Financial independence is the status of having enough income or wealth sufficient to pay one's living expenses for the rest of one's life without having to be employed or dependent on others.
But, what does that mean more mathematically? And, practically?
And, specifically, how does that look different for real estate investors than investors in more traditional stocks, bonds and other asset classes?
How I Define Financial Independence
My definition of financial independence is a little different. I define it as when the following 3 major sources exceed your personal expenses:
1. Passive Income
I consider passive income to be income you receive from things like:
- Social Security
2. Net Positive Cash Flow from Rental Properties
The second source of income to be financially independent includes the net cash flow you receive after all the Operating Expenses and financing expenses on your rental properties.
3. Safe Withdrawal Rate on Other Invested Assets
The third source of income to be financially independent is a safe withdrawal rate times any other money you have invested in other assets like stocks or bonds.
Let's look at each of these sources a little closer.
There are three primary groups of passive income: social security, pensions and annuities.
Let's start with what social security is and how you earn it.
Social Security is an income benefit funded by the US government that provides a financial safety net for individuals in retirement, disability, or other life-altering circumstances. It was not really designed to be your full source of retirement income. To qualify for Social Security, you must earn Social Security credits by working and paying Social Security taxes for a predetermined number of years. The number of years required to qualify for Social Security varies depending on your age, but generally, you need to have worked for 10 years or more to be eligible for Social Security benefits.
The earliest you can collect Social Security benefits is at age 62, although the full retirement age is 67 for those born in 1960 or later. If you begin collecting benefits prior to the full retirement age, your monthly benefit amount will be reduced. The optimal time to start collecting Social Security benefits is when you reach full retirement age (67). Your benefit amount will be higher if you wait to collect benefits, and you may also receive additional benefits if you wait until you are 70 years old. If you wait until 70 to start collecting Social Security, your monthly benefit will be up to 8% higher than it would have been at 67. Additionally, delaying Social Security benefits can help to ensure a larger overall benefit amount over the course of your retirement.
Next, let's look at what pensions are and how you might qualify to have one.
A pension is a retirement plan that provides a regular income for a person after they have retired from employment. Pensions are usually provided by employers, although self-employed individuals can also set up their own pension plan. To receive a pension, you must usually have worked for the employer for a certain number of years, and have paid into the pension plan during that time. You are then eligible to receive a regular income from the pension plan in retirement. Some pensions are funded by the government, while others are funded by private employers or self-employed individuals. The amount of money you receive from a pension is usually based on the amount you paid into the plan and the length of time you were employed.
And, the last source of passive income is Annuities.
An annuity is an investment product designed to provide a stream of income during retirement. It is a contract between you and an insurance company, where you make a lump sum payment or series of payments, and the insurance company agrees to pay you a guaranteed income for the rest of your life. Annuities can be structured in a variety of ways, providing different levels of flexibility and risk. Some annuities offer guaranteed income for life, while others offer income for a fixed number of years. They can also provide income that increases over time, or provide payments that are tied to the performance of investments.
Rental Property Cash Flow
Rental property cash flow is the amount of money that you are able to earn from a rental property (what we usually call Gross Potential Income) after all related expenses have been paid. These expenses include allowing for vacancy on the property. The income after we adjust for income is called Gross Operating Income.
Plus, you need to account for all the expenses to operate the rental property business. We call these expenses Operating Expenses and they include things like property insurance, property taxes, HOA, landlord-paid utilities, maintenance, repairs, and any other related costs.
Additionally, many real estate investors will also have financing expenses on the property unless they own the property free and clear.
By investing in rental properties, you can generate a steady stream of income that can help you achieve financial independence.
Safe Withdrawal Rate
The third, and final, source of income to be financially independent is a safe withdrawal rate on any additional money you have invested in things like stocks and bonds.
A safe withdrawal rate is the amount of money you can, in theory, withdraw from your retirement savings each year without running out of money. The rate is typically determined by the expected rate of return on your investments, and your expected lifespan in retirement, but there are some common rules of thumb, the most famous being the 4% rule.
The 4% rule from the Trinity Study suggests that&emdash;based on historical stock and bond rates of return—you have a high probability of not running out of money if you withdrawal no more than 4% of the assets you have invested in stocks/bonds the first year and increase the amount to adjust for inflation each year thereafter. Some people suggest the 4% rule is too low and that you can withdrawal significantly more than 4%… some suggest in excess of 5% and others even suggest closer to 8%. Other people suggest 4% is far too high and that a more conservative 3% per year (or lower) is more prudent.
Planning to Be Financially Independent
There is a great conversation from the book Alice in Wonderland between Alice and the Cheshire cat that sums up a lot of discussions about what you should focus on to be financially independent.
“Would you tell me, please, which way I ought to go from here?”
“That depends a good deal on where you want to get to,” said the Cat.
“I don’t much care where—” said Alice.
“Then it doesn’t matter which way you go,” said the Cat.
“—so long as I get somewhere,” Alice added as an explanation.
“Oh, you’re sure to do that,” said the Cat, “if you only walk long enough.”
What should I do?
I hear the following questions frequently:
- Should I invest in stocks? Bonds? Crypto?
- Should I speculate in vacant land?
- Should I wholesale properties to get started with real estate investing?
- Should I flip properties to generate down payments to buy rentals?
- Should I sell my property? Or refinance it? Or, pay it off?
But, really the answer to these questions requires that you know what being financially independent looks like for you.
In my opinion, you need to know what you want your finances to look like when you're financially independent…
- How much do you have in passive income sources? How much from social security? Pensions? Annuities?
- How much do you have coming in from net positive cash flow from rentals? Is it free and clear rentals? How many? Is it financed properties? How many?
- How much do you have invested in stocks and bonds that you're using a safe withdrawal rate with? What safe withdrawal rate are you using?
Or, what combination of these you'd like to have; for example: a certain amount from social security, some rental cash flow and the rest in stocks/bonds using a safe withdrawal rate.
Ultimate FIRE Budget
I created a free tool you can use to do that planning easily. I call it the Ultimate FIRE Budget. FIRE stands for Financial Independence/Retire Early.
When you go through the budget yourself, realize:
- What you need to be financially independent is your ultimate destination. That's your budget.
- What you choose to invest in to get there is your path. That's your action plan.
I taught a class on What Does Financially Independent Mean? You can watch the class recording below.