As I discussed in this article, financial independence (FI) is achieved when you have enough money to retire indefinitely. But how much do you actually need for that?
If only it were that easy
To calculate the minimum you need for financial independence, use this formula:
The amount you spend each year/0.04
[or, similarly, the amount you spend each year*25]
For example, if you spend $45,000 a year, then you’ll need a portfolio worth $1,125,000 to become FI.
Isn’t that too simple?
(The math, that is, since $1,125,000 sounds like a lot of money to me too.)
Admittedly, this is a rule of thumb. The formulas above will have to be tailored to your individual needs, but even that isn’t too difficult to do.
“Amount you spend each year”
Everything from rent, transportation, food, to entertainment gets lumped into this category.
You can get a rough calculation of your FI number even as a college student. Just use how much you pay for room and board as well as any miscellaneous expenses as the amount you spend each year. Don’t subtract student loans, scholarships, or grants from your calculations, since this type of aid won’t be available your entire adult life.
I wouldn’t include the cost of tuition in this calculation, since we’re trying to figure out the bare minimum needed to be considered FI. You won’t, after all, still be paying for more years of tuition after graduating. I, for example, estimate that with my current expenses for room, board, and miscellaneous expenses that the minimum needed for financial independence is around $420,000.
Here are some formulas to calculate your FI number based on whether you live on- or off-campus:
On-Campus (semester system):
(Meal Plan for one semester*3+Cost of dorm room for one semester*3+ miscellaneous expenses throughout year)/0.04
On-Campus (quarter system):
(Meal plan for one quarter*4+Cost of dorm room for one quarter*4+ miscellaneous expenses throughout year)/0.04
(Monthly Rent*12+Food Expenses+ miscellaneous expenses throughout year)/0.04
Miscellaneous expenses should capture the cost of transportation, any bills you pay from living off-campus, and entertainment (e.g. that Netflix subscription).
That’s Not A Lot to Live On
If you don’t want to live like a college student the rest of your life, then you are going to need more money for true FI. If, for example, you live in the Oregon and plan to live the rest of your days in Singapore, then you will definitely need more than your annual expenses to be FI.
Both are cool places, but one requires *a lot* more money.
Another way to calculate your FI number with some added cushion is to substitute the amount you spend each year with the amount you make each year. This doesn’t exactly work for college students, but you can estimate how much you’ll make after taxes in the future and divide by 0.04.
The Mysterious 0.04
While using your expenses or income to estimate how much you’ll need to retire is understandable, why you divide by 0.04 is more mysterious.
Four percent (0.04) is widely considered to be the safe withdrawal rate for retirees, no matter how early you retire.
Safe Withdrawal Rate: the amount of your portfolio (usually considered as the investments in a retirement savings plan), represented as a percentage, that a retiree uses for expenses
Of course, you don’t have to withdraw 4% from your nest egg. Withdrawing more lowers the probability that your portfolio will last you through retirement while withdrawing less raises the probability.
There is a lot to say in defense of using the Four Percent Rule as a rule of thumb, but fortunately, others have already written extensively on this topic. I highly recommend you read the MadFIentist’s thorough examination of the Four Percent Rule’s validity here. The Trinity Study is the original study that brought the Four Percent Rule to light, which you can access here (this is the second take of the Trinity Study, like Trinity 2.0).
What about inflation?
The Four Percent Rule extracted from the Trinity study is inflation adjusted, so if inflation is particularly high in one year, you would be living on less of your portfolio than normal years. This just means that while your withdrawal rate of 4% remains the same, the amount of money being withdrawn from your portfolio varies.
For example, if you have a portfolio of $1,000,000, then you could withdraw $40,000 at the 4% withdrawal rate. Should your portfolio only be worth $1,100,000 the next year, then you could withdraw $44,000 at the 4% withdrawal rate.
Inflation can also change the amount you need for FI. If your expenses go up significantly (due to inflation or lifestyle changes [e.g. kids]), then you should recalculate your FI number based on your new expenses.
When you retire, then your tax bracket should go down, which decreases the amount of taxes you pay (sometimes to $0).
However, if you love your job and don’t want to retire, then you would just leave your nest egg alone and live off your salary, devoting any excess to fueling your portfolio’s growth. Since you wouldn’t be touching your portfolio, there wouldn’t be anything to worry about.
There are tricks for handling healthcare expenses in retirement, but require a lot more explanation than can be done in one post. Those interested should check out:
GoCurryCracker’s “Obamacare Optimization in Early Retirement”
This is an interesting analysis on optimizing your Obamacare plan as an early retiree.
MadFIentist’s “How to Hack Your HSA”
This is an amazing post on how to use your HSA as a retirement savings plan, with an infographic as an added bonus.
There are several retirement calculators out there, but the two I use the most often are the MadFIentist’s and Vanguard’s. You have to sign up to use the MadFIentist’s calculator, but it’s free to use. Vanguard’s calculator calculates the probability of how long your retirement nest egg will last given a variety of variables.
I also made an Excel sheet (a very simple one, that is). You can download it and play around with the numbers by clicking the “Savings” link: Savings. This post on BudgetsareSexy, however, has a much better Excel sheet and a list at the end of other awesome Excel sheets for FI.
Last, but definitely not least, I highly recommend everyone read Mr. Jim Collins’ Stock Series. He discusses how to achieve FI through passive investing as well as the Four Percent Rule.
Whether you want to retire early, at 65, or go at it on your own from the start, your FI number is a good estimate to guide you on how much to save for the future.