Tips on how to become financially independent
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One of the happiest accidents of my life so far was stumbling upon the personal finance community, a robust and intelligent community that’s figured out how to buy their own freedom by making a few small tweaks to the way they approach money. As a 20-year old college sophomore with more travel rewards cards to my name than years alive on this planet, I realized that if I didn’t make it a priority to learn the ins and outs of personal finance, this exciting award travel hobby could quickly backfire on me.
What I ended up finding was a community that overlaps heavily with our beloved award travel community. In fact many of the most active participants in the TPG Lounge are also active in various personal finance communities. Becoming financially independent requires you to challenge the accepted norms of personal finance, many of which were written a long time ago when life expectancy was shorter and most employees could expect to retire with a pension. It requires you to take action to improve your own life, no matter where you’re starting from. If the idea of being financially secure and having more time to do the things that bring you joy sounds like something you can get on board with, then keep reading as we discuss the ways to become financially independent.
Become financially independent with a simple formula
As foreign, complex and daunting as the world of personal finance might seem, it can be boiled down into a single sentence that you can teach your friends and family:
Spend less than you make and invest the difference
To become financially independent you may need to create some space between your income and your expenses, either by cutting back on your spending or finding a way to boost your income. Simply saving money and parking it in a bank account isn’t enough, as over time inflation will erode the value of that money. In order to gain financial independence you may need to invest your savings, picking an investment vehicle such as stocks, bonds or real estate that matches your risk tolerance and liquidity needs.
Create your own good luck
There are many times on your quest to achieve financial independence where math will butt up against human psychology. If you don’t have the mindset locked and loaded, it will be harder to keep going on a long journey where the results can take decades to appear. A classic example would be the decision to pay down your mortgage sooner vs. investing the extra money, or which approach you should take towards paying off debt (the snowball method, where you pay off the smallest balance first or the avalanche method where you attack the highest interest rate first). In each case, the math suggests a clear winner, but you’ll need to pick a plan that you know you can stick to, even when things get tough.
One of my favorite books on personal finance ever written is The Richest Man in Babylon, which teaches timeless financial principles through the parables of the ancient empire of Babylon, one of the richest societies in history. Despite being nearly 100 years old (the book was originally published in 1926), the principles it teaches have withstood the test of time, from the great depression through all the financial malaise of the 70s, the dot come bubble, and even the global crash of 2008.
One of the simplest and most profound quotes in the book can help you improve any facet of your life, but especially your financial standing:
Good luck favors men of actionThe Richest Man in Babylon
It’s easy to blame the universe for your financial problems: not being born into the right family, not getting a good enough education, not being able to find a job. At the end of the day, your luck is never going to start changing until you get out there and make opportunities for yourself. Go back to school, learn a new skill, get your money off the sidelines and start investing it. While you can’t change everything overnight, the more you put yourself out there the more opportunities you’ll create and the more “good luck” you’ll start to attract.
Pay yourself first
One of the easiest excuses people make for not saving enough is that there just isn’t any room left in the budget after they account for all the other necessities. When saving and investing is the last line item on the budget, it doesn’t get the attention it deserves. We live in a consumerist culture where the line between “wants” and “needs” is blurry, at best, and so paying yourself first is a great way to make sure you prioritize what’s important. Warren Buffet summed it up quite well, saying “Do not save what is left after spending, but spend what is left after saving.”
What does this look like in practice? Set your savings goal first, whether it’s 10%, 20% or more of your take home pay. Then, once you have that money set aside, you can look at how much house or car you can afford with whatever’s left, instead of the other way around. I like to take this one step farther though. When I get paid each month, I move money into my retirement accounts before I pay my bills. It’s a symbolic gesture at best, since my budget is already set and I complete all my financial tasks in one sitting, but it’s a nice reminder that I’m working to save instead of working to spend.
Further Reading: How to Make a Monthly Budget, One Step at a Time
Start as early as you can
It’s hard to become financially independent without a clear goal in mind. Available research tells us that if you have your savings invested in a 70/30 mix of stocks and bonds, a pretty standard allocation, that you can only withdraw 4% a year. This means that you may need 25x your annual spending (1/25=4%) in order to comfortably retire. A lot of people get scared when they start to do the math, and realize that this means that a family with $80,000 in annual expenses needs a whopping $2 million to retire.
Once you’ve had a second to catch your breath, it’s time for the good news. Even if you need $2 million dollars in order to retire, that doesn’t mean that you personally need to save that much. If you invest as much as possible as early as possible, the market will do most of the legwork for you. No one can predict the future, especially when it comes to stocks, but for the sake of argument let’s just assume that over the next 40 years the US stock market performs roughly like it did over the last 40 years, which is about a 7% rate of return (adjusted for inflation).
If you start saving for retirement the day you turn 20, how much would you need to save each month to retire at 65 with $2 million? Surprisingly, if you save just $530 a month, or $6,360 a year, every year from 20 to 65, you’ll hit the $2 million mark. Over the course of your career you’d save about $280,000, and your investments would earn you the other $1.7 million. Due to the exponential nature of compound interest, over half of your total returns come in the last 10 years of your career. Which means that for every year you wait to get started, you’ll need to save exponentially more to catch up:
|Starting age||Monthly savings needed to retire with $2 million at age 65||Total amount saved||Total investment returns|
By waiting an extra 10 years to start saving, you double the amount you’ll have to save yourself (as opposed to relying on market returns) to reach your goals. Of course you can’t go back and change the past, but there’s a very apt Chinese proverb that says “the best time to plant a tree was 20 years ago. The next best time is today.”
Further Reading: The Hard Truth About How To Retire Early
Utilize tax advantaged retirement accounts
Unless you work for a government agency or the dwindling number of private sector companies that still offer pensions, saving for retirement is entirely your responsibility. In order to encourage you to take the initiative and save for your future, the government offers tax deductions for certain retirement accounts like a 401(k) or IRA, and even for certain types of health savings accounts like an HSA. These deductions reduce your taxable income, meaning you can save money on this year’s tax bill and start building up a retirement nest egg all at the same time.
For 2020, here are the individual contribution limits to both a 401(k) and an IRA:
For each account (401k and IRA) you’ll have the choice to invest in a “traditional” account, where the money is tax deductible today, or a Roth account, where you pay taxes now but the money grows tax free and can be withdrawn tax free later on. Both 401(k)s and IRAs have a withdrawal age of 59.5, and you’ll pay a 10% penalty to access your money before then.
If you’re single and make $100,000 a year, that would put you in the 24% marginal tax bracket for 2020 (barring any other deductions or unique circumstances). This means that if you max out your 401(k), you’d end up saving about $4,700 on your taxes. If you want to think about it a different way, that means it only “costs” you about $15,000 to save $19,500. Of course if your employer offers any kind of 401(k) match the numbers could get even more exciting. If you’re a high income professional like a doctor or lawyer and you’re in a higher tax bracket, the savings can get even more exciting.
A 401(k) can be a powerful retirement planning tool all on its own. Let’s say you give yourself a few years to get settled in your first job, and then make a pact, starting from age 25 and on, to max out your 401(k) every year. When you combine tax deductions and the possibility of a company match, this may cost you as little as $1,000 to $1,500 a month, but will result in at least $19,500 being invested for your future each year. If you stick to this plan from age 25 to 65, you can expect to retire with somewhere around $4 million, just in your 401(k).
Keep your investment fees low
We live in the golden age of investing, with major firms like Vanguard, Schwab and Fidelity slashing investment fees to compete for business. While a fee of .5% or even 1% might seem small in the amount, these fees compound against you and balloon over time. Not only are you losing the money that you’re paying in annual investment management fees, but you’re losing the future returns that money would have made if you left it invested instead.
If a fund charges you a 1% management fee, that means your return will dip by 1% over your investing life. In the example above, of the 25 year old who hustles hard to max out his 401(k) for 40 years in a row, how much do you think a 1% fee would cost him? In all the examples so far in this post, I’ve been using an average rate of return of 7% to demonstrate the power of compound interest. If your rate dropped from 7% to 6%, then maxing out your 401(k) for 40 years in a row would leave you with $3.2 million instead of $4 million. That’s still far more than most people need to retire comfortably, but it means that over the course of your career you’d be paying about $800,000 in fees to your investment managers. That’s roughly the same amount of new money you’d have put into your 401(k) in that same time frame, and far too much.
Nowadays there’s no excuse to pay fees like that, when you can find mutual funds and ETFs tracking every major stock index (such as the simple and popular total US stock market index) that charge fees under .05% if they charge a fee at all. This same principle applies to any advisors or money managers you choose to use. While there’s no shame in seeking out professional help with your investments, you should be wary of any advisor who charges you an “assets under management” or AUM fee. Rather than taking a percent of your money year after year, you should look for a fee-only advisor who charges a flat rate for their time no matter how much money you’re investing. This helps assure that their interests are aligned with yours, and will likely lead to better advice for you.
Cut back on your biggest expenses: transportation, housing and food
Despite what some sensationalized headlines in the news will tell you, you aren’t going to achieve financial independence just by giving up your daily Starbucks fix or by never buying avocado toast again. Yes, you should make every effort to spend consciously and intentionally, and only in areas that truly bring you value, but you also want to avoid the mistake of being “penny wise, pound foolish.”
Budgets are a very individual thing, but almost everyone spends the most on the following three categories: transportation, housing and food. While skipping your daily Starbucks routine might save you a hundred dollars a month, that pales in comparison to the amount you could save by moving to a cheaper apartment, getting roommates to split the rent, downsizing to a cheaper car and cooking more meals at home instead of eating out.
Pick the category that’s least important to you and start there. If you work long hours every week and aren’t spending that much time at home anyways, consider finding a cheaper place to live. Or if you’re in a big city with a comprehensive public transit system, see if you can learn to live without the car. Try meal prepping for a week or two so you don’t have to pay for lunch at work every day, and so you have dinner made already when you come home tired from work and are tempted to just order in. Making a small lifestyle change in one of these categories can have massive financial ramifications. Freeing up an extra $500 or $1,000 a month to save and invest will help you reach financial independence faster, and if you cut your expenses permanently than you won’t need as large a nest egg to support your lifestyle in retirement.
At some point, almost every human on the planet (with very few exceptions) will have to work a job and trade their time for money. This is so simple and obvious that we tend to forget about it, but it should be on your mind every time you open your wallet. That meal out doesn’t cost $40, it costs an hour and a half of your working life. That new car payment isn’t costing you $500 a month, it’s costing you almost a full week of work. Only by re-framing our relationship with money, including how (and why) we spend it and how we put it to work for us, can we become financially free.
Featured photo by katleho Seisa/Getty Images.
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