“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.
For me, I fall in favor of the latter camp of trying to develop passive income streams that will support my retirement lifestyle. This would be ideal as it would then allow me to never consume the capital which would then allow me to leave a substantial financial legacy to my heirs.
If by the time I reach an age where I want to call it quits I have not quite achieved this goal, then the hybrid model is a fall back one and still not a bad option as more likely than not I will end up having more money at the end than I started out with.
I am sure that it would be fine either way, but having the option is certainly nice.
I’d personally love to have a high enough side income stream that I could rely solely on that.
I think it helps to spend more time discussing what you are financially independent from. Many people think of FI as independence from a W-2 income or a “paycheck” but they may have income from a non “normal job.” Others define it is being independent from work of any sort entirely. The root of so much discussion is in these definitions.
The latter group would probably be on board with “School 1.” Being a 25x/4%’er means you don’t actually need to make any money. You can sail with your nest egg through retirement and into old age (hopefully). The internet retirement police live in this world.
If you think of FI as independence from a W-2 job then either the hybrid model you suggest or a straight passive income approach is more in line with that idea. All the passive income streams you mentioned take a great deal of effort and work to build. Blogging. I think about it every day and usually spend an hour or two either reading, writing are fussing with my site!
The hybrid model you suggest is probably more of a ‘real life’ application for most people. Some income coming in from side gigs, part time work, etc and then a bunch of investments 4%ing the rest.
I agree that it certainly matters as much why you are seeking financial independence as how you plan to accomplish it.
Vicki Robins does a good job in Your Money or Your Life detailing the many ways to get to what she terms as the Crossover Point. Where all of your passive monthly income from investments, rentals, royalties, etc. suddenly grows to more than your expenditures. Financial Independence is on the event horizon of the Crossover Point.
I like the idea of passive income that takes effort but not capital to create. In my mind, your book, website and maybe medical invention beat out dollar for dollar your investments and real estate crowdfunding.
Loved the article!
Thanks! I need to get around to reading the book that spawned it all! Just haven’t had a chance to do so, yet.
And thanks for the encouraging words!
Definitions are funny. Is financial independence when investable net worth equals 25 x annual expenses or is it when passive income equals expenses. Both are correct. And you’re right, a hybrid works too.
Terminology is funny too. Is it financial independence or is it financial freedom? Are they the same thing. Is one better (or a higher amount of money) than the other?
The truth is, neither definition truly describes financial independence. When your net worth equals 25x annual expenses, it does work… but you are still dependent on returns from the stock market. And in the second definition, you are still dependent on your passive income sources being consistent and lasting for a long time. What if your passive income streams dry up? There is no guarantee that these will last forever.
Anyway, I like the definition laid out by John of ESI money: Financial independence or financial freedom is when you have wealth to cover expenses indefinitely.
It’s broad enough to cover both definitions, and a hybrid of the two just like you mentioned.
Thanks for the reference, DMF! You’re a treasure trove of information, man. I always appreciate your perspective. Of course, I am going to like ESI’s definition. He’s a smart guy!
There are a lot of purists out there espousing the SWR only or passive income only model.
I don’t see why a hybrid approach can’t work. It’s something I’n striving to do in the future myself!
So many people advocate strongly for only one of the two models, but the hybrid model makes a lot of sense. Like dieting, it’s “everything in moderation.” I’m definitely starting to work more on the passive income stream side of the equation, and it seems like a lot of docs are moving in that direction. According to recent surveys, over half of all physicians in the country are considering non-medical work to be an important part of their income. Great post!
I used to subscribe to the 4% rule, especially at the beginning when I didn’t know what else to do. Now that I’ve hit my number, I want to build up another cash flow stream through a side-hustle. The mental part of living off of the nest-egg is harder than I thought. I guess the years of constantly tracking and managing my money don’t just go away. Now, I’m scared to drawn down.
Great post. Thanks. I like the way you elevate and summarize the topic, which makes it easy to remember what our options are. I agree with @Frugalharpy. After accumulating wealth following years of diligent saving, I find it mentally very hard to start the withdrawal phase and accept the fact that your net worth will decrease … another great topic for TPP, where philosophy can help. So, I am in the camp of the hybrid model but with more weight on the passive income side.
Absolutely. A good point! Something for me to consider 🙂 With passing time I have become MUCH more of a fan of the Hybrid Model to FI 🙂
I’m following the hybrid model as well but it is relying on a retirement pension and VA disability