Summary: This post answers the question “what is financial independence?” by providing a workable definition for the phrase.
This post was going to be about the key factors people need to consider/manage to achieve financial independence (FI). But we’re going to have to save that for another time.
The reason we’re going to have to wait is because I’m not sure what the definition of financial independence is.
As I started to write the initial post, I looked up the definition on Google and found there actually is no single definition. There are multiple definitions with slight but meaningful differences.
So on this post we’ll work on answering “what is financial independence?” Surely with all the smart people that read this blog we can figure it out, right?
The Many Definitions of Financial Independence
While I did find a variety of meanings for FI, there are really two that seem to be competing for “the” definition of financial independence.
So let’s begin by reviewing the one I like the best. 馃檪
Here’s the definition of FI I agree with most from the Think Save Retire blog (FYI, the post also lists how other bloggers define financial independence):
For me, financial independence is simple: it means that you are not beholden to a job to provide for your livelihood. Instead, your wealth supports your lifestyle.
The keys to this definition to me are:
- You do not have to work. You can choose to if you like, but it’s not required.
- Your expenses are covered by your assets — the income generated by them, drawing down (spending) your assets, or a combination of both.
- Your assets cover your expenses indefinitely. This is not stated outright but to me it is implied. For instance, if your assets cover your expenses for three years, you are not FI under this definition (or in my book either).
This is also the definition that Retire by 40 uses as follows:
Financial Independence: Supporting our lifestyle with passive income and side hustles while minimizing withdrawal from our savings.
He does throw “side hustles” in there which I don’t think is needed, but generally we are on the same page.
But there is another point of view out there…
Income-Only Financial Independence
The second major definition I ran into is similar to the first but different in one key measure.
Wikipedia explains it as follows:
Financial independence is generally used to describe the state of having sufficient personal wealth to live, without having to work actively for basic necessities. For financially independent people, their assets generate income that is greater than their expenses. For example, a person’s quarterly expenses may total $4,000. They receive dividends from stocks they have previously purchased totaling $5,000 quarterly, while also having more money in other assets. Under these circumstances, a person is financially independent.
In other words, you are not financially independent unless income from your assets covers your expenses. It doesn’t matter if you have enough assets to cover expenses, it’s income that is the key.
But it’s a bit confusing as there’s a whole lot to consider in their definition:
- “having sufficient personal wealth” — Sounds like they are initially ok with the “wealth” and not “income” definition of FI
- “work actively” — Is there “inactive” work? Do they mean passive income?
- “basic necessities” — Is this different than “living expenses”?
They appear to agree with the first definition except they do not allow for the draw-down of assets. They say to be FI that income from your assets need to cover your expenses.
This is the same concept promoted by Early Retirement Extreme, the blog that was a key part in bringing financial independence to the mainstream. Here’s what he says:
Financial independence is defined as being able to meet all current and future cash outflows with passive cash inflows.
Again, no use of assets allowed.
Money Boss JD Roth (you may remember him as the guy who started Get rich Slowly, built it up to a huge blog, then sold it for a ga-zillion dollars) agrees with them:
Financial independence is the ultimate goal for most folks. At this stage, your investment income is sufficient to fund your current standard of living for the rest of your life. You can afford the basics, but you can afford some comforts too. You have enough.
So J.D. agrees with the “income covers expenses” definition of FI.
My Take on Financial Independence
I completely disagree with the definition that does not allow for the use of assets to be financially independent. Here’s why — consider this extreme example:
- A guy has $1 billion in assets and no debt
- His assets generate no income
- His annual expenses are $100,000
Is he financially independent?
I would say he is. At $100k spend per year it would take him 10,000 years to spend everything. I think that’s well past how long most people live. Even at spending $1 million a year he’d have enough for 1,000 years. Certainly he’s FI, right?
That said, having your assets generate enough income to cover expenses could be considered a “higher form” of FI. It gives an added level of freedom because you never have to worry about your assets running out since they are never used (only the income). This is the type of FI I have, but I still believe the first definition is a better one.
How I Define Financial Independence
Taking all this into account, here’s my definition of financial independence:
Having wealth to cover expenses indefinitely.
We could throw in “without having to work” if anyone likes, but I think it’s implied above.
I also don’t think it has to be only from income but could be from assets too, so that’s why I didn’t qualify it.
Now’s your turn. How do you define FI? Do you agree with one of the definitions above or do you have your own that you prefer?
P.S. For those who prefer a video version of this post, see the ESI Money YouTube channel.
photo credit: paologmb view from my room via photopin (license)
For the most part I like your definition but I do question using the word “wealth”. Wealth is defined as an abundance of valuable possessions or money. To me that would exclude things like Social Security, pensions and income trust funds. I am not sure any of those are possessions.
In my 40’s I developed a six-step plan that, so far, is working. Take this advice for what you paid for it.
1 – Pay your living expenses, including housing, transportation, food, insurance, education, communications, etc.
2 – Build a four to six month liquid emergency fund.
3 – Save enough in your 401k to get the company match. If you don’t have access to a 401k, put the max into a traditional IRA to get the tax break.
4 – Save the next into a Roth IRA to get tax-free money after retirement. Since you’re limited to only 5500 in IRA’s annually, if you did the IRA in Step 3, look for other tax advantaged savings like an HSA or a tax-free bond fund.
5 – Increase your 401k/IRA savings until you’re saving at least 15% of your income annually.
6 – Anything left? Spend it on anything you want! Vacations, restaurants, hobbies. Just don’t let 1 to 5 slip!
If you find you can’t get past Step 1 — you are living beyond your means. Cut back spending (look at $25/month auto insurance from Insurance Panda, for example) or raise your pay, there is no other way.
Not all debt is bad, but revolving debt will KILL you. All you’re doing is paying Wall Street. Avoid it! Other debt needs to be included under #1.
ESI, I like the simplicity of the definition, but I think “wealth” misses a few, key assets:
1. SS
2. Life Insurance
3. Pensions
4. Etc
There are many people who are FI through SS, but don’t have wealth.
Looks like I repeated Bill’s comment.
All very good thoughts to ponder more and I would have to say a pick and choose what applies to me.
I am not exactly sure of my definition of financial independence is. One observation I have seen is that people who are financially independent work at keeping themselves financially independent. Watching their money to cover expenses while still growing. Living a lifestyle they are comfortable with living. So FI is a lesser form of work to free up your ability to do things without being committed to a job, but pay your bills and live a lifestyle you are comfortable with and not run out of money or having to go back to work.
I have several hobbies that if I made an effort in creating a business could make me some money. However I feel that a hobby you enjoy because I like to create and possibly sell and make some money I would find appealing ,however it could become a job if needing to make a profit to pay bills and keep producing which I may not enjoy because it is work. That is why they call work is work. Work does not equal play for a lot of people even though a profitable hobby could be defined as this. FI allows the person who is working the ability to do whatever they want, whether it is work or play.
So being able to pay my bills, live the lifestyle I want, work on the hobbies I like and if I sell some of it, is bonus money but not necessary for me to live off of.
My parents have a lot of net assets wealth, but their assets don’t produce any cash flow. So, now that they’re in their mid-60’s they’re trying to figure out how to turn it into cash flow producing assets. Which is not easy when it’s tied up in things like land or their dream house and they’ve never thought about cash flow before. So rentals or dividend stocks/bonds are new and terrifying for them.
So, I think it’s very appropriate to define this clearly so that you can start with the “end in mind” (Covey). It also helps us all to look at each of our financial decisions in relation to that goal.
For instance, right now, our house equity is something like 55% of our assets. Which is nice, but I would prefer that our assets were made up of cash flow producing investments like rentals. We have one full paid for rental which after HOA, taxes, insurance, vacancy etc, nets about $800/mo.
Every month when I receive the rent from the rental and pay the mortgage on the house, it underscore that fact. We’ll hopefully have the mortgage paid off in about 5 years and then start buying more rentals. It just takes a lot longer than I would like! 馃檪
I agree that it is okay to spend assets for FI. For me, we don’t have and don’t plan on having kids. So although we want to leave something for our nieces and nephews, we are content to spend some of our wealth at the end versus just rely on income. But it is my hope / plan that we don’t immediately start that way come retirement age.
I also agree with the comment about side hustles. People that read this blog are likely to never be content with just living off that passive income- I think most of us will strive to ensure our wealth is enough to last. That caution can lead us to cushion expenses with side jobs. I’m sure that’s how it will be with my wife and me. I know I’ll feel better when taking a spontaneous vacation if I just got paid for a side gig.
With many of the definitions, the interpretation depends on how broadly or narrowly you define “income.”
I’m largely an investor in passive index funds, and I don’t like to separate dividends from total return. If the total return from all investments (dividends and capital appreciation) can reasonably be assumed to support your lifestyle indefinitely, I consider that financially independent. The 4% SWR equates to having investments of 25x annual expenses. I think that’s a good definition, or at least a good starting point than can be fine tuned to one’s individual situation after factoring in SS, pensions, RE income, etc…
Financial Freedom? That’s a bigger number.
http://www.physicianonfire.com/financial-independence-versus-financial-freedom/
Cheers!
-PoF
Financial = Relating to money matters.
Independence = Not depending on another.
Thus FI = Not depending on another for anything relating to money.
Depending on another includes:
1. Needing to work.
2. Having someone regularly gift you or support you.
3. Potentially govt payments including SS or even pensions could be seen as depending on another based on how secure you think they are long term. Some pensions have already failed or been cut.
Not depending on another could include:
1. passive income
2. wealth draw down.
3. trust fund that is irrevocable.
4. inheritance that is already in hand, not just expected or promised.
5. secure pensions.
6. probably SS although the future is never 100% certain there. Probably best to assume some of it could be cut, especially if you are younger and higher income.
The only necessity is that where ever the money is coming from, it cannot run out before you do. If it can, you aren’t fully independent.
I think it always ends up as cash flow
Whether income from work/labor, or assets that produce an income, or assets that provide no income and are instead liquidated or spent, it is still cash flow
And cash flow comes from work, or investments/assets, or a business you own some part of.
You could draw down a checking account with $20M, or use cash flow from assets, or quit working at a business you built up and own and collect the profits.
But it is still cash flow, in the end.
So my definition of FI: ample passive cash flow to cover expenses in perpetuity
I like that!!!!
+1 for Troy. I like that answer too. I’d only quantify the timeline for this, it should cover enough cash flow as needed during your life and perhaps that of your dependents. In perpetuity covers it but this just provides more detail.
-Mike
“ample passive cash flow to cover expenses in perpetuity”
^^ love it
I think the definition is important. But I also think this can mean different things to different people. Certainly that is true because everyone has a different level of expenses.
But there is something very complex about personality and how people interact with their money.
I think for me it is enough to say that financial independence has been achieved when you no longer must work. If work is voluntary only – you are financially independent. So I agree with your definition 100%.
For me, FI is having enough wealth to generate a consistent cash flow sufficient to support your desired lifestyle for longer than your life expectancy.
To me, Financial Independence is the ability to get by without having to work. Right now for us we have enough where we have to cut back our lifestyle probably move but we could survive. I’m young enough and so is my wife and we’re skilled enough that we could find work in many places. I’m an engineer and right now is a good time to be an engineer. I look at Financial Independence as the fallback plan. If for some reason I couldn’t work as an engineer and or my wife couldn’t work for some reason, then the family would still be supported even if we were living at a lower standard of living. That’s very important to me. As it stands that’s kind of like the first goal for me. The second goal is early retirement, and that requires the 4% 25 x business. My hope is to get to that 4% 25 x number sooner rather than later.
Excellent advice! We need to learn early to make our money work for us! For me, financial independence is something different than what we are looking at. People are talking mostly about retirement, i.e. when we can retire safely. Financial independence for me is when we can comfortably not work, and not have to worry about covering your bills for several years.
I like it! So many blogs and media preach that FI is related to frugality, while in practise you can have a lavish life, and still be FI – as soon as your passive income is higher than your spending.