Sometimes when I’m at work, I wonder what would happen if I quit my job today. This thought usually emerges when I’m asked to do unnecessary work to make some “important” metric appear better. Or after being involved in a series of email chains that could be better handled with a quick conversation, or a lengthy meeting that could have been handled in a quick email. Gotta love the inefficiencies of the corporate life.
Don’t get me wrong, I like my job well enough. I just don’t feel that I will ever feel truly fulfilled at a traditional 9-5. There are some aspects of a corporate job that make me want to run away screaming, so I can’t help but imagine that day I reach financial independence…
For nerds like me, it’s fun to figure out what would happen if I just stopped adding to my investments today. It reminds me that there are different levels of financial freedom. While I am not yet completely financially independent, I do have some comfort knowing that (at age 25) I have already invested enough for traditional retirement. The secret is the power of compounding.
My Current Net Worth and Goals
For some reference, my net worth is around $90,000 (at age 25).
I’ll be honest—I’m not exactly sure what my net worth goals are yet. I think it would be cool to say I have a $100k net worth by age 25 (and I’m currently on track to hit that before I turn 26). But I don’t have a real reason behind that number. I just want to grow my net worth as fast as possible, while still doing the things I enjoy.
But what net worth is financial independence for me?
My Financial Independence Number
A 4% withdrawal rate is generally considered the “safe” withdrawal rate. This means that if you stopped adding to your investments, you could withdraw 4% each year without depleting the original amount. This assumes average stock market gains, and accounts for inflation.
So if you had a net worth of $500,000, you could withdraw $20k every year. If you had $1,000,000, you could withdraw $40,000 per year. My current expenses are about $35k per year, so that would make $875,000 my financial independence number (assuming my expenses don’t increase).
Of course, there are exceptions to the 4% rule. Generally, this 4% withdrawal rate applies to money you have invested in the stock market. For other forms of consistent passive income, you’d subtract that from your yearly living expenses. For example, if you own a business (that is either passive or you plan to continue working indefinitely) that generates $30,000 profit each year, you could subtract this from your yearly expenses to figure how much you need in the stock market. So if your expenses are $40,000 per year, you’d only need to withdraw $10,000 from your stock investments. Then you’d only need $250,000 invested in the stock market to meet your $40,000 expenses (plus your business generating the remaining $30k, of course).
Or you may invest in real estate and have rental income. Rental income would work similarly to owning a business, in that whatever you make in profit from rentals each year would be considered indefinite passive income. If you earn $500 per month from each rental, and own 5 rental properties, that would generate $30,000 per year. Again, you would only need enough invested in the stock market such that 4% of that would cover the rest of your yearly expenses.
Keep in mind that it takes money to buy real estate or start/buy businesses, and you have to consider that when calculating your returns. For example, if I spend $200,000 on a rental property that generates $12,000 per year, that’s a 6% return. The actual returns get a little more complicated than that if you take out a loan to purchase the property, but that’s a topic for another time.
Because I’m interested in investing in real estate and maybe even starting a business someday, I don’t think I’ll need $875,000 invested in the stock market before I’m financially independent. BUT I’d rather have too much saved than too little, so until I have a clearer idea on my consistent income from real estate/business investments, I plan to continue investing in the stock market. Another reason to do this is because of the tax advantages of 401(k)s, HSAs, and IRAs.
But for now, my general plan is to continue maxing out my Roth IRA and HSA and contributing the minimum to my 401(k) to receive my full employer match. On top of this, I plan to invest in real estate and possibly a business. I’ll consider myself financially independent when my real estate and/or business consistently generates enough to cover my remaining expenses (after 4% of my stock investments).
What if I Stopped Investing Today?
Let’s have some compound interest fun! Let’s look at what my stock market investments would do if I stopped adding to them today. Of my $90k net worth, about $65,000 is invested in the stock market (the rest is in cash or real estate).
Let’s plug that info into a compound interest calculator. Note I use 7% as a conservative value for average stock market returns. I put 0 in the annual addition amount since I’m trying to see what happens if I stopped adding to my stock investments and just let them grow.
In 10 years, my $65,000 turns into $130,000. Not bad. And makes sense by the rule of 72 (divide 72 by the annual rate of return to get how many years it will take for the initial investment to double).
If it takes about 10 years for 7% interest to double, we would expect the $130k to double to roughly $260k in another 10 years (20 years total).
What if I let the $65,000 grow until the traditional retirement age of 65?
$975,000—not bad at all. Enough to withdraw about $39,000 per year for the rest of my life (according to the 4% rule).
But what if I continued investing in the stock market at my same rate for another 5 years, then stop?
Investing $20k per year for 5 years puts my principal at $215k at the end of the 5 years.
If I then let that $215k grow for the next 35 years (when I would hit 65):
Wow—2.3 million dollars! Talk about the power of compound interest! I could then withdraw almost $100k per year for the rest of my life. And that doesn’t even consider my other planned forms of investments!
So, even if I stopped investing in the stock market at age 30, I would still have $2.4 million in the stock market at the traditional retirement age. So that means, from age 30 to 65, I would only need to make enough money to cover my expenses (around $35,000 right now). Now I’m not saying I would stop investing, and I’m not necessarily recommending that, but it is possible. It’s another degree of freedom. It gives you options, and it gives you freedom.
Degrees of Financial Freedom
There are different degrees of financial freedom.
A first degree of financial freedom is when you have enough in your reserve funds to cover a year of expenses, so you could handle losing your job or quitting before you have another job lined up.
Another form of financially free is when you no longer need to add to your investments to have enough at traditional retirement age, you just need to make enough money to cover your expenses until then. This gives you the freedom to pursue a dream job that pays less, or start your own business, or travel more often.
The “most” financially free is when you can live totally off your investments now.
These steps to financial freedom are similar to the steps required to drive a car. First, you get a learner’s permit and always have an adult in the car (comparable to the financial situation when you built your emergency fund). Next you get a restricted permit and can drive some places yourself (like when you no longer HAVE to add to your investments but still must cover yearly expenses). And finally, you get your license and can drive by yourself (you can completely live off your investments). Each is an important step, and you get to each step by putting the hours of driving practice in (comparable to the discipline of saving).
It’s important to keep in mind that there are different degrees of financial freedom. There is not a hard line where someday you’re 0% financially independent and the next day you’re 100%. Every dollar you invest on the path to financial freedom, is another advancement along the degrees of financial freedom. All of these advancements are supported and accelerated by the power of compound interest.
Where are you in your path to financial freedom, when you consider the power of compound interest?