If you are pursuing financial independence and early retirement, you should have a financial independence number. If you have been on an FI journey for a while, this is nothing new to you.
The financial independence number is the amount of money you need to be able to live off the returns on your net worth without depleting your net worth. Once you have money in the bank equivalent to your financial independence number, you can call yourself financially independent for life because it does not deplete your net worth.
Before we get to how you calculate your financial independence number, we need to understand a few things first.
How much money will you spend?
Before we dive into the calculations, you need to find out how much money you will spend each month once you reach financial independence.
A good starting point is to find out how much money you spend per month at the moment. If you don’t have a budget where this is visible, try to give an estimate of how much money you spend every month everything included (e.g. housing, transport, clothes etc.).
Keep in mind that some costs go up once you achieve financial independence and perhaps retire early.
Multiply your monthly spending by 12 to find out what your required yearly spending is when you become financially independent.
As an example, I spend roughly $2,500 per month, which makes my yearly spending requirement $30,000.
What is your safe withdrawal rate?
Next up is your safe withdrawal rate. This is used in combination with your yearly spending to calculate your financial independence number.
Much has been written about the safe withdrawal rate. People usually don’t disagree with the concept of safe withdrawal rates, but they like to discuss the value that it should have.
The safe withdrawal rate is the percentage of your net worth that you can withdraw each year without running out of money before you die. It originates from a 1998 study called the Trinity study. This is where the 4%-rule comes from if you have ever heard about that.
The Trinity study argued that you should have a safe withdrawal rate of 4% by looking at returns from 1925 to 1995. In that time period, it would have been highly unlikely that you would have depleted your net worth if you had only withdrawn 4% every year. This is assuming that your net worth would still have been invested in a stock-dominated portfolio.
I personally use a 4% safe withdrawal rate, but others argue that you should be even more conservative such as using a 3% safe withdrawal rate.
Why do I use 4% then? Well, if it turns out that 4% withdrawal depletes my net worth, I will be fine with spending less or earning some more money for a while. Keep in mind that the safe withdrawal rate assumes that you don’t make any additional income apart from investment returns.
Which safe withdrawal rate should you use? I would suggest something between 3-4%, and you’ll be fine.
Calculating your financial independence number
Now to the grand finale! Using the two financial ingredients from this post, you’ll be able to calculate your financial independence number.
You can calculate your FI number using this equation:
Financial independence number = Yearly spending / Safe withdrawal rate
As an example, my financial independence number is:
$750,000 = $30,000 / 4%
My financial independence number is $750,000. Once I have a net worth of that, I am financially independent and I can stop working for the rest of my life. Easy as that!
Having a number makes financial independence much more tangible for most people. For me it is a great motivation to have a clear goal, and I religiously track my progress every month.
Your turn: What is your financial independence number?