Bob's $1.2 Million Nest Egg; Larry's $4K per month; How they both became Financially Independent
Have you ever heard the term financial freedom, or financial independence (FI)? This is when you have enough income to pay for your expenses for the rest of your life without having to rely on formal employment. Is this a goal of yours? Well, it is for many of my clients and they often ask two questions; #1 How do I figure my FI number? And #2 How long until I can get there?
The first step to determining your FI number is to figure out your expenses. Most traditional advice I read tells people to use their annual expenses. I tend to advise looking at your expenses on a monthly basis, since this is how most bills are paid. However, either way works.
Let’s take a look at the story of the twins, Bob and Larry. Both have annual expenses of $48,000 or $4,000 per month. [Remember to add everything in expenses, especially things that you may not necessarily pay for now but would need to account for if you stopped working (health/dental/life insurance, etc.)]. Bob uses the traditional method of pursuing FI, while Larry follows the Ignite My Money philosophy. Let’s look at the numbers.
Traditional advice states to take your annual expenses and divide it by .04 to determine your FI number, so that’s what Bob does. Based on the math, he determines his FI number to be $1.2 million. The reason Bob uses .04 is because the traditional method advises withdrawing 4% from your “nest egg” each year in retirement. So in this example, Bob would withdraw 4% or $48,000 from his account each year to cover his expenses. Therefore, once Bob hits $1.2 million, he would be financially independent.
Anyone see the problem with this? There are actually a few concerns.
1. The term “withdraw” implies that Bob has put his money into some kind of retirement account like a 401(k) or an IRA. This means that Bob can’t touch this money until age 59 ½, so that is the earliest he can be financially free.
2. Most articles advise using the traditional 4% withdrawal rate, however they warn that the money may run out after 30 years. So if Bob lives past 89, he could be in trouble. With modern medicine and increasing life expectancy, I think most of us plan on living past this age.
3. How long will it even take for Bob to save up $1.2 million? Most people would find this number to be very daunting, especially since the average 65 year old has $182,000 in their retirement accounts, but let’s play along.
Assume Bob earns an $80,000 salary, and after taxes brings home $60,000. His expenses are $48,000 so he is able to invest $12,000 per year toward his FI number. That means, at a 6% annual rate of return, it will take Bob roughly 34 years to reach his FI number of $1.2 million! Bob would have invested $408,000 ($12,000 x 34) of his own money to get to that number.
Now let’s take a look at Larry, who used an alternative approach to become financially independent much quicker and for much less money invested? Remember, Larry has the same $48,000 per year in expenses. But rather than looking at such a large, intimidating number like $1.2 million, Larry decides to focus on creating the $4,000 per month to cover his expenses. Here is his strategy.
Larry decides to invest his extra $12,000 per year into cash flowing real estate. He has done his research and knows that he can buy a single family home in the Midwest for $60,000, rent it out, and clear about $200/mo. profit after all his expenses including property management, vacancy, repairs, etc. So Larry takes his $12,000 and uses it as a 20% down payment toward his first investment property. He continues to invest his $12,000 each year going forward, and because he doesn’t need the extra income yet, he also invests his profits too!
What are the results? Larry achieves financial independence in just 9 years! He owns 20 properties valued at ~$1.2 million, and they generate annual cash flow of ~$50,000! Besides only having to wait 9 years to reach his FI number, Larry also only had to invest $108,000 of his own money ($12,000 x 9).
· Although Bob and Larry had the exact same FI number, Larry reached it 25 years earlier!
· While Bob had to invest $408,000 of his own money to achieve financial freedom, Larry only invested $108,000 of his money, saving $300K!
· Larry’s money was available to him at any age, and not trapped in a retirement account
· 9 years into his Financial Independence journey, Larry has become “job optional”
· Larry’s tenants are paying off his mortgages and making him financially independent
So now that you know there is more than 1 way to achieve financial independence, we encourage you to take the following steps:
1. Determine your FI number
2. Create a plan to get there
3. Go do it!
You may be closer than you think!