5 Steps To Plan For Your Financial Independence Day

Now that we’ve celebrated our national Independence Day, it’s a good time to contemplate being able to celebrate your own Financial Independence Day. Financial independence is a state of being in which you don’t have to work to pay your living expenses. You may decide to retire or you may choose to work because you want to, not because you have to. Sound appealing? Here are some steps to make it happen:

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1) Decide what your lifestyle would be like.

Do some daydreaming and think about what you would do if you didn’t have to wake up to an alarm clock each day and go to work. Where would you live? What would you do with your time? Before you go too crazy, just keep in mind that the more extravagant the lifestyle you envision, the harder it will be to make it happen. The more minimalist you are, the sooner your financial independence day can arrive.

2) Project what your expenses will be.

Your best bet is to start with your current spending by looking at the last 3-12 months of bank and credit card statements and recording your expenses on a worksheet like this. Then think about how those expenses may change with your new lifestyle. For example, you may spend less on housing if you plan to downsize or move to an area with a lower cost of living. On the other hand, you may spend more on travel, hobbies, and health care. (You can use this calculator to estimate your health insurance costs through the Affordable Care Act, but be sure to enter only taxable income since nontaxable income like withdrawing tax-free Roth money or spending down principal from savings and investments won’t count against you in calculating the subsidies you can get.)

3) Calculate how much you need to save.

I like this calculator because it’s free and was designed to allow you to model scenarios in which you retire long before collecting any pension or Social Security income. Start by entering your expenses from above, the total value of your portfolio (retirement accounts plus any other savings and investments you plan to fund your retirement), and the number of years you may live in financial independence. (To be safe, you might want to assume you live to 100.) Just don’t enter any commas as they mess up the calculation.

Then click the “other income/spending” tab to enter your projected Social Security benefits (you can estimate your projected benefits by entering your planned retirement age on the Social Security web site) and any pension or other income (like from a job, business, or rental property) you anticipate. If you’re not ready to be financially independent now, click the “not retired?” tab and enter your planned retirement date and how much you plan to save per year between now and then. (Don’t forget to include any employer contributions to your retirement plan.) Reducing your expenses can both increase your savings and reduce your expenses in retirement so consider additional ways to save.

Under the “your portfolio” tab, enter an approximation of the fees you pay and how your investments are split. (You can also use this to see the impact of various investment mixes on your retirement.) If you expect any big one-time changes in your portfolio like the addition of proceeds from selling your home or taking a lump sum pension payment or a withdrawal due to purchasing real estate or paying college expenses, you can enter them under “portfolio changes.”

Finally, click the “submit” button on any tab to see what the results would have been based on historical rates of return and inflation if you had followed your plan in every year starting in 1871. (Of course, a lot has changed since then, but the idea is that the more years you include, the more accurate the results are likely to be.) You can ignore the chart with all the lines and focus on the success rate or what percentage of years you would not have run out of money. There’s no guarantee you won’t experience something worse than the worst historical result over that time period, but that’s the best we’ve got.

If you don’t like the results, see if you can make a plan that works by changing your savings rate, retirement expenses, and/or retirement age. Other possible strategies include using part of your portfolio to purchase an immediate annuity, taking a reverse mortgage, and getting extra income from a job or business or even renting out part of your home. (All of those could be entered as a pension under the “other income” tab.)

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4) Use tax-advantaged accounts.

There are a lot of tax-advantaged retirement plans available, so the trick is to know how to prioritize them when saving for retirement. Start by making sure you’re getting the full match in your employer’s retirement plan. It’s hard to beat free money. If you’re eligible to contribute to an HSA, you may want to make that your next priority since the contributions are pre-tax and the money can be used tax-free for qualified health care expenses now or in the future. If your employer offers you a 457 plan, that may be next since there’s no penalty for early withdrawals.

After that, you can try to max out your employer’s retirement plan (including any after-tax dollars that can be converted to Roth) and/or an IRA for more investment and withdrawal flexibility. In particular, contributions to a Roth IRA can be withdrawn tax and penalty-free at any time. The earnings are subject to possible taxes and early withdrawal penalties, but the 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 Roth. Just be aware of this potential pitfall if you have an existing pre-tax IRA. 

5) Keep your investments reasonably diversified and low cost.

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 since low fees have been a proven predictor of superior performance. The easiest way to do that is with a low-cost target date fund. Since each fund is fully diversified to be a one stop shop, you can put all your money into the fund with the year closest to when you plan to retire. It will then automatically become more conservative as you get closer to that target retirement date so you can set it and forget it.

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Need help? Retirement planning can be complicated so you may want to consult with an unbiased and qualified financial planner to walk you through the details of each step. Your employer may even offer access to one for free as part of a workplace financial wellness program. In any case, failing to plan may 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…