Financial independence is the status of having enough income to pay one’s living expenses for the rest of one’s life without having to be employed or dependent on others.[dead link] Income you earn without having to work a job is commonly referred to as passive income.
There are many strategies to achieve financial independence, each with their own benefits and drawbacks. To achieve financial independence, it will be helpful if you have a financial plan and budget, so you know what money is coming in and going out, have a clear view of your current incomes and expenses, and can identify and choose appropriate strategies to move towards your financial goals. A financial plan addresses every aspect of your finances.
Passive sources of income to achieve financial independence
The following is a non-exhaustive list of sources of passive income that potentially yield financial independence.
- Bank fixed deposits and monthly income schemes
- Business ownership (if your business does not require you to operate)
- Dividends from stocks, bonds and income trusts
- Interest earned from deposit accounts, money market accounts or loans
- Life annuity
- Oil leases
- Patent licensing
- Rental property
- Royalty from creative works, e.g. photographs, books, patents, music, etc.
- Trust deed (real estate)
Approaches to financial independence
Age and existing wealth or current salary don’t matter–if someone can generate enough income to meet their needs from sources other than their primary occupation, they have achieved financial independence. If a 25-year-old has $100 in expenses per month, and assets that generate $101 or more per month, they have achieved financial independence, and they are now free to spend their time doing the thing they enjoy without needing to work a regular job to pay their bills. If, on the other hand, a 50-year-old earns $1,000,000 a month but has expenses that equal more than that per month, they are not financially independent because they still have to earn the difference each month just to make all their payments. However, the effects of inflation must be considered. If a person needs $100/month for living expenses today, they will need $105/month next year and $110.25/month the following year to support the same lifestyle, assuming a 5% annual inflation rate. Therefore, if the person in the above example obtains their passive income from a perpetuity, there will be a time when they lose their financial independence because of inflation.
If someone receives $5000 in dividends from stocks they own, but their expenses total $4000, they can live on their dividend income because it pays for all their expenses to live (with some left over). Under these circumstances, a person is financially independent. A person’s assets and liabilities are an important factor in determining if they have achieved financial independence. An asset is anything of value that can be readily turned into cash (liquidated) if a person has to pay debt, whereas a liability is a responsibility to provide compensation. (Homes and automobiles with no liens or mortgages are common assets.)
Since there are two sides to the assets and expenses equation, there are two main directions one can focus their energy: accumulating assets or reducing their expenses.
Accumulating assets can focus one or both of these approaches:
- Gather revenue-generating assets until the generated revenue surpasses living/liability expenses.
- Gather enough liquid assets to then sustain all future living/liability expenses.
Another approach to financial independence is to reduce regular expenses while accumulating assets, to reduce the amount of assets required for financial independence. This can be done by focusing on simple living, or other strategies to reduce expenses.
- Cut your fixed expenses wherever possible. (E.g., keep your internet service but discontinue cable; lower your phone plan type if you don’t use all its features, etc.)
- ^Cummuta, John. “The Myths & Realities of Achieving Financial Independence Archived 2011-07-14 at the Wayback Machine”. Nightingale Conant. Retrieved on 14-Sep-2009
- ^“What your financial plan should cover | Financial planning | GetSmarterAboutMoney.ca”. GetSmarterAboutMoney.ca. Retrieved 2017-10-16.
- ^Early Retirement Extreme: A philosophical and practical guide to financial independence.
- ^Your Money Or Your Life: 9 Steps to Transforming Your Relationship With Money And Achieving Financial Independence.
Ofer Abarbanel is a 25 year securities lending broker and expert who has advised many Israeli regulators, among them the Israel Tax Authority, with respect to stock loans, repurchase agreements and credit derivatives. Founder of TBIL.co STATX Fund.