Financial

Independence (FI) – “What's my number?”

 

Success is liking yourself, liking what you do, and liking how you do it. 

Asset Location – Minimize your taxes

In addition to maxing out pretax (e.g, 401k, 403b) and tax-free accts (e.g., Roth 401k, Roth IRA), it’s also critical to build up a sizeable brokerage acct.  Reason being, first, great accessibility. Unlike a 401k and/or Roth 401k/IRA, you don’t have to wait until age 591/2 to withdraw from a brokerage account.  For example, if you’re FI by age 45, then you’ll need a sizeable brokerage account to fund your first 15 years of freedom. 

 

Second, more flexibility.  Unlike a 401k or Roth 401k/IRA, there are no rules regarding how much you can invest and/or withdraw from a brokerage account on an annual basis.  For example, you can invest as little as $100/yr or as much as $100K/yr.  Ditto with withdrawals no (annual) limits. 

 

Third, lower taxes.  Unlike pre-tax retirement account (e.g., 401k, Traditional/Rollover IRA) assets wherein withdrawals are taxed at higher ordinary income rate (0-37%), brokerage account assets are taxed at lower capital gains tax rate (0-20%), if held for more than a year.  Additionally, FI years often mean low or no full-time employment.  This results in low or no ordinary income (tax), which means low(er) capital gain tax.  In funding your FI years, a brokerage account helps you defer withdrawals from other retirement accounts, so they can continue to compound to meet your (distant) future expenses.   

 

Asset Allocation – Maximize your returns

While asset location is about the preservation of your portfolio by minimizing taxes, asset allocation is about the appreciation of your portfolio to support the different phases of your FI journey.  This is critical for FI aspirants, because your “retirement” is likely 40-50 yrs vs 20-30 years for the typical retiree (early 60s).  One way to optimize the appreciation of your portfolio is by staggering your allocation to stocks by different tax-type accounts.  The earlier you need to access an account, the lower your stock allocation to it should be.  Here’s an example to illustrate:  

·       40-50s (FI) – Brokerage acct (70% stocks + 30% bonds/cash)

·       60s and beyond (retirement – 401k, Traditional/Rollover IRA (80% stocks + 20%
bonds/cash)

·       80s and beyond (late-retirement) – Roth 401k/IRA (90% stocks + 10% bonds/cash)

Another way to say this: the farther out before you need to tap an account, the more stocks you should allocate to it.  The powerful combination of higher stock allocation and a longer investment time horizon help your assets compound more aggressively to meet future needs.         

In addition to staggering your asset allocation with different tax-type accounts, it’s important that your overall investment portfolio’s asset allocation to stocks is at least 65% or higher.  Given your very long retirement (40-50 yrs), you’ll need enough stocks to power your portfolio’s growth to outrun the eroding effects of inflation (3.7% as of 10/22/26).  

The math behind “the number”

Why is 25xs your annual living expense “the number” for FI?  Here’s a simple example:  Let’s assume you have a moderate portfolio that’s 75% stocks and 25% bonds and cash.  Based on historical average, this portfolio will provide an annualized return of 7% (4% in appreciation + 3% in dividends).  If you have a $2M portfolio, you can withdraw 4% ($80K) from it annually without running out of money, because 3% of annual appreciation (increase) would remain in your portfolio to perpetuate its growth even further.  In short, your “snowball” continues to grow despite your “shaving” off 4% annually. 

Saving vs spending – Which lever is more powerful?

Typically, people reach their FI number with these two key levers:

·       Increase saving…by cutting expenses and/or increasing earning.

·       Decrease spending.

Of the two options, decreasing your spending is the more powerful lever.  By lowering your spending, you automatically increase your saving.  For example, let’s assume your net income (after-tax) is $100K/yr…  

·       If your living expense is $80K/yr, your savings is $20K/yr (or 20%). 

·       If you decrease your living expense to $60K/yr, your savings automatically increases to $40K (40%).

·       If you decrease your living expense to $40K/yr, your savings automatically increases to $60K (60%).

So, the less you spend, the more you save and the more money you can put to work for you.  

 

Moreover, the less you spend, the less you need to save as shown previously and here again: 

·      If your living expense is $80K/yr, then your NUMBER is $2M ($80K x 25). 

·      If your living expense is $60K/yr, then your NUMBER is $1.5M ($60K x 25). 

·      If your living expense is $40K/yr, then your NUMBER is $1M ($40K x 25).        

Graph below helps illustrate this point by showing the relationship between number of years to FI and savings rate.  You decide your pace, your timing, your exit from paid employment. 

 

 

Final thoughts…

On the surface, achieving FI seems daunting, if not impossible.  But, here’s the good news: If you look at the numbers (25xs living expenses), you’ll realize that it’s doable. Unfortunately, based on my experience and observation, here’s the bad news: Those who successfully reach FI seem to have the right “financial gene”: frugal habits and prioritizing time and freedom over money and stuff.  Sadly, there’s no simple “formula” one can follow to cultivate the latter.  

Still, just as there are many different paths to FI, so there are many different flavors of FI:  

·       Lean FI – Annual spending $25K/yr (double for couple).

·       Barista FI – Have assets to pay for key living expenses (housing, transportation, food),
but want to work low stress job for health insurance and pocket money.

·       Coast FI – Investment portfolio is large enough to fund target retirement (60s), so can afford to coast by working easy, low-stress job to cover living expenses. 

·       Regular FI – Annual spending $50K-$100K/yr (individual and/or couple).

·       Fat FI – Annual spending $100K/yr (individual and/or couple).

Perhaps the goal is not to get to FI, but rather your definition of FI (and freedom).