So on my Net Worth page you noticed a number which is called “Financially Independent Net Worth”. This page will explain how I got to that number. It will be updated as I find new information arrives.
How did I figure out my Financially Independent Net Worth?
First I determined what passive income I desired for retirement. I assumed that I will probably have a family of 3 people, myself, a wife and a child. I’m not too thrilled about having a kid right now but I figured I’d plan for the worst. Who knows maybe Future Kraken will want a kid and Present Kraken is going to try his best to not screw him over. Mr Money Mustache has an annual budget of about $25,000 and I figured I could do the same.
Next I need to know how much money I need in order to generate $25,000 annually. I will assume a 4% withdrawal rate since that is a number that I have seen around. I don’t understand the 4% withdrawal rate but I will be researching it and posting an article about it in the future. So how much do I need to have saved up?
PassiveIncomePrincipal * WithdrawalRate = AnnualReturn
Solve for Principle
PassiveIncomePrincipal = AnnualReturn/WithdrawalRate
PassiveIncomePrincipal = $25,000/.04 = $625,000
So that’s the number I need in the bank to be withdrawn from in order to support a family. This doesn’t include any net worth that I would have in a house. I would want a 3 bedroom 2 bathroom house somewhere where the cost of living is inexpensive and somewhere that I can do lots of outdoors activities and bike places. I haven’t picked a place yet but New Mexico and Colorado are on the list. At the time of writing this Zillow says that the average cost of a house in New Mexico is $163,500. So we will add that to the number. Also I might want to pay for my kid to go to college, hopefully the kid won’t need much help from me and he can get scholarships or go to school close to home which would be cheaper, I didn’t go to a private university and I turned out fine. Let’s call the price of tuition $40,000, ($10,000/year is about what my schooling cost). Cost of tuition is going up at an alarming rate but I’m willing to bet my child’s future on two things: 1) Schools will hit an upwards limit on what people can afford and it will eventually plateau 2) this is $40,000 when I’m 30, which means that it will have at least 18 years to gain interest which should make it a nice lump of money to cover college. So let’s add these two numbers to the passive income principal:
PassiveIncomePrincipal + HouseCost + CollegeTuition = FinanciallyIndependentNetWorth
$625,00 + $163,500 + $40,000 = $828,500
That’s a lot of dough how much would I have to save in order to get that number? Neglecting compound interest it would be about $118,357.14 a year or $9,863.09 a month. Currently my plan is to get some real estate and rent it out so that I can start making passive income while I work my day job. Even with that though, I am not sure if I could pull it off. Ideally my future wife would be willing to contribute to our financial independence so she would be contributing an amount, but who can say. This is all pretty far into the future and there is a lot of hand waving. Let’s look at some less depressing numbers: My Savings Rate!
According to Mr. Money Mustache the only number that maters is my savings rate. Why is this? If it costs you 100% of your income to live then you will never be able to save for retirement. If it costs you 0% of your income to live then you are financially independent and (hopefully) you are just working for fun. This works because the less you spend the less you need. On top of this, the more money you spend the less money you have to save, so it will take you longer to get the already large principal needed to generate that passive income.
Here is the math:
AnnualReturn = Principal*WithdrawalRate
Principal as a factor of cost of living:
Principal/AnnualReturn = 1/WithdrawalRate
So the amount of money you need for retirement is the inverse of the rate at which you plan to withdraw it. The higher the withdrawal rate the sooner
What if I saved 75% or only 25% what would happen? Let’s find out we will assume that a family of two people make $100,000 a year. We will neglect any sort of compound interest so that the math is easier.
Joneses Spend 75% Save 25%
$75,000/.04 = $1,875,000
Years to get there
Principal/AnnualSavings = $1,875,000/$25,000 = 75 Years
Fireballs Spend 25% Save 75%
$25,000/.04 = $625,000
Principal/AnnualSavings = $625,000/$75,000 = 8.33 Years
So since the Fireballs have more money to save they get to their goal quicker. The less you need to live, the less you need to work. Compound interest helps the Joneses a lot more than it helps the Fireballs though. I put this into an excel sheet and this is what I found at a savings rate of 75% Saved and 25% spent it takes about 7 years to retire. With a savings rate of 25% saved and 75% spent it takes 20 years to retire. So that means if I have a savings rate of 75% I can retire in 7 years when I’m 30. This is great news. Let’s figure out what my current rate is:
Monthly Income after taxes: $4,108.02
Monthly savings: $3,000
$2,000 in Index
$750 in downpayment
$250 in 401k contribution (I count this since I get it back)
Monthly Expenses: $4,108.02 – $3,000 = $1,108.02
Current annual expenses: $1,108.02 * 12 months = $13,296.24
Savings/Income = SavingsRate
$3,000/$4,108.02 = 73.03%
That’s not the exact number that I wanted to see but it’s close. My income will increase over time and I don’t plan on increasing my cost of living, hopefully I can decrease it, which means that the amount I can add to my savings will increase so that will increase the savings rate too. What if I continued to save this amount of money every month, how much would I have in 7 years? Including my current net worth of $28,000.
12 months * $3,000 = $36,000
Savings over time:
(Last Year’s Principal + Annual Contribution) * (1+Rate) = ThisYearsPrincipal
($28,000 + $36,000) * (1 +07) = $68,480.00
($68,480 + $36,000) + (1+.07) = $104,480.00
(104,480 + $36,000) + (1 + .07) = $150,313.60
($150,313.60 + $36,000) + (1 + 0.07) = $186,313.6
($186,313.60 + $36,000) + (1 + .07) = $237,875.55
($237,875.55 + $36,000) + (1 + .07) = $293,046.84
($293,046.84 + $36,000) + (1 + .07) = $352,080.12
Total Passive income after 7 years:
$352,080.12 * .04 = $14,083.20
Wow this is pretty cool. If I just keep doing what I’m doing and never get a raise or make any extra money I will have enough to support myself forever at the 4% withdrawal rate indefinitely. Additionally, just because I am financially independent doesn’t mean that I will stop making money. It just means that whatever I am doing would be because I want to do it, not because I have to do it.
Here is the calculated Principal i will need to generate my current expenses:
PassiveIncomePrincipal = $13,296.24/.04 = $332,406
So which number should I set as my goal? The $332,406 or the $828,500, I am going to stick with the $828,500 since it will motivate me to work harder towards my goal. I will keep the $332,406 in the back of my mind though, in case I ever get discouraged.
Photo Credit: Amy Gizienski