In the world of financial advice, we spend most of our time talking about investments, taxes, insurance, etc. These are good things and there is a lot of value in fine-tuning these variables, but sometimes I think we miss the pillar that all of this is built on: saving money.
You can earn the highest investment returns, pay minimal taxes, live a life of luxury, and still be on the verge of bankruptcy. If you spend more money than you make each year then you’ll never be able to stop working.
What is financial independence? Financial independence happens when your investments are earning enough each year to cover your living expenses. You could say that financial independence means work is optional.
There is a direct relationship between your savings rate and the time it’ll take you to become financially independent. Increasing your savings rate has a double impact on your ability to stop working.
First, to state the obvious, increasing your savings rate means that you’re saving more money. All else equal, by saving more money, you will reach your goal faster than if you were saving less money.
But more importantly, increasing your savings rate means you are spending less. If your living expenses are lower, you need less money saved in order to cover them.
Just what you want to hear, right? Another financial advisor telling you to save more money. But I’m not advocating for extreme frugality. If your goal is to achieve financial independence at any age, there will need to be a gap between your income and expenses and the greater that gap is, the sooner you’ll be able to be free.
How much do I need to become financially independent? The general rule is that you need to have saved 25 times your annual living expenses to retire. That number has worked out historically but is going to vary based on your individual circumstances. Nevertheless, it’s a good guide to start from.
So how much do you need to be saving each year in order to stop working someday? The table below shows the years it will take to reach financial independence by savings rate (annual savings / pre-tax income) and annual investment return if you’re starting from scratch.
Years to Financial Independence Investment returns are inflation-adjusted. Living expenses are assumed to be 1 – savings rate and are held constant. The future value target for financial independence is 25 times living expenses. Savings rate is annual saving / pre-tax income. How do I make progress towards financial independence? If you want to fast-track your path to financial independence, you have two levers to pull: 1) increase your investment returns, or 2) increase your savings rate.
Investment returns are unpredictable and very hard to influence after you’ve covered the basics. On the other hand, your savings rate is something that is much easier to control.
3 tips to increase your savings rate: Track your expenses. Be intentional about what you’re spending money on. Increase your income. Investing in yourself can be far more valuable than investing in the market. Pay yourself first. When you get an increase in pay, allocate more of that raise towards extra saving rather than extra spending. Achieving financial independence can seem like a daunting task when you have decades to go, but taking small steps in the right direction today will have a compounding effect in the future.
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