When something aggravates you at work, wouldn’t you like to be able to walk into your boss’s office and quit with no ramifications? That is the dream of financial independence – when a person has saved enough that he can meet all the needs of daily living through investment income alone. A whole industry has sprung up around the idea, with authors, talk-show hosts, and the like extolling the virtues of living on invested money. But is this really an achievable goal for most people?
I put together a simple model, available at Google Docs (sheets 1 and 2 are filled). Assuming a 10% annual savings growth rate, if an individual earning $100,000 per year pays 33% in taxes, saves 33%, and lives in the last 34%, they can achieve financial independence in 17 years. I have assumed that financial independence is achieved when 5% of total savings equals the individual’s current after-tax income. Since investment income is taxed at a much lower rate than earned income, this will provide a standard of living close to that achievable by working full time and simply spending everything. These numbers don’t take into account the tremendous benefits that 401k’s and IRAs can add to the savings picture, which might shave a year or two off of the time required.
If seventeen years too long to wait? Perhaps, but someone starting at 25 and saving diligently would be rewarded with freedom for life after 42. Are these savings rates unachievable? They’re actually close to the norm in countries like Japan.
Taking a more extreme case, what if you make $200,000 a year and can thus afford to save 50% of your income? Saving at that rate enables financial independence in 13 or 14 years. Of course, this means you have to live on 1/6th of your income, since the government takes a third. Our 25 year old big earner could expect to have a retirement party before 40 at that rate.
None of these calculations take into account the further complexities and expenses of life, like educational debt, buying a house, children, and more. But these calculations also explicitly leave out earnings increases, thus leaving our saver’s salary increases free for all of these expenses. As long as he puts away 33k per year, he’ll make it to freedom on schedule.
Most people in the US (and the world) don’t make $100,000 per year, so for many this goal may be out of reach. But for those who do, discipline in spending can enable a much greater reward than the latest consumer gadget – the freedom to pursue whatever dreams the day job just doesn’t satisfy.
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Jorge,
I took a look at you graph, nice work. I think the difference between my calculations and yours are that I use a more aggressive rate of return on investments (10%), I assume that one can retire on 80% of current income (lower taxes on passive income offset most of the drop), and I assume that 5% of savings is a sustainable draw rate.
Given the economic crisis and market crash, many people would object to my 10% rate of return on investments. But if I wrote this article in the early 80’s, people would back and say I underestimated by 5-6% ! And I imagine that anyone who starts investing today will see a 20 year avg. return of 10% or higher, unless the world ends, in which case it doesn’t matter. Then again, a lot of people seem to think the world is ending right now…
At any rate, the crash has proved an impediment for any who want to be financially independent, but we take it in stride, and if you look at the long run, it’s hopefully no more than a couple year setback!
This is a good post and I’ll have to check out your spreadsheet. I developed a rudimentary spreadsheet myself and posted the graph. A picture is worth a thousand words and this case is no different.
If you want any hope of every achieving Financial Independence, then you better be saving north of 15% every year! Check it out at:
http://independentminded.org
Enjoy and happy savings!
Good points – I should have said I am assuming that all savings are invested 100% in stocks, which have a long term (200+ year) growth rate of just above 10%.
Inflation in the US hasn’t been a concern in the last two decades until very recently, though it is beginning to rise now. But I also feel that inflation is overstated to an extent, as in rich countries we spend a small percentage of our income on inflation-sensitive goods (energy, food, etc).
Particularly for hi-tech goods, inflation is overstated as the products are getting ever better, while prices remain the same. That’s actually deflationary.
Hmm.. Well 10% savings rate within US is hard to come by. Isn’t it? You can perhaps compensate for low interest rates by diversifying, bit in risk-less investment, and bit in shares etc.
Also you might want to account for the inflation. When I take inflation to be 3% exponential growth (which is close to US average), a person earning 100K a year would need 22 years, instead of 17.