Start Early, Save Plenty
The goal isn’t wealth, and nor is it a focus on spending money or having money for its own sake. The goals are time abundance and personal freedom and choice. Financial Independence (FI) provides flexibility and offers the opportunity to explore, find adventure, and enjoy experiences while still young. Three simple steps (from JL Collins): “Spend less than you earn, invest the surplus [in a low expense ratio stock index fund] , and avoid debt.”
By the Numbers
- 4% Rule (or Rule of 25): Save at least 25 times your annual expenses to reach FI, and then spend 4% of savings per year. Compounding growth should stay ahead of your spending for the rest of your life, no matter how long you live.
- Save at least 50% of your income, if you can.
- A married couple filing jointly can make >$100k per year in passive capital gains and qualified dividends from stocks and pay 0% federal tax! Earned income is penalized.
FI Primers (to learn more)
- Mad Fientist: https://www.madfientist.com/optimize-your-journey-to-fi/
- Choose FI: https://www.choosefi.com/start-page/
(For all investments: use a total US stock market low expense ratio fund (or S&P 500 if total not available), like from Vanguard. To diversify, you can add a total US bond market index fund, and/or an international stock index fund. Historically the US stock market has provided the best returns.)
- Enjoy your career and build your reputation, experience, and knowledge.
- Advocate for yourself, including asking for proper pay and insisting on a work-life balance.
- Fund a 401(k) (or equivalent) to its maximum during employment if possible.
- At least save enough to get employer matching (if any) to the max.
- Fund a traditional IRA beyond that if possible (up to the deductible amount) if you’re in a higher tax bracket, or a Roth if in a lower tax bracket (like 10 or 12%).
- Instead of one of the big national banks, leverage a credit union if possible or an online bank for the best checking and savings rates and terms.
- Save some money in a taxable account — preferably for a total savings rate of at least 50%.
- Keep 1-2 months worth of emergency funds in money market in an insured bank (emergencies include losing one’s job for an extended period).
- Maintain 2-4 more months in a money market fund or a tax-free municipal bond fund (you can alternatively, depending on risk tolerance, keep this in a stock index fund).
- Save the rest in a total US stock market low expense ratio fund.
- Pay in full for everything (no debt), perhaps except for a house.
- If you buy a house, pick a cheaper house in an improving neighborhood for growth potential.
- As your salary and income increase, try to not allow for lifestyle creep — see if you can continue to live the same as before.
- Save at least 25 times your annual expenses. This total is across all accounts, whether tax-advantaged or taxable (so includes retirement accounts).
- Once you’ve reached that number, you’ve achieved financial independence. Many people have done this in only 10-15 years after college! How long it takes to reach this goal depends on your annual expenses, annual income, and savings rate, along with stock market performance.
- You can now do what you want, and you can call it “early retirement” if you want — you’re totally free to do what you love.
- You can withdraw and spend up to 4% of your starting point savings each year and never run out for the rest of your life, no matter how long you live. You can maybe even pull out more, especially if you’re still earning other income, though if you’re still earning income you could pull out even less presumably. For example, if you need $40,000 per year for expenses in the first year of FI, your FI number is $1 million. You can slightly increase the withdrawal each year to account for inflation.
Once you’ve reached financial independence or freedom, follow the additional steps below.
- Do what you love and what gives you a sense of purpose in life.
- Spend time with family and friends.
- Consider geoarbitrage to minimize costs (which may also allow for being able to survive on 3% or less of annual withdrawals of the original amount). For example, there are several income tax-free states in the US. Or, many countries have high standards of living while being much more affordable than the US (e.g., Portugal, Czechia, Costa Rica). Plus, consider health care costs alone — these are MUCH cheaper in every country outside the US (you can even buy international health insurance that covers everywhere except the US). And if you are in a foreign country for most of a year you may qualify for the Foreign Earned Income Exclusion (FEIE).
- Roll over your 401(k) directly to a traditional IRA (there’s no penalty or taxes here).
- Roth IRA Ladder: Each year convert a portion of your traditional IRA to a Roth IRA — 5 years after each conversion it’s considered to be a contribution which can then be taken out penalty and tax free. Note that the portion should preferably be under the first tax bracket (standard deduction) and thus not taxable. With this technique you are getting both the original money and all growth completely tax-free! (Warning: the government may close this “loophole” at any time.)
- Capital gains/losses harvesting: Each year sell and then re-buy a portion of taxable funds (capital gains are 0% taxed up to the 12% tax bracket (second bracket), so up to that bracket max), for long-term gains only (so what you sell you should have owned for at least 1 year). This ups the cost basis over time, allowing for little or no tax when taken out to put into your pocket, and also allows for a higher likelihood of a loss later on that can be used to offset some taxes (up to $3k). You can also buy less than sold so as to use some if/as needed. The US government incentivizes (perhaps unintentionally) a life of leisure instead of working — e.g., a couple filing jointly can make up to over $100,000/year in capital gains and dividends (no wages) and pay $0 in federal tax!
- Teach your family members these principles for their welfare.
- As you age, watch your savings — it may be possible to begin withdrawing more and gifting to charities and/or to family members.
- Consider creating a charitable foundation — it’s actually fairly straightforward on Vanguard. You can use this account to give to charities, and it can be funded tax-free and avoids capital gains taxes.