How to Calculate Your Financial Independence Number

Takeaways

• Understanding how to calculate your Financial Independence (FI) number is a crucial step in planning for an early retirement.
• Your FI number represents the total amount of savings required to cover your living expenses without needing to work.
• Factors such as annual expenses, investment returns, and inflation significantly influence your FI number.

What is a Financial Independence Number?

Your Financial Independence (FI) number is the amount of money you need in savings and investments to sustain your lifestyle without relying on work income. Reaching this number means you can retire (or pursue other passions) with minimal financial stress.

Knowing your FI number is the first step toward achieving financial independence and early retirement.

What Factors Contribute to Your Financial Independence Number?

While you could base your FI number solely on your annual expenses, a more accurate approach requires you to consider several key factors:

• Annual Living Expenses: This is the cornerstone of your FI calculation, including all essential and non-essential costs like housing, food, entertainment, and travel. To better understand this number, check out our guide on how to create a budget for retirement.
• Savings Rate: The percentage of your income you save and invest. A higher savings rate accelerates your journey to financial independence.
• Expected Investment Returns: The average annual return expected from your investments, including stocks, bonds, and real estate, which significantly impacts the compounding of your wealth over time.
• Inflation Rate: The anticipated annual increase in the cost of living, which decreases your money's purchasing power over time.
• Retirement Timeline: The number of years you plan to live off your savings. The longer the timeline, the larger your FI number. Knowing this number is especially important if you're planning to retire early.
• Withdrawal Rate: The percentage of your nest egg you plan to withdraw annually to fund your lifestyle.

How to Calculate Your Financial Independence Number

There are various methods to calculate your FI number, but we'll focus on two common approaches:

The Simple Way

The most straightforward method involves just two steps:

1. Estimate Your Annual Expenses: Include housing costs, utilities, groceries, insurance, transportation, and discretionary spending. Use your current expenses or adjust for retirement based on the lifestyle changes you expect.
2. Apply the 25x Rule: Multiply your estimated annual expenses by 25. This rule assumes a 4% annual withdrawal rate, which should sustain you for 30 years or more (although there are no guarantees). For instance, if your annual expenses are $40,000, your FI number would be $1 million ($40,000 x 25).

The Complex Way

Beyond just expenses, various market factors like inflation and investment returns affect your FI number. A popular strategy is to determine a range of FI numbers based on different scenarios that contain variations of all of the variables we listed above.

For a quick way to test various scenarios, use the Financial Independence Calculator on our site.

The 4% Rule

The 4% Rule is a widely recognized guideline in early retirement planning. Once again, it suggests that withdrawing 4% of your retirement savings annually should give enough funds for your retirement to last 30 years or more. This rule is based on historical data from a balanced investment portfolio of stocks and bonds.

However, the 4% Rule has limitations. Some experts recommend a more conservative withdrawal rate (e.g., 3.5%) for safety, especially in low-interest-rate environments or if you anticipate a longer retirement. You should consult a financial advisor to determine the withdrawal rate that’s right for you.

How Can You Reach Financial Independence?

Now that you know how to calculate your financial independence number, how do you reach it? Unfortunately, there's no silver bullet. It requires discipline in saving, investing, and managing expenses. Here are some strategies:

• Reduce Expenses: Lowering your annual costs offers two benefits: freeing up more money for saving/investing and reducing the FI number you need to reach. Consider downsizing, reducing debt, or embracing a minimalist lifestyle. Implementing a 50/30/20 budget is a good place to start.
• Increase Your Savings Rate: Don’t stop at reducing expenses—put that money to work. Maximize the percentage of your income saved and invested to benefit from compounding interest.
• Invest Wisely: Focus on a diversified portfolio that matches your risk tolerance and financial goals. Regularly review your investments to ensure they align with your retirement timeline.
• Tax-Advantaged Accounts: Maximize the benefits of tax-advantaged accounts like a Roth IRA. If you’re a high earner, consider a Backdoor Roth IRA to bypass income limits and secure tax-free growth.
• Focus on Income Growth: Explore ways to boost your income through side hustles, career advancement, or passive income streams, such as real estate or dividend-paying stocks. The more money you earn, the more you can allocate toward your future.

By understanding the factors that influence your FI number and implementing disciplined strategies to reach it, you can take control of your financial future. Remember, achieving financial independence requires patience, planning, and consistent effort, but the rewards of financial security and freedom are well worth it.