258 | Back to Basics Part 2: The Income Side of the Equation | ChooseFI podcast

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Episode description

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Episode description

Brad has been taking part in a mastermind group and teaching its members about financial independence. While they understood the “Why of FI”, how to get started wasn't as clear. The Back to Basics series of episodes covers just that, how to get started on the path to FI.

The journey to financial independence is not about deprivation. It is about a life of personal choice and abundance. Its starts with understanding your “why” and then setting goals for the next 5, 10, or 15 years.

There's a difference between the money you need to pay bills and meet basic needs and discretionary spending. Understanding how much your lifestyle costs is the first step.

It can be psychologically difficult to do this first step. It may reveal mistakes, but it's important to be honest with yourself and not beat yourself up over them. We all make mistakes.

After knowing what your life costs, what comes next? To calculate your FI number based on your current lifestyle, multiply your monthly expenses by 12 to get your annual expenses. This is how much money you will need each and every year in retirement to cover your expenses.

The 4% Rule of Thumb suggests that you can withdraw 4% from your total assets each year to live on and reasonably expect the money to last for the remainder of your life. For example, if you have $1 million in assets, 4% of it is $40,000 that you could withdraw each year. The 4% withdraw rate is adjusted for inflation.

To get to your FI number, multiply your annual expenses by 25. $40,000 multiplied by 25 is $1 million. $80,000 in annual expenses, multiplied by 25, results in a FI number of $2 million.

Whether starting with a net worth of zero or with some assets, the next step would be determining your current path to your FI number.

The point of saving money is not for it to be finally used for a retirement far off in the future. Save to reclaim decades of your life when you can spend time as you see fit. Reframing the goal of saving allows you to reorient and see that saving money is investing in your time.

One of the reasons Brad and Jonathan enjoy board games so much may have parallels with financial independence. Both involve iteration and getting better and better at making smarter decisions through gamification.

People who win games the most have an intermediate mindset. They understand the limitations balanced with longterm thinking.

When looking at income, what is the bare minimum needed to cover your expenses? For a married couple living in Virginia spending $80,000 a year on expenses, they will need to earn an income of $102,000 before taxes and without contributing to savings or retirement. They would pay $9,000 in federal taxes, $5,000 in state taxes, and roughly $8,000 in FICA (social security and medicare taxes), for a total of $22,000 in taxes.

When income and expenses are exactly the same, you can never afford to retire. How do you create some space between the two?

Expenses are not always fixed. Cars loans come to the end of their terms and student loans are paid off. Add in some cuts to a few other line items in your budget and you might find an extra $1,000. How might that change things?

Cutting $1,000 from your monthly expenses reduces your annual expenses and subsequently your FI number by a whopping $300,000.

What should you do with that extra $1,000 a month? Putting that savings into a 401K allows that money to begin working for you.

In addition, the $1,000 a month going into a 401K becomes a tax deduction and reduces your federal income tax. For the couple in the previous example earning $102,000 per year and bringing home $80,000 after taxes, contributing $12,000 to a 401K doesn't mean they have $12,000 less to spend. With the tax advantages of contributing to a 401K, they will bring home $70,000, only reducing their take-home pay by $10,000. They saved $2,000 in taxes. Since they already have enough money to meet their expenses, that extra $2,000 saved in taxes could go toward a Roth IRA.

Part 3 in the Back to Basics series will talk about optimization on both the income and expenses side of things.

Our hypothetical couple, starting with a zero net worth, after investing $1,167 a month (totaling $14,000 per year) at an average 8% rate of return, will hit their FI number of $1.7 million in 30 years.

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