Becoming financially independent is a topic that is recurrent on many blogs & books that you can find out there. Financial independence is basically the point in time where your passive income (more on that later) is becoming greater than your monthly expenses, which mean you don’t have to work anymore.
There are many definitions, theories & plans about how to get there, and sometimes it can all be confusing. I reached financial independence in the middle of last year, and that’s why I wanted to share what what the process I used to plan my own road to financial independence.
In this article, I will tell you what I call financial independence, what calculations you need to make, and how to come up with a plan to get there. And to finish this article, I’ll tell you why this is not the end of the journey, but really just the beginning. Let’s dive in!
Let’s start this article by defining what financial independence is exactly about. To see what definition is generally accepted, let’s have a look at the definition from Wikipedia:
“Financial independence is generally used to describe the state of having sufficient personal wealth to live, without having to work actively for basic necessities.”
It’s a great way to define financial independence, but there are two things that needs to be explained from this definition: what is ‘wealth’, and what are ‘basic necessities’.
Let’s start with wealth. For me, wealth here is your real passive income. I added ‘real’ here, because by real passive income I mean income coming from assets that you are not managing actively. I think too many people get some income from an online business for example, like selling eBooks, and believe this is passive income. Believe me, it is not. Without the right marketing, sales management, and platform this kind of income will go to zero at some point.
So by real passive income, I will refer again to a definition from Wikipedia:
I will add to this list revenues from affiliates sales on a websites, which is why I consider my Amazon affiliate sites as investments and not as a business.
Let’s now look at what ‘basic necessities’ means. Clearly, this is the most confusing point in the definition. My basic expenses are probably different from yours, and your basic expenses are also probably really different from what your expenses will be in 10 years from now.
Therefore, for the rest of this article, I will define basic necessities as your current monthly expenses now. This means that having passive income that is greater than this number will indeed grant you financial independence. It also explains why I said in the introduction that becoming financially independent is only the first step in a long road, as your most probably have more wishes in life that what you can afford right now.
Now that we defined financial independence, we are going to build a plan that will lead us there. And the first step of this plan is to define what amount of cash you need every month to cover your expenses. This is call the Target Monthly Income, or TMI.
To get this number, you first need to make the list of everything you are spending every month. This includes:
You really need to make the sum of everything you are spending at the moment. The goal is not to eliminate here, just to make the list. Once you have the number, add 10% to it. This will make sure that our TMI will be enough to cover the expenses even if they are fluctuating slightly.
Then, you also need to take taxes into account. In most countries, you will indeed get taxed on the income you are generating, including income coming from passive sources. Let’s assume that you are taxed at a rate of 30% on average. You need to divide the number you got earlier by 1-0.3 = 0.7 to get your target monthly income, this time adjusted with taxes.
Congrats, you now have your TMI, or the monthly income you need to get or to surpass to become financially independent!
In most of the books or articles about financial independence, the next step is always what is the number you need to have invested to become financially independent. However, this is often related to strategies that tells you to save for many years in low-cost index funds, and then just ‘unload’ the assets by selling them to cover monthly expenses.
This is not my vision of becoming financially independent. Here, I will really talk about how to invest for income, not just for building a big pot of cash. There are four ways that I use to invest my money:
This not an article about how to invest, but for more information about the way I use to invest my money, you can check my book called After Profits that I specially wrote on this topic.
The number you need to define at this stage however is the average yield that your investment will produce. This is the percentage of income that will be produced over a year by the money you have invested. For example, a savings account usually yields around 1%, whereas dividend-paying stocks usually yield around 5%. Once you defined the yield of the investment strategy you will take, you can move on to the next step.
Now that we have our TMI (the income number to reach every month) and the average yield of the money you will invest, we can finally define how much you need on your investment account(s) to reach financial independence.
To get this number, it’s quite easy. First, multiply your TMI by 12, which will give you the annual income you need to get from passive income to become financially independent. Then, divide this number by the yield, not forgetting that the yield is usually in %. The number you will end up with is what you will need to become financially independent.
Let’s take an example. Let’s imagine that you determined your TMI is $2000, and that you want to invest your money with a yield of 5% annually. You then need 2000 x 12 / 0.05 = $480,000. That’s a huge sum in that particular case, but this is the number that will set you free.
At this point, you now got your objective in sight: the freedom number, or the sum that will be sufficient to produce regular monthly income to cover all your basic expenses. It’s now time to see how to actually reach it.
What you need to do here is to commit to putting money into your investment account(s) every month. This, and only this will ensure that you will be on your way to financial independence. It’s very simple, but also very difficult at the same time. Indeed, money usually ends up being spent, and the most difficult part on your way to becoming financially independent is actually having a strong discipline when it comes to your finances.
For me, the plan what to set aside a given percentage of my income (now at least 40%) every month and to invest this money, before I take any of my income to pay expenses. This ensured that I was paying myself (= my investments) first, before the money could be spent on expenses.
If you followed all the steps of this article, you should be on your way to becoming financially independent. However, as I mentioned at the beginning of the article, this is just the first step. Becoming financially independent, according to the definition I used in this article, is only the first step of a quite long road.
Indeed, we only talked about basic necessities. Paying those with pure passive income is of course great, but chances are that your current lifestyle is quite far away from your dream lifestyle. When I actually reached financial independence last year, I already had my next goals defined, which correspond to my dream lifestyle I want to reach, and I am now working hard on those new goals.
So this is the next step for you once you are able to pay your basic expenses with your passive income: define your ‘dream’ TMI, or the monthly income you would need to pay everything you ever dreamed of. Then, follow the steps of this article again, and you will be on your way to your next financial goal.
Are you also on your way to financial independence? Or have you reached it already? Don’t hesitate to share your challenges in the comments below!