Now that we have celebrated our National Independence Day, it is the right time to consider the possibility of celebrating your own Financial Independence Day. Financial independence is a condition where you don’t have to work to pay for living expenses. You can opt for retirement or you can choose to work because you want to, not because you have to. Sounds appealing? Here are a few steps to accomplish this:
1) Decide what your lifestyle would be.
Imagine a little and think about what you would do if you didn’t have to wake up with an alarm clock and go to work every day. Where would you live? What would you do with your time? Before you go crazy, just keep in mind that the more extravagant the lifestyle you imagine, the harder it will be to realize. More minimalist Yes, the day of your financial independence may come as soon as possible.
2) Predict what your costs will be.
It’s best to start with your current spending by looking at the last 3-12 months of your bank and credit card statements and recording your expenses on a worksheet like this. Then think about how those costs can change with your new lifestyle. For example, you can spend less on housing if you plan to reduce the size or move to an area with lower living costs. On the other hand, you may spend more on travel, hobbies, and health care. (You can use this calculator to estimate health insurance costs through the Affordable Care Act, but enter only taxable income, because non-taxable income like withdrawing non-taxable Roth money or spending principal on savings and investments will not count towards the subsidies you can get.)
3) Calculate how much you need to save.
I like this calculator because it is free and is designed to allow you to model scenarios in which you retire long before you collect any pension or social security income. Start by entering your costs from above, the total value of your portfolio (pension accounts plus all other savings and investments you plan to finance for retirement) and the number of years you can live financially independently. (To be sure, you might have to assume you live to 100.) Just don’t enter commas because they confuse the calculation.
Then click on the “other income / consumption” tab to enter the estimated social security benefits (you can estimate the expected benefits by entering the planned retirement age on Social Security Website) and any pension or other income (for example from work, business or rental property) that you expect. If you’re not ready to be financially independent now, press “aren’t you retired?” and enter the planned retirement date and how much you plan to save annually from now until then. (Remember to include employer contributions in your retirement plan.) Reducing costs can also increase your savings and reduce retirement expenses, so consider additional ways to save.
On the “your portfolio” tab, enter the approximate amount of fees you pay and the way your investments are divided. (You can also use this to see the impact of different investment combinations on your retirement.) If you expect some major one-time changes in your portfolio, such as adding income from selling your home or lump sum pensions or withdrawals due to real estate or college fees, you can enter them under “Portfolio changes”.
Finally, click the “Submit” button on any tab to see what results would be based on historical rates of return and inflation if you had followed your plan every year since 1871. (Of course, a lot has changed since then, but the idea is that the more years you include, the more accurate the results will probably be.) You can ignore the chart with all the lines and focus on the success rate or what percentage of the years would not be left without money. There is no guarantee that in that time period you will not experience anything worse than the worst historical result, but that is the best we have.
If you don’t like the results, see if you can make a plan that works by changing your savings rate, retirement costs, and / or retirement age. Other possible strategies include using a portion of your portfolio for buy an annuity immediately,, taking a reverse mortgageand getting extra income from work or work or even from renting part of your home. (All this can be entered as a pension on the “other income” tab.)
4) Use tax-friendly accounts.
There are a lot of retirement plans available to your advantage, so the trick is to know how to prioritize them when saving for retirement. Start by ensuring that you fully fit into your employer’s retirement plan. It’s hard to beat free money. If you are eligible to contribute to the HSA, you may want to consider this your next priority because the contributions are pre-taxable and the money can be used tax-free for qualified health care costs now or in the future. If your employer offers you a 457 plan, it could be the following because there is no penalty for early withdrawals.
After that, you can try to maximize your employer’s retirement plan (including any post-tax dollars that can be converted to Roth) and / or the IRA for greater investment and withdrawal flexibility. In particular, contributions to the Roth IRA can be withdrawn without tax and at any time. Earnings are subject to possible taxes and penalties for early withdrawal, but contributions come out first. If your income is too high to contribute to a Roth IRA, you can contribute to a traditional IRA and then convert it to a Roth. Just be aware this potential trap if you have an existing pre-tax IRA.
5) Keep your investments reasonably diverse and low priced.
There is no magic formula for investing. Just be reasonably diversified based on your time frame and risk tolerance and keep your costs to a minimum, as fees are low proven predictor top performance. The easiest way to do this is a cheap fund of targeted dates. Since each fund is fully diversified to be all in one place, you can put all your money into the fund with the year closest when you plan to retire. It will then automatically become more conservative as you approach that target retirement date, so you can set it and forget about it.
Need help? Retirement planning can be complicated, so you may want to consult with an impartial and qualified financial planner to guide you through the details of each step. Your employer can even offer free access to one part of the workplace financial wellness program. Either way, failure to plan can mean planning to fail, so before you give up or procrastinate, ask yourself what you would do if you could declare your financial independence and never have to work again …