Whether you want to stop working altogether or do something completely different, it is important to know how much you will need. As you will see, it is perfectly feasible to calculate a specific Dollar or Euro amount.
- Step 1: How much money do I need every month?
- Step 2: How much cash flow should our investments generate?
- Step 3: How much capital do we need to generate those returns?
- Step 4: When will we hit that goal?
The idea of achieving financial independence, known as FI in the online community, is very appealing. Many people work hard to hit that goal. However, most of them do not even know how much money they need to stop working.
If you do not know where you need to get, you will be unable to arrive at your desired destination. Therefore, we will break down the process required to calculate how much money we need to stop working into 4 simple steps.
Step 1: How much money do I need every month?
First, we need to know how much money we need on a monthly basis. This will be determined by where you want to live, your desired standard of living, and whether you will own your home or rent it.
As you will see, owning the home you live in has a couple of great advantages that can fast track your progress towards financial independence.
On the one hand, owning our home will allow us to spend less money. In the best-case scenario, if we own a home outright, the only expenses we may have to pay depending on where we live are property taxes, service charge and repairs. This will be much cheaper than renting, especially in the long term.
Additionally, if we view our home as an asset and the option of living there rent-free as the dividends, these will be tax-free and guaranteed dividends. Hence, as an investment, our main home will have less risk than any stocks or rental properties we may own.
The other great advantage is that we minimize our inflation risk. In a way, we have already paid for most of our future housing costs and, consequently, higher housing prices or rents will barely affect us.
For example, assuming we do own a house outright, we want to live on $5,000 per month. This means $60,000 annually.
Step 2: How much cash flow should our investments generate?
Next we calculate how much money we need our investments to generate. Because most likely we will have to pay income taxes, we need to know how much gross income we require.
If we have to pay an average income tax rate of 30%, we will need our assets to generate $60,000 / (1-0.30) = $85,714 every year.
Step 3: How much capital do we need to generate those returns?
The gross returns we have just seen in step 2 must be generated exclusively by our investment portfolio. Our main home is not included here, even though that helps us reduce our monthly expenses.
Those returns have to be generated by the assets we own. Otherwise, if we have to start selling assets to meet our goals, we may eventually run out of money.
Additionally, the value of those assets should, over the long run, at least increase in line with inflation. If this were not the case, we would have to adjust our standard of living down at some point.
For this reason, we should not invest exclusively in high dividend-paying stocks. Our investment portfolio should be diversified enough to weather all types of macroeconomic scenarios. And there is usually a good reason why certain stocks pay such high dividends: they are risky investments.
If you want to learn more about why it is so detrimental to just invest to maximize dividends, check out this post:
Top 4 Risks of Dividend Investing
Financial independence should minimize risks. For this reason, our wealth must be invested in a truly diversified way, as rich people do. Those are the ones who never seem to run out of money.
In my opinion, I think it is safe to assume that we will be able to generate at least a 3% return above inflation if we have a well-diversified investment portfolio that contains both financial assets and real estate.
That return may be lower some years but is likely to be higher most of the time. And we want that cushion, as that will give us peace of mind to enjoy our lives.
Something I would like to mention as well is that a truly diversified portfolio should include assets other than stocks and real estate. This is because we want to increase diversification and be in an optimal position to weather anything that can happen.
As a result, owning some bonds and cash will help our portfolio in times of weak economic growth and financial distress. It will also pay us some interest. And owning some gold, silver and Bitcoin is a good way to hedge against high currency devaluation and political turmoil.
By factoring in a return of only 3% above inflation, we have enough leeway to add those diversifying assets that may yield less than stocks and real estate.
We said we needed $85,714 pre-tax every year. This corresponds to an investment portfolio of $85,714 / 0.03 = $2,857,133. In summary, we need just under $3 million to stop working without having to every worry about the future.
Step 4: When will we hit that goal?
Finally, we must calculate when we are likely to hit that figure. For this you can use a financial calculator. This will allow you to take into account the expected returns of the assets you already own and are invested. Your can use a rate that is slightly higher than the 3% as you can afford to be slightly more aggressive in your investments when you are still working.
Hence, you can use a 4% return. The reason why we use such low figure is that this is a real return, meaning that we expect our returns to be 4% above the inflation rate. Here is the link to a good financial calculator.
Once you are there, you can click on N (for the number of years), and then input the following figures: the wealth you already own (PV), the wealth you need to retire (FV), the expected return (I/Y) and the annual savings (PMT), that is, the monthly savings multiplied by 12.
If you are not happy with the number of years it will take you to get there, you will either have to ideally increase your savings or lower your desired standard of living. Though lowering your standard of living (FV) is probably not what you want.
Deciding to use a higher expected return is not prudent, since there could be a crash at any time. It would essentially make your calculations way less reliable.
As you can see, achieving financial independence is possible. This is what is required if you want to stop working. For most readers, the conclusion they will draw is that they need to increase their savings. And that may make it necessary to increase their income level.
The other conclusion readers may draw is that it pays to own your own home. If you are able to understand why (less taxes and lower risk of inflation), you can incorporate this into your analysis, plans and life projects.
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