Financial independence, early retirement, or retirement at any age may seem like impossible goals. But like other goals, the best way to ensure you are on the right track is to put together a plan, and then periodically check your progress and correct course as needed.
In what follows, we at FIDough Hub lay out the basics of what you need to know to put together your own Financial Independence Dough (FIDough) plan so you can eventually declare FIndependence!
You often hear that you should (1) save some percentage of your income (typically 10-15%), and (2) assume that after you stop earning money from your primary job, you will live on something less than your current income (you often hear 80-85%). This traditional advice may work for some, but if it does it is only coincidental. So, if you are saving at least 10% of your current income, kudos to you — you are doing better than most. But this focus on income ignores what really matters for developing a useful FIndependence/retirement plan. The key is understanding your current spending habits, what level of spending you want to maintain when retired, and where the money to cover this spending will come from.
Taking the steps toward FIRE
So, to develop a basic plan for financial independence, you must figure out three things: (1)how much money do you want to be able to spend in retirement? (2) where will this money come from? And, (3) to the extent some of this money will come from savings, how much do you need to save and how will you do that?
Step 1 – Determine the amount of money you would like to spend in retirement.
Although many financial planners start retirement planning by using your current income as an input, your current income really doesn’t matter. If you are starting out in your career, expect to earn more later, and currently earn less than you would like to ultimately spend in retirement (because, for example, you plan to travel more than you currently do), planning your retirement on the basis of youro current income won’t work. Similarly, if you are saving more than 15% of your income, expect that continue, and do not expect your lifestyle to change much in retirement, why in the world would you assume you will live on 85% of your current income in retirement? It makes no sense.
The only thing that actually matters is how much money you would like to spend in retirement. So figure this number out, and make sure you do it right. A great place to start is by tracking your current spending. (As explained, here there are many great tools to help with this, such as Personal Capital.)
Once you understand your current spending, you should then examine that spending and identify expenses that will likely go away (e.g., dry cleaning, baby sitting fees, etc.), and expenses that you will likely incur (by choice or otherwise) after you stop working (e.g., health insurance costs and other items paid for by your employer).
Recognize that this retirement “spending” number must also do more than merely cover your usual expenses. It must include enough to permit you to “save” for those infrequent big ticket items like cars, new home roofs, etc. You may also want to include a budget amount for travel that is higher than what you currently spend. It should probably include some “cushion” for unexpected contingencies. For these reasons, figuring out your “expenses” in retirement is often more complicated than many think, but vital to developing a realistic FIRE plan.
Step 2 -Figure out where the income to cover your expenses will come from, and how much of it must be covered from savings (i.e., your “FIDough Income Number”).
Once you have some idea of the amount of money you want to be able to spend in retirement, figure out where the income to cover these expenses will come from. Depending on your situation, this income could come from a wide variety of sources, including social security, a pension, or some limited income you expect to make when “retired.” And, of course, be realistic. Depending on your age, you may not want to count on social security, and check out the health of a pension before deciding to count on it.
The important piece of this puzzle, then, is how much income will you need from savings. For those lucky enough to participate in a healthy pension plan that vests in twenty years, the answer may be zero. But for most, it will be a positive number, and for many all or nearly all of what they plan to spend in retirement must come from savings.
This number is your FIDough Income Number – the annual income you would like your FIDough (or “nest egg”) to generate. This number must be high enough (when combined with other sources of income) to cover all of your expected expenses.
Step 3 – Multiply your FIDough Income Number by 25.
Once you have figured out your FIDough Income Number, you can get a rough (or is it ruff) idea of the amount you need to save in order to retire. In particular, to determine your Catching FIDough Number, a good place to start is by multiplying your FIDough Income Number by twenty five (or thirty). This is known as the “25 times” rule of thumb and is derived from the well-known 4% rule.
Your FI Number = your FIDough Income Number X 25.
This number, which is the official minimum you need to declare financial independence. This figure, however, is in today’s dollars. Accordingly, it must be inflation adjusted into the future based on the number of years remaining before you want to officially become financially independent.
Although more than 25 times is even better, if your savings is roughly 25 times larger than the amount you will need to withdraw from your retirement portfolio in your first year of retirement, you should be in pretty good shape (especially if you are willing to make spending adjustments late if necessary).
There are of course other complexities and nuances that you can learn about here, but having some rough idea about your Catching FIDough Number is a great place to start with your own FIDough Plan. Another good resources on the topic is this book.
Step 4 – Figure out how to reach your FI number
To determine how to save enough to reach your FI Number (to save enough to catch FIDough), you need to determine the number of years remaining before you want to catch FIDough (your target date for catching FIDough). You must then determine the remaining amount you need to save/invest to get your FI number within your timeframe goal. So, if you want to catch FIDough in 5 years, and you are $100,000 short of your Catching FIDough Number, you must grow your saving an average of $20,000 per year for the next five years.
Here too there are some complexities and nuances due to things like expected investment returns, etc., but you now have the basic framework to begin building your plan to catch FIDough.
An excellent explanation of the impact your savings rate can have on catching FIDough is Mr. Money Mustache’s The Shockingly Simple Math Behind Early Retirement.
Once you have your basic plan in place, the hard work begins. Saving and investing, and otherwise growing your wealth. If you start looking hard, you might be surprised at the number of places you can trim to help increase savings. Here, we have put together a practical plan that actually helps people save more without a traditional budget.
Update your plan annually or so to check your progress, and make adjustments to your numbers. If you have trimmed expenses, perhaps you can retire earlier than you initially planned!
Good luck with your plan!