$0 to FI in 25 years or less
The term FI, or financial independence has become a more mainstream term over the last 10 years, post financial crisis. After mass layouts people were looking to take more control over their financial future rather than to place their fate, to a degree, in the hands of an employer.
There are many ways you can become financially independent. You work until an advanced age(late 60s early 70s) and once you feel you have enough you retire. You sell a business for millions of dollars and live off of it forever. Understandably most people want to avoid the first and wouldn’t have the fortune of the 2nd. With that thought in mind I developed a simple system, that if followed can get you to FI in 25 years or less.
First this system is built to spend the majority of what you make now, being able to make work optional, and still spending at that same level during your non-working years. Now with any rules of thumb type system there will be assumptions and exceptions, so there will be limitations in certain situations. My goal is not to give you a bulletproof way of handling your spending or saving decisions. My goal is to give you a framework that with your further research and/or alongside the assistance of an advisor you can hit your own financial independence target sooner.
Another housekeeping item is that this system applies mostly to your average W-2 worker who isn’t self-employed or a real estate investor. I have additional systems pertaining to these groups that I will release at a later date. So if you are not a W-2 worker the principles are still applicable but the timing, numbers and decision making for you might be slightly different.
Lastly, the projection and analysis are built using things we can’t control like taxes, market performance and inflation. I can only use historical data and averages to come up with the projections. So you are welcome to nitpick the details but you might miss the point. Also I am assuming at minimum your income will keep pace with inflation and tax rates will stay similar to today. Logistically if you have already accomplished a step or may not have access to an account(like an HSA) move onto the next step. There are many contingencies along the way and I will provide more context for unique situations in the future. So with that let’s get started.
Step 1 - Commit to contributing at least 20% of your income towards savings or debt reduction
This is probably the toughest step for most people to make. First, why 20%? In the book of Genesis, there is a character named Joseph who is promoted to 2nd in command in all of Egypt. He is tasked with leading the government in their policy to save the nation from future starvation. Pharaoh, the leader at the time, was given a vision that Joseph interpreted there would be 7 years of good times and 7 years of bad times. In preparation, the country would need to take 20% of the produce during the good years and set it aside for the 7 bad years.
Egypt enacted this plan and during the famine the government had so much leverage over the people(who didn’t prepare during the 7 bad years) they eventually had to sell themselves and their land for food. Laying aside the grimness, if the preparation of saving 20% worked for Joseph it will also work for you.
In some FI communities it is common to save upwards of 50-80% of your income to hit FI at a very early age. If this is your objective then awesome, however the 20% is easier for more people to wrap their head around as it gives a balance between extreme cutting of spending today with being able to spend more tomorrow.
There are many things that compete for our dollars. With escalating costs understandably this step is becoming more challenging. However if you never decide to live on a set spending lifestyle you will struggle to feel comfortable not working. If you consistently live on 90%-95% of your income you will not only have little margin to save but it will take much longer to accumulate a net worth total that gives you confidence that you can live off of your investments without significantly reducing your lifestyle. Every dollar you save is a dollar you don’t spend. Your lifestyle then evolves and you will notice you become comfortable with that new level of spending. That lower spending makes it your future net worth target lower and your time to FI earlier.
So I would encourage you to assess how much you are saving currently and how much of your money is going to debt. If your income is below the national median household($70K) this may require you to make some major adjustments like moving or re-evaluating your career path. No matter your starting point, getting to a place where you can allocate that 20% is possible.
If your income is below the threshold, then I would encourage you to, after steps 2 and 3, to begin investing in things that can enhance your earning potential. Whether that is education, training, searching for higher paying work or becoming more valuable to your employer to command an increase. Ultimately the best return you achieve will be as a result of the growth of your income over time.
Now once you commit to this step you will need to do a few things.
- Identify what your fixed expenses are
- Do a 90 day lookback at your discretionary spending
- Cut any non-essential fixed expenses or decide to reduce your discretionary spending
- You will need to set a specific amount of discretionary monthly spending and travel you will stick to and track
- Gather the interest rates on any debts you have
- Grab a current pay stub and determine if they are withholding the right amount of tax
- The IRS has a not terrible tool that you can use or consult with a tax professional https://apps.irs.gov/app/tax-withholding-estimator
- Commit to reviewing your spending every 30 days
Once you do this, you will have clarity around how much you can spend every month over your fixed cost. Now you may find that you should make major adjustments, like reducing your housing, food or transportation expenses(make up 60% of our spending on average). This wont happen overnight but you will want to start researching alternative options in these areas that would allow you to get within the savings range. .
I fully admit this is a mentally challenging process and you may ultimately decide to quit before you get started. I believe wholeheartedly the juice is worth the squeeze but I would encourage you even if you don’t get to 20% savings then commit to contributing something. If it is $25 or $50 a month, start there. Commit to increasing your value to make more income and decide to save any immediate raises you receive.
The 20% target is not an all or nothing step. If you are saving/paying down debt at 5%, 10% or 15% then you can still follow the system, with the hope of getting to 20%, you just may not be able to fully fund all the accounts.
Step 2 - Save $2500 in ER Fund
Hopefully you have already hit this initial step but with the assumption you are starting at $0 then you may have some work to do. This initial number is enough to cover most any immediate emergencies you would encounter and give you some financial stability. You can debate if it should be higher or lower but start saving to a number within $500-$1K of this $2500. This step is best accomplished by paying yourself every month. If you know your fixed expenses from step one, then you know how much is available to be spent or saved.
You can either have a direct deposit to your savings account when you get paid or set an auto-transfer at your bank. I would also encourage getting a credit card that can be used for emergencies as a backup and, if you have the discipline, can be used to pay the fixed discretionary expenses you decide on. I personally have a credit card for my personal monthly discretionary spending, a joint family card for our monthly discretionary spending and an “ER or unexpected CC” we use for abnormal monthly expenses. This allows me to easily assess how much we spent total on these items and we get hundreds if not thousands of points every year in rewards. This doesn’t work for everyone but with some discipline you can enhance your expense tracking and the extra rewards is a nice bonus.
Step 3 - Contribute to your employer’s retirement plan up to the match
Now that you have a financial cushion you will want to explore a more long term focused saving item outside of your month to month situation. If you have an employer plan, then this is the next best step for you to take. Most employers that offer a retirement plan, whether that’s a 401K, 403B, 457 etc will offer some kind of matching contribution. If you make $100K and your employer offers a 5% match, then that would require you to contribute $5K a year. In doing this you will immediately double your money as your employer also contributes $5K to your plan.
If you think about it that match is a part of your compensation plan it just requires some effort on your end to receive it. Why leave free money on the table? Even if you don’t invest in the stock market, which most plans only offer that option, although Fidelity recently allows some plans the ability to invest in Crypto, what other avenue is going to immediately double your money? You also have the option to self direct the money in an individual IRA if you decide to leave the company in the future. This will allow you alternative investment options.
If your employer doesn’t offer a matching plan then you can skip to the next step. You will also want to check on the vesting schedule for your plan. Meaning how long do you have to be employed at the company before you get to retain the matching funds.
Step 4 - Pay off your high interest debt
Up to this point most advisors would agree on the initial steps with some nuance. This next step is somewhat debatable, but the emotional and math factors suggest this is the next optimal step. Now what is high interest? This question can be answered simply but I reserve the right to say “it depends” for the sake of all the finance nerds running to their spreadsheets. When it comes to debt payoff you have a choice, over your minimum payment, to save or pay extra. If this was strictly a math problem you only compare the value and return of your investment compared to the interest you are paying on your debt. For example the chart below details a few examples.
You can see that based solely on the numbers it would be more advantageous to invest the excess money as long as you can earn the same rate of return as your debt’s interest rate. This is simply due to the fact that the interest is being charged on a declining number vs the interest you are earning is on an increasing number.
Imagine if you run, with the same effort, going uphill vs going downhill. The momentum of the hill will propel you faster going downhill than uphill. So you would reach the bottom faster going downhill vs when you reached the top going uphill. To bring this to our savings vs debt conversation, you don’t have to earn as high of a rate of return on your investments to end up earning more money than the interest paid on your debt. A good rule of thumb is that whatever your debt interest rate is you only need to earn a return that is 2% lower to have gained more interest than you would have paid. With the nature of how interest is calculated on credit cards that number narrows to 1%. So if you have an 8% rate you would need to earn around 6% on your investment to come out better or 7% if it is a credit card account.
I may have lost you for a second but I just wanted to provide some context. After hundreds of scenarios and for simplicity sake my guiding principles are if your debt can be paid off in under 5 years and your interest rate is above 5% then pay the debt off 100% before saving outside your 401K. If the interest rate on that debt is below 5% and your payoff term is longer than 5 years then you could find some balance between saving vs paying your debt down.
This answer may be more specific to you and your situation so you should run the numbers yourself and/or consult an advisor. This is not definitive because the shorter your time horizon the higher probability your investment return won’t get you the required outcome you are desiring. If we pay the debt off, we know exactly how much our savings is. The chart below, from highcharts.com, shows that the S&P 500 returns historically have performed well over the average 5 year period. However those returns are not guaranteed and there are times where your investment would have been down. This element can’t be ignored so I would lean on the conservative side to pay down the debt unless I have an extended payment period or a very low interest rate.
Step 5 - Build 3 months Savings
Alright so now that your debt is paid off you now have the minimum payment from the debt plus the excess you were applying to contribute to your savings. The 3 months of savings is calculated using your current spending monthly. I would base it off your fixed expenses plus your target discretionary spending amount from step 1.
Step 6 - Build your house DP
Not everyone will decide that homeowner is for them. The reason we are going to this step next is because if you have the opportunity to purchase a home at a good price then you will want to be in the proper financial position. My suggestion is to save a 5% down payment plus an additional 3% for furnishing. The projected house is no greater than 30% of your income. You may do your initial savings plan off a 20% of income projection.
This requires a little math and research but you will find this step will not delay your timeline too much and will give you greater financial stability. Generally renting is less expensive than owning(outside of a house hack type situation) so if you find yourself renting for an extended time that is okay as you are working the plan. When you decide to purchase you want to maintain your 20% savings level post purchase. So ultimately you will want to buy closer to 20%-25% of your income for the house so that you would not have to sacrifice your discretionary spending too much.
Step 7 - Contribute 50% to HSA/Roth until maxed
This next step has a contingency. One is that you have access to an HSA account. To be eligible you have to have a high deductible health plan($1400 Ind/$2800 Family). Ideally your employer offers one but even if they don’t you have the ability to establish an HSA on your own.
The HSA is the most tax effective vehicle in the tax code. It is the only account that gives you tax deductible contributions(up to $3650 Single/$7300 Family/ Additional $1K can be contributed from each spouse over age 55), tax deferred growth and tax free distributions, for qualified medical expenses.
One of the features that makes the HSA so powerful is that there is no timeline for you to use the money from your qualifying medical expense. Let’s say you open an HSA and fund it with $1K. You have a doctor bill that year for $1K. You have the choice to either take the money from the HSA(tax free) to pay the bill or you can pay it out of pocket. The reason it would be preferable to pay out of pocket is that you can invest your HSA dollars and they will grow tax free over time. As long as you keep the receipt for that $1K, you can take the money from the HSA in the future at any time. So if you invest that $1K and it grows to $8K you can “reimburse” yourself from that $1K expense years later after the investment earnings had paid for the expense many times over. Once you reach age 65 you can use the money for whatever purpose(although taxable) or it can be used tax free to pay for health insurance or any other qualifying medical expense. If you start your HSA contribution early enough you can basically pre-pay a the majority of your future medical cost with a fraction of the money being out of your pocket.
If your total savings would not allow you to max out the HSA and also contribute to the Roth then I want you to split your contribution 50%/50%. So if you only have $5K to save when you get to this step you would want to contribute $2500 to the HSA and $2500 to the Roth.
The Roth gives you the added flexibility of being able to access your contributions without a penalty before 60. Meaning if you contribute that $2500 you can withdraw it with no problems. Also you are not limited on how you utilize the money in the future and receive the tax free treatment. Having more money in the Roth will give you ample planning opportunities to reduce your taxes during your post 60 retirement years.
If your income is too high to contribute traditionally to a Roth then I would recommend using what is known as a backdoor Roth. This is where you make a non-deductible contribution to an IRA and then convert that IRA into a Roth. You will want to walk through this strategy with an advisor and the rules around this are subject to change.
Once the Roth account is set up you will save an additional 3 months of your expenses in cash inside the Roth before you start investing. This allows you to get the full 6 months ER fund total between your savings and inside your Roth account. I want you to start the habit of saving into this account sooner which is why we don’t wait until we have 6 full months in our savings account first.
Step 8 - Contribute the excess to max out your 401K
After you have hit the employer match, hit your liquidity goals, maxed out the HSA and Roth and you still have money left over then you should turn back to the 401K. This will provide additional tax deductions which can go towards your additional savings or spending.
Step 9 - Contribute the excess towards a brokerage account
If you still have money left over after the first 8 steps then you turn to your liquid brokerage account. I like the idea of direct indexing which will give you more tax favorable options as you accumulate and later withdrawal money. You would want to have a uniform investment strategy across all of your accounts so you view it as one large portfolio vs having a strategy for each account independent of the others. You will want to work with an advisor to determine your individual strategy.
Step 10 - Apply extra money or bonuses toward low interest debt.
I end with this step if you elect to eliminate your low debt items faster or your mortgage. This will free up your fixed cost and allow you to spend more discretionary money in the present. When you take on debt you are consuming future earnings. When the debt comes due your earnings will not be as free to spend on things you want. So when you are done paying off something you wanted in the past and are still at the 20% savings level then you are free to spend on current things you want now. I love hearing stories so if you follow the system and find it working or have questions send them to firstname.lastname@example.org.
Prospect - Single age 35
$-5K net worth; $0 Savings and $5K CC debt
$50K income; no state taxCom
Employer match of 5%
Step 1 - Commit to contributing 20% towards debt or savings ($833 monthly)
Bi-weekly paycheck: $1256.77
Rent - $1000
Health Insurance - $100
Utilities - $125
Phone - $40
Internet - $40
Streaming - $20
Gas - $125
Insurance - $100
Groceries - $300
CC payment - $125(minimum)
Discretionary Budget - $650
Incidental expenses - $100
Goes on 2 road trips annually with the 2 extra bi-weekly paychecks they get yearly
Step 2 - Save $2500 in 3 months - $833/ mo
Step 3- Contributes $96.15 per paycheck(5%) to 401K plan to receive company match; tax savings of $300 annually
Step 4 - Contribute $625 extra monthly towards $5K CC debt. Payoff in 10 months
Step 5 - Build 3 months savings. Saves $750($625 extra plus $125 from CC) towards savings goal of ($8150 or $2723 average monthly spending * 3). Takes additional 8 months.
Step 6 - Build House DP.
Estimate starter home for $200K. DP/closing cost of $10K over 13 months. Save up to additional $6K for furnishing during the home buying process. Estimated 8 months.
FHA loan - $190K @ 7% over 30 years
Loan Payment - $1370
Estimated Escrow - $355
Total Payment $1725
Gets a roommate to pay $800 a month keeping housing cost the same as when renting.
Step 7 - Save 50% towards HSA until maxed/ 50% towards Roth plus excess to Roth
After 42 months begins saving $304 monthly into HSA and $320 monthly into Roth(The contribution limits will probably have increased). Gets tax savings of $717 from HSA.
Step 8 - No current excess until hitting income over $70K.
Step 9 - No current excess until hitting income over $175K
Step 10 - Has the option to increase the rent on house hack and apply that extra money to the mortgage for early payoff or to spending.
Hypothetical Retirement Balance Sheet at age 60
Roth - $261,470
401K - $654,815
HSA - $359,469
House Value - $397,871
Mortgage - $62,496.61(with no extra payments - would be completely paid off with $100 extra monthly payment from rental increases)
Net Worth - $1,611,128.39
TT score(net worth/ annual spending(inflation adjusted to $60,579) = 26.6
SSI at @ age 67 $3,800
Monte Carlo(chances of not having to adjust spending with age 95 life expectancy) - 94%
*This is not an offer to buy or sell securities. This is for illustrative purposes only
**Assumptions - Inflation: 2.5%; SSI inflation: 2.5%; Wage increases 3%. Investment returns based on last 50 years of return data tied to Vanguard Target Date 2060 fund