Winning your financial independence
(MoneyWatch) Time to break out the sunscreen and fire up the barbecue because July 4 is just around the corner. Celebrating our nation's achieving its independence got me to thinking that it might also be a good time to assess your own independence -- financial independence, that is, and maybe even change your strategy for achieving it.
Financial independence means different things to different people, but most see it as achieving the security and the freedom to do whatever they want with their lives.
I personally view money as stored energy that powers our ability to pursue happiness. To assess how much stored energy you have toward financial independence, use this simple calculation.
Wealth in years = net worth / annual expenditures
Using this measure, a millionaire worth $2 million who leads an extravagant lifestyle costing $1 million a year has only two years of financial independence. In contrast, a person worth $150,000 who needs only $6,000 a year to supplement Social Security has 25 years of financial independence. This person might never need to work again. Unfortunately, the same cannot be said for the millionaire.
Though we would naturally expect our portfolios to grow, we may not also count on our expenditures to grow, as inflation and taxes eat away at gains. It would, in fact, be reasonable to assume that after-tax growth in net worth might keep up only with inflation.
There may be a tendency to think that the millionaire would be happier leading that extravagant lifestyle, yet research shows he might be only marginally happier. The big house and luxury car would bring only short-term happiness and would be followed by the anxiety of running out of money to support that lifestyle.
How to achieve your freedom
The implications of the measure above for building wealth are enormous. The two ways to build wealth are to earn more or spend less, or do both.
Earning more is always good, yet it actually has a far lower impact on our freedom than spending less. And it does because earning more means giving some away in taxes, combined with the fact that you hopefully won't work forever. On the other hand, spending less has a much larger impact, as the government doesn't tax savings and we can still spend less in retirement.
Let's take the simple example of a 50-year-old woman who can make $10,000 a year more and will retire in 15 years. That translates to $150,000, but if a third goes to taxes she is left only with an additional $100,000. On the other hand, if she spends $10,000 a year less and has a 33 year life expectancy, that translates to $330,000 in savings.
So how much money you need to live on is a far greater factor in determining where you are relative to your financial independence. Say you get to Social Security age and have saved up $250,000. Depending on how much you need each year to live on to supplement your Social Security, the amount of time your wealth can sustain your lifestyle could vary wildly from a couple of years to the rest of your life.
Spending less today has a double whammy effect: It increases the amount of your savings as you approach financial independence, and decreases the amount of the portfolio you will need to spend each year. Both build wealth faster than you might imagine. Research demonstrates that living more frugally is actually much easier to get accustomed to than we think it is.
Achieve your independence
Though the Fourth of July is a time to celebrate America's freedom and independence, you can also use it as a day to reflect on your own freedom and financial independence. Once you achieve the latter, you are free to be large and in charge of the rest of your life. Do whatever brings you happiness, and don't let anyone tell you what that should be.