How do you become financially independent? Don’t take out debt (or pay it off quickly), spend less than you earn and invest the difference. Hey, you already know all the basics!
But how much money do you need to be financially independent? And how long does it take for your net worth to get big enough? In this post, I’ll tell you how to set up a customized plan for your financial independence.
Estimate your future expenses
To get a sense of how much passive income you‘ll need to be financially independent, you have to consider what your spending will be at that point. Don’t make it too complicated. Start out with a rough estimate.
Look at your current expenses and think about how they will change when you‘re not working anymore. They will probably not stay exactly the same. You will spend less on things that are related to your work for example, so discount professional clothing, coffee-to-go or even transportation. For other areas you might want to increase the budget, e.g. if you want to travel more.
Don’t skip the expenses that are currently calculated from your gross salary and aren’t paid out of your bank account. There will be no more contributions to pensions and unemployment insurance. This does not make any difference in your net spend, but you don’t earn any more benefits either. You’ll have to take that into account later when you make assumptions concerning your income streams.
Don’t forget health insurance
There is one relevant item currently paid out of your gross salary and matched by your employer: your health insurance. If you are privately insured, the employer’s share is paid on top of your net pay. In any case, you have to take out health insurance yourself when you are no longer covered by an employer.
Your expenses will therefore increase by the health insurance premiums. If you and your spouse are covered by statutory health insurance at the moment, and your partner continues to work, you may be able to get family insurance through him or her. If you’re currently privately insured, you do not have this option. In any case, you’ll have to take health insurance premiums into account when making your spending assumptions.
Do you have a company car?
There is another constellation where current deductions from gross pay become relevant to your spending estimate: if you currently have a company car and do not want to sacrifice a car in the FI phase. Currently you “only” have to pay taxes on the pecuniary advantage of the company car, and the trips from home to work are taxed as well. It will almost certainly cost you more to buy and maintain the same vehicle model privately. That would have been the case for all company cars that my husband and I had over the past 20 years or so.
In this context, you might want to look at my post on cost of transportation.
Everyone has their own priorities, of course.
The higher the expenses, the bigger the required assets
But just to give you an idea: If you decide to buy a car that costs you 500 EUR a month, you have to save up a dedicated net worth of 150,000 EUR if you use the 4% rule for the sake of simplicity (you can dive into my reservations regarding the 4% rule here). A monthly cost of 300 EUR requires “only” 90,000 EUR. That‘s a significant difference, I think. And it’s probably one of the reasons why the ‘millionaire next door’ (no affiliate link) tends to drive a low-key vehicle.
When I did my estimates for the FI phase, I just took the spreadsheet that I use to track our current spending anyway. You can add extra lines – e.g. for health insurance premiums – or delete rows if current expenses such as mortgage payments will disappear in the future.
What is your “FI number”?
Cool, now you have an estimate of your Financial Independence Retire Early expenditures! But how much net worth do you need to be able to cover these expenditures with ‘passive’ income?
This depends on many variables: do you want to preserve the capital, or is it okay for your assets to be depleted during your lifetime? What’s your asset allocation and where do you plan to invest your savings in the future? How high will the rate of inflation be?
Basically, it is correct to consider all these variables. On the other hand, you might only be at the beginning of your path to financial independence at the moment. Although some of the very frugal FI bloggers propagate periods as short as 10 years to reach financial independence, I would realistically expect it to take 15 to 20 years to reach your target. Across such a long period of time, any prediction that goes beyond very average numbers has little validity.
That’s why I would actually work with a simple model like the 4% rule or its reversal, the 25x expenses to come up with a rough estimate for a start. That gives you an idea where you have to be headed. The numbers can subsequently be adapted to reality, depending on the evolution of your spending and assets.
Motivate yourself by setting milestone goals
You’re FI-number will probably seem quite large from today’s perspective, and a destination that’s far away. Motivating yourself for a long-term goal is not easy. That’s why I think it’s important to break it down to smaller milestones – and make sure to celebrate each milestone when you’ve made it there, you’re doing great!
My suggested milestones on the road to FI would look like this – each is a goal in itself, even if you don’t want to go all the way or feel hitting the end goal is not realistic from today’s perspective:
Step 1: An emergency fund worth 3 months of current expenses
Step 2: An emergency fund worth 6 months of current expenses
Step 3: F *** – you-Money, Level I: 1 year of current expenses
Step 4: F *** – you-Money, Level II: 2 years of current expenses
Step 5: F *** – you-Money, Level III: 3 years of current expenses
Step 6: 5 years of future expenses
Step 7: 10 years of future expenses
Step 8: 15 years of future expenses
Step 9: 20 years of future expenses
Step 10: 25 years of future expenses
Timing of income streams
The 25x-expenses rule is designed for a mix of stocks and bonds. This might not be your asset allocation. Maybe you have a pension plan to which you – and / or your employer – are currently distributing, and where there is payout at some point. And as long as you work as an employee, you’ll be earning state pension benefits.
That’s future income streams that you need to include in your planning. Our plan for example contains one phase before official retirement age, and one phase after. In theory, we could spend down more from our assets, e.g. sell a rented apartment, in the first phase and this would be compensated by our state pensions in the second phase.
How do we include the state pension?
In reality, we have planned this somewhat differently and are currently looking at the state pension as a hedge against rising premiums for health insurance and as a certain safeguard against the “longevity risk” (terrible expression). We might also decide to apply for at least one of our state pensions as late as at the age of 70. The state pension increases by 0.5 per cent every month drawing of the pension is postponed after reaching the statutory retirement age (67 in our case).
That might all seem quite far away for you. But if you want to live off your passive income until the end of your life, you won’t get around planning upto an age of 95 or 100. As I said, I like to consider „real“ retirement Phase II. How far you need to get into the details of this phase will depend on how old you are today.
And how fast will I be FI now?
Okay, now you should have thought about
- how high your expenses will be if you are no longer working for a living
- how much income you can expect from insurances or pensions that you already own
- and whether you have additional claims such as a state pension
You got all that? Great, then you can figure out now how long it will take you to reach financial independence (retire early).
To calculate this, you need your savings potential, ie the money you currently have available to invest. (If you’re still looking for savings, here are some posts to help you lower your housing, food, and transportation costs). Now you have to multiply this amount with an estimated rate of return, e.g. with the average, long-term rate of return for stocks , if you plan to invest in ETFs.
Do not forget taxes
Be careful: You need to calculate with the return after taxes, so, to stick with the example of stocks/ETFs, with the return you end up after the deduction of capital gains tax, including solidarity surcharge plus church tax if applicable. As long as you don’t use up the annual tax-free amount of 801 EUR for singles / 1.602 EUR for married couples filing together, no tax is deducted. If you’re a landlord, any gains from renting will be taxed with your personal tax rate.
To extrapolate the build up of your net worth, just google “compound interest calculator” or even better: create your own net worth Excel spreadsheet. Put years in the rows, net assets and corresponding income streams into the columns. Why not include the milestones from above? Don’t forget to add any income streams from company, private, or state pensions, even if they are only paid out in „Phase II“.
You still have questions? Feel free to contact me!
Financial Independence Rocks!