What does financial independence look like?
Financial independence is the freedom to maintain your lifestyle without outside income. It’s the end of reliance on other people’s money. The idea of financial independence is more appealing than the work it takes to achieve it. Financial independence isn’t about how big a salary you have – it’s about what you do with it.
The easiest way to gain financial independence is to start early. Start saving, start investing, start looking for passive income streams. The younger you are when you start thinking about your financial freedom, the easier it is to attain. Financial habits become ingrained.
You can be the person who maxes out their 401K contribution from day one on the job. Or you can be the guy who decides to wait and get a bigger paycheck. The person who needs the bigger paycheck now will always find a reason to need it. Like saving, spending becomes a habit.
Where is your money going?
When you think about your salary, do you ever wonder where it’s going? Do you know what your monthly bills are? How about your debt – credit cards, car loans? If you’re paying a mortgage you are building equity. If you’re paying a car loan, you’re putting money into a depreciating asset.
Most people use plastic – credit or debit – pay for day to day expenses. It’s so much easier to swipe than to carry cash in your wallet. When you swipe, it almost doesn’t feel like money. A latte here, a lunch there, and another pair of Nikes – you’d be surprised how fast it adds up.
Take a look at your bank statement and add up the coffee charges for three months. Or the restaurant lunches or the apparel you like. Everyone has spending habits – look at what yours are costing you.
If you want to govern your habits, no matter what your age, this simple rule will help clarify your financial priorities. The idea is 50% of your after-tax income goes for necessities – housing, food, transportation utilities. Thirty percent is spent on things you want.
The remaining 20% goes to savings and/or paying off debt. If you have tons of debt, there isn’t much for savings. Try to avoid debt, especially credit cards.
It’s a reasonable way to manage your money. But when you’re considering financial independence, we’d suggest a tweak. Flip the amounts for wants and savings. Apply 20% of your income for wants and save the 30%.
Let’s say your annual after-tax income is $45,000. That puts your monthly income at $3750. Here’s what your 50/30/20 looks like: $1,875 for necessities, $1125 for wants, and $750 for savings/debt.
If your necessities are above $1875, you’re living above your income. If that’s the case, look at where you can downsize. If you’re dependent on salary alone – the situation will become dire fast if your paycheck goes away.
Now, what happens if we put our 20% into a high-interest savings account for 5 years. We open the account with $750 and put in $750 every month. In 5 years, the account will be worth $46,951.16 with an annual interest of 1.00%. But when we swap the 20% for the 30% with the same parameters, your total is $70,426.74. That’s roughly an extra $14, 000.
It takes tremendous discipline to pump that much money every month into savings. There will be months where something comes up. The more you can automate the transfer of funds, the easier it is. If you run into an emergency, you can withdraw money without any penalty. It’s a savings account, so it’s liquid.
If you can put your money in and leave it, it’s a nice supplement to any other investments you might make. It’s not subject to market volatility in the event of a stock or treasury downturn.
You can play with the calculator on Nerd Wallet to see the results for your numbers.
Financial Present vs Financial Future
Unless you’re interested in economics, it’s hard to visualize the financial future. Right now, you’re working, you’re healthy, you’ve a good salary, and you need stuff. Or at least you want stuff. Knowing the difference between what you need and what you want affects your net worth.
Net worth is pretty simple. You subtract your liabilities from your assets and whatever’s left is what you’re worth. How does that play into your financial future? The more liabilities you carry, the less you have to save or invest. A negative net worth means you’re underwater. Unless you get yourself straightened out, you’re probably headed to bankruptcy court.
Your net worth may not affect your credit score. It does affect your creditworthiness. If you have too many liabilities – credit card debt, high-interest loans – you may not be able to get credit when you need it.
First Thing to Do
We recommend you cut back on buying stuff – especially on credit. Do you need the new iPhone? Is that 60” HD TV a necessity? If you can make do with your current phone and watch your 50” TV, it’s money you can put toward your future.
The discipline required to controlling spending is similar to managing your weight. The approach has to be practical or it won’t stand. If you can NEVER buy stuff you want, it’s like never having a burger again. Ever. It’s not practical. But there are things you can do to slow yourself down.
Give yourself a bi-monthly an allowance. Carry that amount of money in your wallet. When it’s gone, it’s gone. If nothing else, it will make you pay attention to what you’re spending. You may find you spend less with cash than you do with a card.
If that’s the case – you have two choices. Reduce your allowance or save the difference for a bigger ticket item. But whatever you do, be consistent. Your money should always have a purpose.
If you decide to save to buy something, you need to put that money away every time. That will reduce your allowance, so think it through. Of course, the third option is to funnel that extra cash into your savings account.
Passive income is the money that’s made without labor or wages. You can create an investment portfolio with stocks and treasuries. Putting money into a Real Estate Investment Trust is a good choice too. You benefit from owning real assets without having to spend time being a landlord. There’s a whole list of options in this article.
How to Build Financial Freedom
Creating financial independence is a balancing act. You need to manage the money you’ve got while finding ways to make more. According to financial adviser Dave Ramsey, the goal is to save 15% of your income.
1. Open your account
Get your high yield savings account opened right now. Here’s a list of some of the best in 2020.
2. Max your 401k
If you’re not putting in the maximum contribution, change that now.
3. No 401k?
Over a third of Americans have no 401k offered by their employer. There are any number of alternatives to choose from if your job doesn’t offer a 401k. Consider these long-term investments. They aren’t liquid and if you pull money out, there may be a penalty and a tax.
Traditional IRA: This individual Retirement Account provides tax benefits upfront. You can deduct your contributions as you make them. When you take your money out after retirement, it’s taxed as income. That may or may not be an issue, but it’s assuming your tax rate will be lower as you age.
Roth IRA: This IRA does not provide tax breaks upfront, it offers them on withdrawals. If you’ve had your account 5 years, at 59 1/2 your withdrawals are tax-free. Depending on your tax rate in retirement, this is a big plus. If you’re married, both partners have their own IRA under the spousal IRA. A family can double their savings. There are income limits to qualify for a Roth IRA: $124,000 if you’re single, $196,000 if you’re married.
(*Contributions for both IRAs are limited to $6,000 – $7000 per year.)
Sole-Participant 401K: Self-employed workers can create their own 401ks. Contributions are tax-deductible, with a maximum contribution of $19,000 a year. That goes up to $26,000 if you’re over 50.
SEP IRA: SEP stands for Simplified Employee Pension. It is a retirement plan for the self-employed. It also helps small business owners provide retirement options for their employees. It works the same way as a traditional IRA but allows contributions from an employer. SEP plans are easier for small business owners to set up and employees are vested immediately.
Even if you have a 401k, consider a Roth IRA, especially if you’re married. If you qualify, a Roth IRA will deliver on financial independence. If both of you open Roth IRAs, you double your retirement income. Fund them at $500 a month for ten years, at 6% annual interest, the 2 accounts total $158,000. That’s tax-free money for qualified withdrawals.
4. Build A Passive Income Stream
Passive income is the money that’s made without labor or wages. It involves investing in stocks or commodities. Putting money into a Real Estate Investment Trust is a good choice too. You benefit from owning real assets without having to spend time being a landlord. There’s a whole list of options in this article.
5. Cut back on car loans
Car loans are a detriment to financial independence. The interest rates tend to be high and the term long. The average cost of a new car today is over $37,000. If you can avoid having a car note, take it. Yes, that means you’ll be driving an older car. See if you can pick one up from a family member or friend.
If that’s not an option, you need to rethink how you approach choosing a car. The value of a new car drops around 30% the minute you drive it off the lot. That car with the 60-month term loan, averaging 5.27% interest (more if your credit score is low.)
Don’t get suckered buying a car. And don’t buy more car than you need. Buy used and pay a mechanic to check it out. Go as cheap as you can and still have reliable transportation.
6. Work for a raise
The idea of work ethic often gets lost in financial conversations. But when you work hard at the job you have, you’re creating a career path. Going above and beyond at work gets you noticed. If it doesn’t, make note and make connections. Don’t burn bridges – build your reputation. But take the next step.
7. Sell your expertise
You may be surprised how much money you can make selling your skills. There are all kinds of opportunities out there. Create eCourses on topics ranging from fly fishing to proper prenatal care. Classes are an ongoing income stream. Create the course and put it out there. If you’re active on social media, use your accounts to market it.
If you sell a course for $75, and 100 people buy it – $7500. eBooks are less profitable but still can supplement your income. Offer them at a discount for people who take your course. You could create a workbook that complements your topic. The more you put your name out there, the more interest you can build.
Another option is to create tangible products. Look at your hobbies as well as your career. Create an app or game. Sell fishing lures or jewelry or quilts. You can easily create an Amazon store or check out Etsy. If your idea is unique, you may want to get a patent or trademark for your invention.
8. Save more, spend less
This is the true driver behind financial independence. Control the instant gratification you feel from shopping and spending. Teach yourself to save first and you put yourself on the path to financial freedom.
It’s hard to imagine the relief you feel when you realize your financial well being is set. When you diversify your investments – stocks, bond, real estate – there’s less volatility to manage. Make sure you have a mix of long-term assets and liquid assets.
Your high yield saving account has no penalties for withdrawal. It protects your IRA or 401K from early withdrawal penalties. Building a passive income stream makes you less dependent on salary. Every action you take reduces your financial dependence on other people.
The goal is financial freedom. You can get there. Start now.
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