If you want to be rich you have to ask yourself this question
I talk to a lot of people about why we, as young professionals, should strive for financial independence. Most of them agree, but sometimes I suspect that we’re not in agreement about what the term “financial independence” means.
A number of friends have told me, “I’m so happy to be financially independent. I no longer rely on my parents to pay for things like my rent, my car, my phone bill, etc. It feels great to be self-sufficient.”
Even though I might raise an eyebrow, I understand why people just out of college use the term “financial independence” to mean “I pay for all my own expenses.” It’s a big change in our lives to suddenly be responsible for our own well-being, and we should be proud when we’re successful at it.
But the phrase “financial independence” (or “FI”) goes well beyond this definition. When we reach FI, it not only means that we don’t have to rely on our parents’ money, it also means that we no longer have to rely on working for money at all.
This concept often blows people’s minds, including my own when I first learned about it, so to understand FI we have to first identify the difference between earned income and passive income and secondly, ask the most important financial question of all.
Let’s start with the two types of income. Earned income is what you’re most familiar with — it’s money that you earn from labor. So whether you’re working at a concession stand for $5.00 an hour or at a law firm for $100,000 a year, all of that money is earned income. The biggest downside to earned income is that you have to spend time to work for it — time that you’d probably rather spend doing something else, like reading a young adult novel on a sandy beach.
Passive income, in contrast, is income that you earn even when you’re doing nothing. That sounds pretty awesome, doesn’t it? Passive income includes money you collect from renting an apartment to others, portfolio income from stocks and bonds, and money you collect from owning a patent or royalty, among others.
You achieve financial independence when your passive income covers your expenses, so there’s no need for earned income. You no longer have to work for money. Instead, your money works for you.
You may be thinking, “that sounds a lot like retirement!” That’s exactly right. Retirement is a process of converting earned income into passive income. That’s the point of a retirement account like a 401(k) or an IRA. They’re tax-advantaged accounts that help employees convert earned income into passive income.
The downside of these tax-advantaged plans is that, with few exceptions, you can only access your money at age 59½, when the government finally tells you it’s OK. I don’t know about you, but I don’t want to sit in a cubicle from now until 2050 waiting until I can finally live on my hard-earned retirement money. I would rather convert my earned income into passive income as quickly as possible so I can do whatever I want without worrying about money. I don’t want a boss and I don’t want to attend meetings. I want to live my life on my own terms.
When you live off earned income, you are literally spending time to earn money. That’s what $10/hour means. You convert one hour of your life into ten dollars. When you live off passive income, you are converting your money back into time. If you reach financial independence at age 50, you’ve bought yourself potentially 50 years of freedom (FI is great for your life expectancy)! If you reach FI at age 30, you’ve bought yourself about 70 years of freedom, you old coot.
Another way to find out if you’re financially independent is to ask yourself the most important question in personal finance: “If I lost my job today and had no other source of income, how long could I survive on my savings?” If the answer is “my savings will never run out no matter how long I live” then congratulations, you are financially independent!
Unfortunately, most retirees eat into all of their savings before passing away, or have to rely on government assistance because they haven’t saved enough. That’s why many people wait until they are 65 or older when all those entitlement programs kick in. Financial independence, on the other hand, can happen at any age as long as your annual passive income exceeds your annual expenses. There’s no need to rely on any person, job, or government program at all!
If this sounds like a fantasy and you’re wondering, “how the blue blazes can I save enough money to last me for the rest of my life?” then I strongly encourage you to contact us at firstname.lastname@example.org.
In future blog posts, we’ll continue to explain the principles behind reaching financial independence and how to apply those principles to your own life. We hope you’ll join the conversation and look forward to helping you achieve your financial goals so that you can focus on the things that really matter to you.
Alejandro is a financial planner with Monte Largo Financial Advisors LLC.