“It must be borne in mind that the tragedy of life doesn’t lie in not reaching your goal. The tragedy lies in having no goals to reach.” —Benjamin E. Mays
My overarching passion in life is to teach others how to use financial independence to combat the physician wellness problem that exists in our country. Whether you feel you are burned out or morally injured, financial independence helps doctors practice medicine on their terms.
What is Financial Independence?
In philosophy, few things are more important than defining our terms. The reason definitions are so important is that entire conversations can be held in agreement (or disagreement) because we have not properly defined a word in the discussion.
One of the most important terms in the personal finance space is the phrase “financial independence.”
While everyone agrees that financial independence is the number at which you are independent of a paycheck, and no longer need to work a normal job… there are two different schools of thought when defining the math behind financial independence.
Let’s discuss each school of thought. Then, we will discuss how to combine the two models to give a real-life definition of financial independence.
1. Financial Independence via The 25-X / 4% Rule Model
One of the ways the personal finance community determines your financial independence number is the following two-step process:
- Determine your anticipated annual spending in retirement (yes, this means you have to track spending).
- Multiply the above number by 25
The number that results is your financial independence number. For example, if you determined that – once all of your debt is gone – you will require $100,000 each year in retirement, then your number is $100,000 x 25 = $2,500,000.
The reason that this math works out is because of something called “The 4% Rule.” This rule is based on the Trinity Study, which showed that you can spend 4% of your nest egg and remain relatively reassured that your funds would last 30 years (95-100% chance based on a 50% stock / 50% bond portfolio).
The corollary to The 4% Rule is the 25X rule. You need $100,000 in retirement? That’s $2.5 million total saved. What’s 4% of $2.5 million? You guessed it, $100,000 per year to spend.
This is not the only way to define financial independence, though, and leaving it here has gotten many bloggers in trouble who still earn income from their blogs!
Note: The above 4% safe withdrawal rate assumes a 30 year time horizon for retirement spending. If you need more – say, 40-45 years – a lower safe withdrawal rate will likely be required. Similarly, this means you’d need more money to retire early.
2. Financial Independence via Passive Income
More and more doctors are pursuing side hustles as a way to get to financial independence. Examples include real estate syndications, active real estate, online entrepreneurship, and even work as advisors and consultants.
For example, some of my income streams have included The Physician Philosopher, my book (The Physician Philosopher’s Guide to Personal Finance), a medical invention, and prior medical expert witness work.
The higher your non-clinical income, the less money you require from your paycheck. And the more passive, the better.
The reason to point out is that this can help to understand the second model of financial independence via passive income, which I’ll define as the following:
Financial Independence is the point at which your monthly passive income streams equal your monthly spending.
The concept is simple, yet important.
If you have enough money coming in to cover your monthly spending, then you have reached a point where you are no longer dependent on earning a paycheck. Hello, financial independence!
This is an alternative way to define financial independence.
A classic example here is real estate. If you have enough passive income coming from rental properties that you own – or deals you are involved in – to cover your monthly spending, then you are financially independent.
The Hybrid Model
Some argue over which of the two models above carries the most weight. The debate between the two models proves to be a false dichotomy. In this debate, I think we can have our cake and eat it, too.
Let’s look at an example. Using the same number we gave in the first model: $100,000 annual spending. The traditional 25X model would require us to grow a nest egg of $2,500,000.
Well, if our passive income amounts to $30,000 in annual income, then what remains ($70,000 in annual spending) – is what must come out of our retirement nest egg. Given the passive income stream, we now only need a nest egg of 25X our annual $70,000 requirement = $1,750,000.
That’s a dramatic difference! We have shaved off $750,000 from our required savings number due to passive income. That’s powerful stuff.
A way to remember this is that for every $10,000 in annual income that you can reliably produce, this decreases your FI number by $250,000. This is the reason that passive income is so powerful! Even if it isn’t always truly “passive”.
Take Home: What is Financial Independence?
It’s amazing how a simple twist on definitions can produce dramatic results in our financial planning. Once we have painted the big picture of our financial plan, we just have to figure out which financial independence model we plan to use. Remember, you can use both via the hybrid financial independence model!
Obviously, there are two inherent assumptions that are worth mentioning. First, the larger your multiplier on your annual income (i.e. 30-X instead of 25-X) the safer you are in knowing your money will last. This is particularly important if you plan to have a long retirement horizon. Second, if you are going to depend on passive income, it needs to be very stable!
When thinking about financial independence, I hope that these two models will help. Don’t feel stuck in one model or the other. You can use any of the 3 models of financial independence to get to your goals.