Your Financial Independence (FI) number is the dollar figure representing the total assets you need to generate a stable income that covers your living expenses. This typically consists of investments and savings that allow you to achieve financial freedom. To calculate your FI number, you first need to understand your annual living expenses. While it’s challenging to predict exactly how much money you will need 10, 20, or 30 years from now, you can start by analyzing your current expenses and making educated guesses about future costs.
As you become more familiar with personal finance and fine-tune your money management skills, your FI number may evolve. You should also keep in mind that life is unpredictable, and unexpected expenses will arise. As Brad Barrett from ChooseFI says, “Life is lumpy.”
The 4% Rule
The 4% rule helps you calculate your FI number (your “nest egg”) based on your annual expenses. It states that your FI number is 25 times your annual expenses. In other words, you can safely withdraw 1/25 (or 4%) of your investment portfolio each year without depleting it. If this 4% is enough to cover your expenses, your nest egg becomes a sustainable source of income. This is often referred to as the safe withdrawal rate.
For example, if you need $40,000 per year to cover your living expenses, the 4% rule suggests you need 25 x $40,000 = $1,000,000 as your FI number.
The 4% rule generally applies to returns on investments in the stock market and may not be as relevant for other income sources, such as rental income. Let’s take a look at where this rule comes from. In 1994, financial advisor William Bengen conducted extensive research on U.S. stock market performance from 1930 through 1970. He observed that, for a portfolio consisting of 50% stocks and 50% bonds, one could safely withdraw 4% annually without exhausting the portfolio over a 30-year period. The Trinity Study (1998) further supported this finding, examining stock/bond portfolios from 1925 to 1995 and also suggesting 4% as a safe withdrawal rate.
However, it’s important to note that these studies are over three decades old, and past stock market performance does not guarantee future results. Some in the FI community consider a 3% or 3.5% withdrawal rate to be more conservative. While I find 3% overly cautious, it ultimately depends on your risk tolerance. The 4% rule is not an absolute, but rather a guideline—a “north star” to help you set a goal for financial independence.
What If You Have Other Income Sources?
If you plan to have additional income from sources like a side hustle or rental property, you can adjust your FI number accordingly. Simply subtract the additional income from your annual living expenses.
For example, if you need $40,000 annually but expect to earn $10,000 per year from rental income, your investments only need to cover the remaining $30,000. Your FI number would then be 25 x $30,000 = $750,000.
What About Inflation?
Inflation erodes the value of money over time. For example, in 2004, the average cost of a gallon of milk was around $3. Today, in 2024, it’s just over $4 (Source: US Inflation Calculator). While we can’t predict inflation precisely, we can estimate future costs based on historical data. Over the past 100 years, inflation has averaged around 3% annually.
Fortunately, the 4% rule accounts for inflation. This means you can project future expenses based on today’s prices, simplifying your calculations. For example, instead of worrying about what a gallon of milk will cost in 20 years, focus on today’s price. Similarly, calculate your future expenses using today’s costs and adjust for any additional retirement expenses you foresee.
Start with an Emergency Fund
An emergency fund is a financial cushion that helps you manage unexpected life events. While you can’t predict when these events will occur, you can prepare for them. What if you lose your job and need a few months to find a new one? Or if your car’s transmission breaks down and requires immediate repair? These situations can be resolved more easily if you have an emergency fund in place. It provides peace of mind, knowing you have something to fall back on.
Before aggressively pursuing FI, it’s wise to prioritize building an emergency fund.
The size of your emergency fund depends on your personal comfort level, but it’s generally recommended to save 3 to 6 months’ worth of expenses. Your emergency fund should be kept as cash—not under your mattress, but in a place where it’s easily accessible and not subject to the fluctuations of the stock market. A good option is an FDIC-insured high-yield savings account. While it may not grow as fast as investments, it serves as a necessary foundation to prevent life’s bumps from derailing your FI journey.
Check out my article about Emergency Funds for more details.
Other Considerations
One of the biggest unknowns for future expenses is healthcare. While you can’t predict your future health, you can make educated guesses based on historical data. According to Fidelity’s Retiree Health Care Cost Estimate, an average retired couple at age 65 may need approximately $315,000 saved for healthcare in 2023 (Source: Fidelity). You might want to factor this into your FI number. If your employer offers a Health Savings Account (HSA), it can be a great place to save for healthcare expenses with tax advantages.
Also, taking care of your health today can help minimize future medical costs. A balanced diet, active lifestyle, and managing stress can reduce the risk of chronic diseases, such as type 2 diabetes, providing a hedge against future healthcare expenses.
Another major cost to consider is college tuition for children. In the 2023-2024 academic year, the average cost for a public school is around $24,000 per year, while private school tuition can be closer to $42,000. If college is still far off for your children, you may estimate around $100,000 in future expenses. A 529 plan is a good option for saving for college, though it depends on your state’s regulations.
You can also account for aspirational goals like upgrading your home, traveling, or luxury spending. You can either add these costs to your FI number or create separate “buckets,” with distinct savings for each goal (e.g., healthcare, travel, college funds).
Summary
The 4% rule is a useful guideline to help you calculate your FI number, which serves as a financial target for achieving independence. While inflation, life events, and unexpected expenses are difficult to predict, you can make informed estimates about your future living costs. It’s important to establish an emergency fund early in your FI journey to provide a safety net and prevent disruptions. As you move further along the path, periodically review your annual expenses and make adjustments as needed to stay on course.