Early retirement and financial independence sound pretty amazing, right? Stop working full time and pursue other interests, spend more time with family, travel to new places, or just continue working while having the peace of mind to know that you can stop whenever you want. What’s not to like? At this point, you may be wondering how long it would take you to achieve this kind of freedom. Before you can set a goal date, it is important to know how much you will need to officially announce that you are financially independent. The answer to that question may seem complex to figure out, but it’s really pretty simple. This is due to what is known as the “four percent rule.” Basically the four percent rule states that if you have your money in a well diversified portfolio going into “retirement,” you will be able to withdraw four percent of your beginning investment each year without ever running out of money. The calculations that were used to determine this rule are based on historic stock and bond returns. For example, you will need $1,000,000 invested in a well diversified portfolio in order to withdraw $40,000 per year for the rest of your life without ending up in the poor house.
This is somewhat of a worst-case scenario though. Considering the average market return of 7-9% per year over long periods of time, four percent may seem pretty low to you. You’re right, it is low. It is much more likely that you could withdraw a significant amount more than four percent each year and still be fine, but better safe than sorry when your financial future is at stake. I don’t know about you, but I would much rather overestimate and have too much money at the end of my life than to underestimate and end up eating cat food for my last few years on earth.
Figuring out how much money you will need in order to live off of four percent can lead to difficult calculations for some. But, never fear, we have the power of elementary school math to help us out. Working backwards, you can determine how much your current yearly expenses are, and then multiply that number by 25. As with the previous example, if you add up your expenses and determine that you will need $40,000 per year to maintain the lifestyle that you wish to have, $40,000 x 25 = you guessed it, one million dollars (please imagine me saying this in a Dr. Evil voice).
In order to determine what your yearly expenses will be in retirement, you will need to make some educated guesses. Will you be spending less money on gas when you don’t have to drive to work each day, or will your gas bill increase because you plan on driving around the country several times? Will you be living in the same house for the rest of your life, or is it likely that you will upgrade or downgrade? Will your health insurance costs increase after you retire? Will you be spending your extra time cooking more meals at home or will you go out to dinner more often? Only you are able to answer these questions for yourself, but I would suggest being conservative on the estimates.
There has been some criticism of the four percent rule for early retirees because it is usually based on a “normal” length retirement, not fifty or more years that are possible with early retirement. For my situation, I do not believe that this will be a concern. My reasoning for this is that I plan to continue to “work” on something for the rest of my life. It is highly likely that I will be able to monetize one or more of the hobbies that I pursue in the future. Even if this turns out to not be the case, I will have no problem working part time at any number of jobs to earn a little additional money if needed. It would take only a very minimal amount of income to supplement the returns from my investment portfolio, if any at all. In addition, I enjoy earning cashback and achieving now sign up bonuses on credit cards. It is very unlikely that these things will change in the future, and this will lead to some additional income (or at least reduced travel expenses) as well. I will feel completely comfortable declaring myself financially independent when I reach my target number based on the four percent rule.
So now that you have the actual amount that you will need in order to live off of (i.e. the $1,000,000.00 from the previous example), you can use a compound interest calculator to determine when you will be able to get to that number. The calculator is very easy to use and lets you choose all of the factors on which you choose to base your calculations. I use a conservative yearly savings amount as well as a 5% expected rate of return just to be safe.