by Lyle Daly | Updated July 21, 2021 - First published on Nov. 19, 2019
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This is one question you don't want to get wrong.
The concept of financial independence, meaning to have enough savings that you don't need to work anymore, has become increasingly popular in recent years. This is in large part due to the FIRE movement, an acronym for "financial independence, retire early." A growing group of Americans are calculating their "FI numbers" and figuring out exactly how long it will be until they can call it quits at work.
Whether you're interested in early retirement or you just want to be able to retire comfortably at 65 or 70, it's important to know how much money you'll need. By calculating the amount you need to save for financial independence, you can ensure that you're on track to retire when you want.
So exactly how much will you need? It's a complicated question, and first, we need to establish a definition of financial independence.
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Financial independence is when you have enough in your savings and investment accounts that the average annual return is equal to or greater than your living expenses.
Once you've reached that point, you can conceivably live on that money indefinitely, because you're not depleting your savings to cover your bills. For example, if you have $1 million saved and it's earning a 5% return each year, you could withdraw $50,000 a year and break even.
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The challenge is determining what's truly a safe withdrawal rate. Fortunately, there have been multiple studies done to shed some light on this subject.
If you've read much about financial independence, you've probably come across the 4% rule. It claims that 4% is a safe withdrawal rate from accounts with a mix of stocks and bonds. That means once you've saved 25 times your annual expenses, you've presumably reached financial independence.
The evidence behind this rule is the Trinity study. Three finance professors at Trinity University tested potential withdrawal rates for various ratios of stocks and bonds using market data from 1925 to 1995. Ultimately, they found that withdrawal rates between 3% and 4% were unlikely to deplete a person's retirement portfolio over a 30-year period.
Now, there are some issues with how that study has been interpreted in the 4% rule:
The 4% rule is a good starting point and it's simple to understand, but it's not necessarily safe.
The Early Retirement Now site has done a much more recent and detailed study on safe withdrawal rates. Like the Trinity study, it analyzed withdrawal rates with several different ratios of stocks and bonds.
It looked at longer withdrawal periods, though, starting at 30 years and going up to 60 years to account for those who retire early. It also analyzed more withdrawal rates, starting at 3% and going up to 5% in 0.25% increments. The Trinity Study, on the other hand, only used increments of 1%.
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In this case, there were some clear winning numbers -- a 3.25% withdrawal rate and a 75:25 stock-to-bond ratio. These were 100% successful for each withdrawal period up to 60 years.
A 3.50% withdrawal rate also worked in most cases. With a 100:0 stock-to-bond ratio, its lowest success rate was 98% over a 60-year period. With a 75:25 ratio of stocks to bonds, its lowest success rate was 97% over 60 years.
And what about a 4% withdrawal rate? Even with the ideal stock-to-bond ratios, this withdrawal rate's success dropped to 93% over 40 years, and it decreased more for longer periods. That may seem good overall, but remember that it won't be good enough if you're the one running out of money during retirement.
To be financially independent, a smart savings target is between 28.5 to 31 times your projected annual spending. That range allows you a withdrawal rate of about 3.25% to 3.50%, both of which are proven to be successful even over periods of longer than 50 years.
Let's say you want to be able to spend $60,000 per year in your retirement. You'd aim to save anywhere from $1,710,000 (and take a withdrawal rate of 3.51%) to $1,860,000 (and take a withdrawal rate of 3.23%).
You can never be completely sure how long your savings will last. There's always the possibility of a worst-case scenario that takes out a huge chunk of your portfolio. But once you've reached the savings target above, you're in excellent shape if you decide to live off your nest egg.
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