I don’t share my net worth or annual spending. So I’m using dummy numbers to illustrate what I’m doing with my own numbers.
A note about terminology: I’m using the terms passive income, investment income, sustainable income streams, forward dividends, and forward 12-month investment income (F12MII) interchangeably in this article. The important thing to keep in mind is that the funds producing taxable investment income should be excluded from the FI number lump sum.
Start with Annual Spending
Late last year, I demonstrated how I track annual spending using Microsoft Excel and its pivot table functionality. That method gave me the exact amount our family spent in 2018.
Start with your annual expenses. In this example, I’m going to use the number $65,000 for annual expenses.
For someone whose annual spending is $65,000, their FI number (based on the math of the 4% rule) would be $1,625,000.
= (65,000 * 25) = 1,625,000 or = (65,000 / 0.04) = 1,625,000
Invested Assets or Net Worth?
Remember, the FI number goal is to build a lump sum of savings and investments (or “invested assets”) equal to the amount.
That’s different than net worth.
Some people simply calculate their net worth and use that to measure progress toward financial independence.
Using net worth is less accurate because it includes the equity in your primary residence. Unless you plan to liquidate your home and move to Guatemala, you’re going to need the home.
Best practice is to use invested assets to measure progress toward financial independence instead of net worth.
Adjust for Sustainable Investment Income
OK, so I’m using a combination of the FI number and investment income. How does that work?
I share with you my forward 12-month investment income (F12MII) every quarter. F12MII is my own term, so if you google it you’ll probably end up right back here. Other people call it passive income or forward dividend income.
F12MII is the estimated income I’ll earn from my dividend stocks, real estate crowdfunding holdings, high-yield interest on cash, and rental property over the next 12 months. This is money I earn whether I’m employed or not.
For this example, let’s make it a round number and use $12,000, generating income of $1,000 per month.
Some of that $12,000 income, especially from the real estate, is taxable. So I’m going to make a ballpark 15% adjustment for taxes.
= (12,000 * (1-0.15)) = $10,200
However, one of the most beautiful aspects of dividend investing in the U.S. is that qualified dividends and capital gains are subject to a 0% tax rate for income up to $38,600 for singles and $77,200 for married couples filers for 2018 taxes.
Dividends and capital gains are not taxed below those thresholds. So dividend income generated for a married couple with total income below $77,200 is tax-free. Read more here. But we’ll still make the 15% adjustment.
Now that we’ve made an adjustment for taxes, we subtract net investment income from annual expenses.
= (65,000 - $10,200) = $54,800
When adjusted for investment income (aka F12MII), the retiree in this example now only has $54,800 of expenses to cover from safe withdrawals from savings. We’ll use this as our new baseline to calculate our adjusted FI number.
Recalculate FI Number
With our new expense coverage requirement, we can recalculate our updated FI number.
= ($54,800 * 25) = $1,370,000
Instead of $1,625,000, the FI number in this example is lowered to $1,370,000 after adjusting for passive income streams. We’ll need that much savings in retirement accounts to reach financial independence.
The money invested that enables us to earn $12,000 in passive income is excluded from the FI savings number. This includes equity in any rental properties. I also exclude college savings.
The Obvious Shortcut
Before we go on, I should mention the obvious. Earning $12,000 in investment income requires a lump sum invested in taxable accounts. Why not just use that amount towards your FI number?
For example, to earn $12,000 in passive income you’ll need about $342,000 of invested assets yielding 3.5%.
The difference between the original FI number and the adjusted FI number is:
= (1,625,000 - 1,370,000) = 255,000
So why not take the easier road and add the $342,000 to the FI number and declare financial independence sooner?
Because most of us are more concerned about a secure retirement rather than a more imminent one.
I prefer to keep taxable passive income assets and retirement savings separate because I do not want to draw down the principal of my sustainable income streams. Keeping stable income streams without drawdowns will help me live my ideal retirement.
Chart it Out
Let’s recap the numbers then chart this sucker out. Keep in mind, this is all for illustrative purposes only.
Annual Spending = $65,000 FI Number = $1,625,000 Annual Investment Income = $12,000 Annual Investment Income Adjusted for Taxes = $10,800 Adjusted FI Number = $1,370,000
Without any passive income, you’d need to save $1,625,000 worth of total invested assets in our scenario.
If you earn $12,000 of annual passive income from investments, you’ll need to save $1,370,000 in invested assets (probably in retirement accounts) aside from those assets generating income in taxable accounts.
Since net worth is an easy number to get, I’m going to use it in our chart to add a second line for comparison. But remember, net worth includes the assets that make up investment income plus the equity in your primary residence. You’d want to plot net worth against the original FI number, $1,625,000 and it’s still less accurate.
But we’re going to cheat and plot it against the adjusted FI number anyways.
The last thing we need to do is add up retirement savings and any assets not contributing to taxable investment income. This is the amount of savings in IRAs, Roths, 401(k)s, 403(b)s, or any other tax-friendly account, and other non-income producing assets.
I use Personal Capital to aggregate all of my accounts in one place. It automatically calculates my net worth when I log in every day. It also makes it easy to grab the current balances of my retirement accounts for this exercise.
I then sum up my retirement savings at the end of each month and plot it against my FI number, both as a percentage and by the total dollar amounts.
This is a fairly new exercise for me, so I only have a few months of data. But I’ve dummied net worth and retirement savings to illustrate what the charts would look like after tracking our example above for a year.
The purple line represents our FI number. Green, net worth. Blue, retirement savings chasing the FI number.
And here’s another version of the chart using numbers instead of percentages.
When the blue line crosses the purple line on my real charts, I’ve reached financial independence.
You can do this with a net worth or zero or a million or more. Don’t be discouraged if your numbers aren’t great today. Start tracking anyways. You’ll be amazed with the amount of progress you can make in a year or two.
The only way you’ll see it is with a chart.
Once a spreadsheet is set up with the tables and charts, all you have to do is collect the data each period. Could be monthly, quarterly or yearly.
I’m planning to use a static annual spending number for the entire year, then update it fresh each January. However, you could make a moving FI number using trailing 12-month spending data.
That would encourage you to spend less each month, bringing the purple line (FI number) down and moving you closer to financial independence.
Lowering the purple line is a big opportunity for us as our preschool costs decrease and our F12MII rises over the coming years.
Then as our retirement accounts compound, our rental property appreciates, and Mrs. RBD starts to earn again, the blue line should accelerate upward.
But since I’ve only recently started tracking to this detail, I’m not ready to forecast our FI date. And it’s hugely market-dependent.
As I build out this chart over the coming years, our financial independence date should come to light. I’ll eventually see the green line surpass the purple line. Then one day, the blue line will cross the purple indicating that I’ve officially reached financial independence.
At which point, I’ll go right back to work.
Photo by zatvor via DepositPhotos used under license.
How do you measure progress toward financial independence?
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