#112 | How to know if you are FI

September 3, 2021

Episode Summary:

In this week’s episode, we talk about how the FIRE community traditionally defines Financial Independence (FI) and how you can use that information to help you plan your own life. We explain the ever-popular 4% rule and dig into the benefits and drawbacks. Finally, and most importantly, we share how you can establish your own criteria for FI.

Episode Notes:

We start by reading a couple of listener questions on how much is enough to retire and what you need to consider yourself financially independent or work optional. The answer to these questions isn’t necessarily hard to figure out, but it’s super specific to the individual, making general advice and rules less useful.

Financial advisors will help you determine financial independence by income replacement. If you make $100K and live off that, you should need $100K in retirement and you’ll be ok. But this is because they don’t know your expenses or your desired lifestyle. So you might be working towards retirement at 65, where you can earn $100K, and you only need $50K. Then you’ve worked way too long.

The traditional FI definition, as decided by the FIRE community, is the 4% rule. Said another way, 25X your spending. So if you have 25X your spending, you can withdraw 4% each year and never outlive your money. So if you spend $50K, your FI number is $1.25M. $100K and you need $2.5M. You could put that into an index fund, and you’re good to go. This could be the case for someone, but let’s break this down a bit:

Benefits:

It’s simple.
It’s a great guidepost to help you gauge progress.
It provides structure to how to manage your money by automating it to a degree.

Drawbacks:

Having an accessible portfolio of 25X your expenses for many people means choosing taxable accounts vs. retirement accounts, paying down a mortgage, etc. This approach would incentivize you not to pay down your mortgage, which we think is a great idea.
It doesn’t encourage you to diversify into other investment classes like rental properties.
It may not actually work over a very long period of time. If you’re just barely at the FI number, there’s no room for error. A couple of years of negative returns, a big medical expense, or needing to help aging parents, and you’d need to make a change. Vanguard did a study showing the 4% rules probability of success, and as you’d imagine, it’s a higher probability of success the older you are.

So how do you know you’re ready? What’s a better plan? The 4% rule, in our opinion, let’s you know when you’re ready to start planning. For example, if you spend $50K a year and your FI number is $1.25M, then when you reach that, then you can start your planning. So this is the bare minimum you’ll need to help you avoid running out of money.

Everyone’s situation is unique, but let’s look at how this works: what will your expenses look like for the next 5 years, 10 years, etc.? Will you own a home or rent or travel? Will your kids go to college? How’s your health? Once you estimate these expenses, you can look at your cash flow.

The listener wanted a checklist: “if you have this, this, and this, you are good to go!”

Is your net worth at least 25X your spending?
Are you able to live off passive income or non-retirement account withdrawals before reaching age 60 without depleting them?
And then at age 60, are your accounts large enough to meet 4% withdrawals?
Are you comfortable pulling from your 401k doing a conversion ladder? This matters because your 401k is in your 25x math.
What’s your level of comfort with the risk and the idea of going back to work? One of my favorite reminders is that your worst-case scenario is everyone else’s every day.

What would a super-strong early retirement look like?

Retirement accounts that are already 25X your spending, meaning that if you were to deplete all other resources by age 60, you’d have much more than 25X ready to go.
Getting your cost of living low, for example, paying off your mortgage.
Passive income to cover your living expenses or the majority of your living expenses prior to tapping into retirement accounts. This can be taxable accounts or rental income, for example.

The 4% is more of a guideline to let you know if you can start planning to retire. Barely meeting it is pretty risky over the long term unless you’re prepared to go back to work.

All this said, pursue the life that makes you happy. If you want to stop working and can accept some risk, go for it. You’ll figure things out.

Top 3 takeaways:

The 4% rule means you have 25X your savings and have reached a traditional definition of FI.
Use it as a starting point, not a final goal.
Plan for more than you think you need. You never know what the future holds.