Understanding Financial Independence
Financial Independence means being able to live independent of a paycheck, which means you are only working if you still want to. There are two types of financial independence: temporary, or depleting; and permanent, or self-sustaining. Temporary independence is thought of as a period of time: for how long does it last? Permanent independence is thought of as a dollar amount: How much can you spend? They are therefore two separate but related concepts to keep in mind when planning for your future.
Temporary Financial Independence
Temporary Financial Independence arises from saving more money than you spend, while you work, and then spending the money you have saved, once you are done working. The degree of independence is how long you can live before you have to go back to work. This gives us the following equation:
[Temporary] Independence (in Years) = Amount of Savings (in Dollars) / Cost of Living (in Dollars per Year)
This equation simply answers the question: how long will my savings last me? This type of independence is depleting because it cannot last forever. Every dollar you spend puts you one dollar closer to broke. This type of independence is most often seen in rainy-day funds or retirement funds; people put away extra money planning to spend it later.
Total temporary financial independence is attainable; this is when you have saved enough money to survive without working for the rest of your life. Temporary Financial Independence is built by a combination of decreasing your cost of living and by increasing your savings. Both of these are talked about in greater depth later.
Permanent Financial Independence
There is another type of financial independence that some people are able to attain. This is permanent financial independence, and it is self-sustaining because it can be relied on indefinitely to support your lifestyle without require the main savings to be spent. It should be thought of not as a duration of time, since the generation of income is indefinite, but instead as a proportion of the money you are spending. That gives us this equation:
[Permanent] Financial Independence = Cost of Living / (Passive Income + Capital Gains)
This equation answers the question: How much of my spending is covered by the combination of my passive income and capital gains? Once this number passes 100%, you are totally permanently financially independent and can quit your job without worrying about where your spending money comes from. This is because you do not need to sell any of your assets or get rid of any of your things in order to pay for your groceries, or night out, or next car. When you die, you can pass along the assets that are generating your income to your heirs, often through a perpetual trust, and they can use the income from their trust fund to supplement their income from working (and then pass it on to their heirs).
The cost of living, like above, is how much you spend in a given year. Passive income is just a fancy term for yearly income from things like rent paid on a second property that require little work from you. Capital Gains is the yearly appreciation or interest on assets like that same property or mutual funds. Passive Income and Capital Gains are often described as “making your money work for you” because they increase the amount of money you have with little effort on your behalf. Permanent financial independence is increased by decreasing your cost of living, as above, or by increasing the amount of savings you have in income-generating vehicles.
Nota Bene: The capital gains, in this case, is the same as the interest or appreciation that makes Buy/Borrow/Die possible, so if you are earning a significant amount from capital gains, then you should also invest in a tax planner who will ensure you do not have to pay taxes on it (because that is for working-class schmucks).