What is Financial Freedom?
Financial freedom is the point where you generate passive income outside of your job that is equal to or exceeds your cost of living. This external income, derived from other sources outside of your job, supports your expenses allowing you to not have to actively work anymore.
Passive income – a type of income earned each day, week, month, regardless if you go to work or stay home all day. This could be rental income, dividend payments from stocks, interest earned from savings or investments, income from running a YouTube channel, online eCommerce store, or other online business.
Cost of living – how much money you spend per year to sustain your current lifestyle. Everyone has different needs, wants, and desires that shape their spending so one person’s lifestyle may cost far more or less than the next person. Consider the two opposing lifestyles of someone who spends $300,000 a year to support their family in a mansion and fancy cars and someone who lives in an average home, average car, and is happy spending $50,000 a year.
To achieve financial freedom, you must be disciplined. It takes time to save money, invest it, and let your invested money earn interest and compounded returns that grow it larger and larger. Consistently saving money, reducing debt, investing, and living within your means can help you achieve financial freedom much quicker.
Let’s go through a 5 step exercise to help you plan mentally and learn the formula and steps to achieving financing freedom. Thanks for being here today!
Calculating Financial Freedom
Step 1 – Determine Retirement Goals
Decide your retirement goals and list them. They can be things you’d like to own, do, give, etc. Retirement planning starts with setting goals you want to achieve one day down the road and realizing that your desired lifestyle can come true.
Here are some questions to help prompt your list:
- What age would you like to retire?
- Where do you want to live? What city, state, country?
- How expensive of a home do you want to own? How many bedrooms, square footage, how many bathrooms?
- Do you want to have two houses and travel among the two based on seasons?
- How many vehicles will you own? What make and model would you like?
- Will you be eating out often or will groceries still be a large portion of your food expense? Higher end restaurants and dining out?
- What vacations and traveling will occur? What is your dream vacation?
- Does the state you live in have state income tax? What’s the property tax rate in that state?
Step 2 – Determine the Cost of Your Retirement Goals & Lifestyle
Now that you’ve thought out all of your goals, you’ll need to come up with a rough estimate of what this lifestyle will cost you per year in today’s dollars. Don’t worry about adjusting for inflation.
Spend time researching different cost estimates of the activities, vacations, and things you expect to spend on each year if you are unsure. This will give you a more accurate lifestyle cost estimate if you’ve looked up the costs online to get an idea rather than just guessed.
*Also take into consideration your location as cost of living varies by region, state, city, etc.
Here are general living expenses you should take into account:
- Mortgage Payments
- Property Insurance
- Property Tax
- Property Maintenance & Repair Expenses
- Lawn Care
- Car(s) Payments
- Car(s) Fuel
- Car(s) Insurance
- Car(s) Maintenance
- Internet Service
- Cable Service
- Phone Service
- Dining Out
- Health Care & Insurance
- Dental & Medical Expenses
- Clothes & Apparel
- Vacation & Travel
- College Loans (Yours or Children’s)
- Credit Card Payments
You can pull up the Annual Consumer Expenditure reports online as well if needed to get a feel for what the average U.S household spends per year on different expenses. They break it down into income brackets as well if you’d like to see what the average expenses are for your income bracket.
Step 3 – Determine the Nest Egg Needed at Retirement
How much money do you need in your retirement nest egg to sustain your retirement cost of living you calculated in step 2?
To calculate it, just multiply your expected cost of living by 25.
Cost of Living in Retirement x 25 = Nest Egg Needed
25 is a safe number because it can be straight cash that lasts you for 25 years in retirement before running dry. The better way though is to assume you have your retirement savings diversified in low risk investments that earn you 4% a year. If you want that 4% interest to cover your cost of living and not have to pull from your investment account to fund expenditures then you need 25 times your cost of living as shown in the math example below if using 4% because of inverse relationships (1/25 = 4%).
- $50,000 per year lifestyle = 4% interest x Nest Egg
- $50,000 / 4% = $1,250,000 needed in Nest Egg
- $1,250,000 / $50,000 = 25 times cost of living
If the math confuses you just think of inverse relationships. If you expect to earn 4% then it
is 1/25 of your investment account. If you expect to earn 5% then that’s 1/20 of your
investment account so you would only need 20 times your living expenses invested in assets.
You can decide how risky you want to be late in your life once you’ve amassed a lot of money but for those of you who want safer 4-5% returns on your money each year then shoot for multiplying your cost of living by 20 to 25 to get your nest egg total need. Or just simply divide the cost of living by the percent interest you expect to earn as seen in the second bullet.
Step 4 – Calculate Annual Savings You Must Invest To Reach Nest Egg Goal
Now that you’ve determined your nest egg number you need to have invested, it’s time to decide how much money you need to be saving each year NOW to reach your nest egg goal. The more you save and wisely invest, the sooner you’ll likely reach your goal.
But before you can calculate how much you need to be contributing to your investment accounts each year you must learn the investment equation and consider a few variables that dictate the investment equation.
How many years do you have until your retirement age goal?
What investment return do you expect to average over the years you have remaining?
- High Risk/Growth = 8% to 12% (Good choice for Younger People)
- Medium Risk/Growth = 6% to 7% (Historical Avg. Return of Stock Market)
- Lower Risk/Growth = 3% to 5% (Keeps inline or ahead of inflation)
Here are some example calculations:
- Saving $10,000 per year for 40 years at 7% will result in a retirement nest egg of roughly $2 million dollars assuming you placed your annual $10,000 contribution in a tax sheltered retirement account.
- Saving $10,000 per year for 30 years at 7% will result in a retirement nest egg of roughly $944,000
- Saving $20,000 per year for 25 years at 9% will result in a retirement nest egg of roughly $1.7 million dollars.
- Saving $20,000 per year for 35 years at 9% will result in a retirement nest egg of roughly $4.3 million dollars.
As you can see in these examples, Time, Interest, and Amount Invested all affect how much you’ll have in your nest egg. You can control the amount you save and invest for sure but time will be determined by your current age and interest rate is a result of the investment choices you make based on your research and consulting with a fiduciary advisor.
Time may be the most important. If you start saving and investing early in life you can have a large nest egg by retirement due to the power of compounding interest. Or you can retire early once you’ve reached the point your investment income replaces your job income plus a healthy margin of income left over in case of emergency that can keep compounding.
If you are already in later stages of your life when you start taking retirement investing seriously then you’ll most likely have to contribute larger savings each year to catch up what you’ve missed in interest gains. This can place a strain on your budget as you may not have a lot of room to save large amounts of money due to your lifestyle spending habits.
The historical return for the stock market is 7% since 1871. Bonds return 3-4% historically.
Younger individuals have many years ahead of them and can be more risky in their investments often seeking growth stocks with 10-15% annual returns.
In later stages of life people generally start shifting their portfolios to lower risk investments because they don’t want to risk losing years of hard work and income. This results in lower returns usually.
So if you plan to start saving for retirement later in life, expect lower returns because you won’t want to be high risk at a late stage in life. This means you have to save a lot more to invest each year because time and interest are against you at this point making it difficult to achieve lofty retirement goals.
Play around with this calculator changing the time, amount invested each year, and percentage growth rate to come up with a plan that meets your needs.
Click Here: Investment Calculator
Step 5 – Compare Your Calculated Savings Needed Per Year to Current Savings
Now you’ve figured out how much you need to start saving to invest each year so it’s time to compare this dollar figure with what you’re actually saving per year currently.
If you find yourself saving more than your calculated number, then good for you. Keep it up!
If you’re behind then here are a few things to consider to increase your savings:
- Find areas of spending to cut that won’t hurt your quality of life. We all have wasteful expenditures we don’t truly need such as purchasing expensive beverages instead of drinking free water. These beverage purchases add up over time when you consider the interest that money could be earning if invested instead.
- Consider getting a part time job to give you more income that can be strictly used for investing.
- Consider signing a contract with yourself that any future raises you receive at work will go towards savings or at least a large portion of that raise. If you can live fine off your current income, then a raise should be treated as bonus income that can help your nest egg grow.
Create a Budget:
This ties in with Step 5 from earlier where you compared your retirement expenses and saving with current expenses and saving.
Since you know these numbers, you can create a budget to try to stick to that will make saving much easier and more organized as a result of having a solid plan in place.
Your budget will include your necessary living expenses such as food, housing, transportation, insurance. You’ll also have many other random expenditures to consider removing or limiting in your new budget.
Here are a few life events that you should set aside a small savings bucket for in your budget:
- Buying a Home
- Starting a Family
- Children’s College Fund
- Emergency Fund/Rainy Day Fund
You can also treat your investment savings as an expense that’s included in your budget. Some people live by the mindset that if they have money left over after taxes and spending then they may invest it. Smart people live by the mindset that investing payments to your retirement accounts are a typical life expense just as a mortgage payment or car payment.
Read: How to Create a Budget
Overall, knowing your financial freedom number can give you focus and help curb compulsive spending.
Life’s great to enjoy along the way and I’m not advocating being a cheap bum but we’re trying to get the excess and waste cut out so you can quicken the time it takes to reach financial freedom and lift the pressure of having to work to earn income.
You can begin doing what you want when you want and finding a passion or side job to do to keep you occupied and not bored out of your mind from retirement idleness.
Thanks for reading today’s article on how to achieve financial freedom the mathematical way. Now go out and do it for real. Be sure to check out additional articles on our blog.
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Be great today,
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