Financial independence is generally used to describe the state of having sufficient personal wealth to live, without having to work actively for basic necessities. For financially independent people, their assets generate income that is greater than their expenses. For example, a person's quarterly expenses may total $4,000. They receive dividends from stocks they have previously purchased totaling $5,000 quarterly, while also having more money in other assets. Under these circumstances, a person is financially independent. A person's assets and liabilities are an important factor in determining if they have achieved financial independence. An asset is anything of value that can be liquidated if a person has debt, whereas a liability is related to debt, in that it is the responsibility of one possessing it to provide compensation. (Homes and automobiles with no liens or mortgages are common assets.)
It does not matter how old or young someone is or how much money they have or make. If they can generate enough money to meet their needs from sources other than their primary occupation, then they have achieved financial independence. Age is potentially irrelevant with respect to financial independence. If they are 25 years old and their expenses are only $100 per month and they have assets that generate $101 or more per month, they have achieved financial independence, and they are now free to do things that they enjoy without having to worry as much. If, on the other hand, they are 50 years old and earn a million dollars a month but still have expenses above a million dollars a month, then they are not financially independent because they still have to generate the difference each month just to stay even. However, this needs to take into consideration the effects of inflation. If a person needs $100/month for living expenses today, that figure will be $105/month next year and $110.25/month in the following year to support the same lifestyle assuming a 5% annual inflation rate. Therefore, if the person in the above example obtains their passive income from a perpetuity, there will be a time when they lose their financial independence because of inflation.
Approaches to Financial Independence
Since there are two sides to the assets and expenses equation, there are two main directions one can focus their energy: accumulating assets or reducing their expenses.
Accumulating assets can focus one or both of these approaches:
- Gather revenue generating assets until the generated revenue surpasses living/liability expenses.
- Gather enough liquid assets to then sustain all future living/liability expenses
Another approach to financial independence is to reduce regular expenses while accumulating assets, to reduce the amount of assets required for financial independence. This can be done by focusing on simple living, or other strategies to reduce expenses.
A general calculation for the time required to reach financial independence is as follows:
The withdrawal rate is the rate at which the individual starts withdrawing capital from his net worth to pay for his yearly expenses (which have to remain constant with this formula) once financial independence is reached. It is directly linked to the number of years the individual can be free of having to earn an income: at 4% a year, an individual can pay for its yearly expenses 1/4% = 25 years only by drawing from its net worth.
An example of someone making $30k/year, with yearly expenses of $10k, paying 25% taxes, with a savings rate of 75%, a net worth of $5k, and withdrawing 4% per year:
Passive sources of income to achieve financial independence
The following is a non-exhaustive list of sources of passive income which potentially yields financial independence.
- Rental property
- Dividend from stocks, bonds and income trusts
- Bank fixed deposits and monthly income schemes
- Royalty from creative works, e.g. photographs, books, patents, music, etc.
- Alimony, Child Support or Child Trust Fund
- Renting out professional or academic qualifications
- Interest earned from deposit accounts, money market accounts or loans
- Oil leases
- Business ownership
- Patent licensing
- Trust deed (real estate)
- Life annuity
- Affiliate marketing
- Cummuta, John. "The Myths & Realities of Achieving Financial Independence". Nightingale Conant. Retrieved on 14-Sep-2009
- Early Retirement Extreme: A philosophical and practical guide to financial independence.
- Your Money Or Your Life: 9 Steps to Transforming Your Relationship With Money And Achieving Financial Independence.
- "What is Passive Income?". Investor Monkey. Retrieved 4 July 2013.
- CCIE Pursuit. "Rent Your Cisco Certification For Cash" Retrieved on 14-Sep-2009
- Vicki Robin and Joe Dominguez (1992) Your Money or Your Life, Viking. Your Money or Your Life: Revised and Updated for the 21st Century, published by Penguin Books in December 2008 by Vicki Robin with Monique Tilford and contributor Mark Zaifman.
- Jacob Lund Fisker (2010) Early Retirement Extreme: A philosophical and practical guide to financial independence, ISBN 978-1453601211