Your 3-step guide to financial independence

Financial independence means having enough passive income to pay your living expenses so you don't need to work for a living. 

Someone who is financially independent is not reliant on others or employment to meet their needs. Instead, they rely on their assets and the income those assets generate to live a comfortable life. 

If you achieve this type of financial freedom, you may decide to retire early.

How to achieve financial independence in 3 steps

There are many strategies for achieving financial independence. What they all have in common is they involve making your money work for you rather than the other way around. Achieving this financial goal is one of the key reasons people choose to invest in financial assets. 

A diverse portfolio of share investments can provide both passive income and the potential for capital growth. Building such a portfolio opens up many possibilities that might otherwise not be available to you, such as a better lifestyle or the ability to retire early. 

Achieving financial independence takes some work but can be boiled down to three steps: 

1. Develop a financial plan – this will give you a roadmap for building your financial future over time
2. Set aside money to grow – your financial plan should include a budget that allows you to set cash aside for investment 
3. Make investments that suit your financial situation – this will depend on how much you earn now, how much passive income you need to live comfortably without working, and your retirement plan. 

Funding your living expenses

To achieve financial independence, you need assets that generate enough passive income to meet your living expenses. How much money is enough is different for each individual. It will depend on your personal financial needs. 

Someone with a lavish lifestyle will need a greater amount of passive income to achieve financial independence than someone with a simpler lifestyle. 

For example, if you have living expenses of $2,000 a month and a net passive income (after expenses and tax on earnings) of $2,000 a month, you have financial independence. 

Financial independence is not achieved overnight. It is a journey that requires consistent time and effort. The key is to gradually but consistently increase your income-generating assets. This means putting money aside for the future and investing it appropriately. The cash flow from your investments will increase your net worth over time. 

What makes an appropriate investment will differ between individuals and may change over time. Financial planning can help you understand what an appropriate saving and investing strategy is for you. 

When you are young, you can afford to take more significant risks because you have more time to compensate for any losses. As you near retirement age, however, you may prefer to invest in lower-risk assets to minimise any potential loss of capital. 

What are the benefits of financial independence? 

The benefits of financial independence are plentiful and varied. Once freed from the need to work to meet living expenses, your time becomes your own. You can control it and spend it as you wish. You can prioritise the things most important to you, such as family, friends, or your favourite hobby. 

A degree of financial literacy is required to gain this financial freedom. You can educate yourself about investment options, which include real estate, shares, and mutual funds. The key is ensuring your assets generate enough passive income to meet your expenses. 

What is passive income? 

Passive income is earnings from sources other than employment or contract work. Examples include dividends from shares, rent from an investment property, and interest on money in the bank. 

The benefit of passive income is that little to no effort is required to generate it. In essence, you make money while you sleep. As the famous investor Warren Buffett said, "If you don't find a way to make money while you sleep, you will work until you die." 

We can generate passive income by investing in assets that provide a financial return. Investing in ASX shares is a popular method of creating passive income, as many ASX shares pay regular dividends to shareholders. 

Shareholders receive a regular income stream without having to actually do any work (aside from making the initial investment). Share prices can also increase over time, adding to the overall wealth of the shareholder. 

How much money do you need to be financially independent? 

The amount will depend on your needs and lifestyle. A broad rule of thumb is that you should be able to live off 4% of the value of your investments in the first year of retirement. You can make minor adjustments to this figure to account for inflation in subsequent years. 

For example, if your living expenses are $50,000 a year, you will need income-generating assets of approximately $1,250,000 to be financially independent. While this sounds like a significant figure, the power of compounding can help you achieve this sooner than you might think. 

Historically, the Australian share market has generated returns of about 7%-10% a year in the form of dividends and capital growth combined. When you're on the path to achieving financial independence, you can reinvest your returns (by purchasing more shares) to begin receiving returns on your returns. You can buy more shares yourself or use dividend reinvestment plans (DRPs) offered by many ASX companies.

This allows you to compound your returns and accelerate your wealth creation over the long term. Compounding can help you grow an income-generating portfolio of assets faster so you can achieve financial independence sooner. 

When planning for financial independence, the effects of inflation must be taken into account. For example, if a person has living expenses of $2,000 a month this year, we can expect their living expenses to rise to $2,100 a month next year (assuming a 5% inflation rate). If they earn $2,100 passive income monthly, they will still be financially independent next year. 

When their living expenses rise by 5% to $2,205 a month the following year, they will no longer be financially independent if their passive income remains the same. This is where the 4% rule can be of assistance. 

What are the challenges of early retirement? 

While early retirement is an exciting prospect, there are potential pitfalls.

Funding shortfalls

Chief among these is the risk of incorrectly forecasting future income and expenses, resulting in a shortfall of funds. This means careful consideration must be given to expected living expenses and income from investments. 

We cannot predict the future, so you must be careful not to overlook unexpected and one-off expenses that can crop up. These can potentially eat into your income or capital, so they should be considered when calculating how much money you need to retire. You don't want to retire early only to find your resources are stretched in old age. 

Therefore, it is wise to have a stash of cash in an emergency fund to provide a buffer to protect your investments.

Unexpected expenses

Unexpected expenses will inevitably arise, requiring funds to meet them. By keeping some cash on hand, you will not be forced to incur expensive credit card debt or exit any of your investments early. 

Your emergency fund can also be used if your investment income is disrupted. This can occur if one of the companies you invest in encounters a hurdle that requires them to retain more earnings than usual. 

Global events

Major global economic events can also disrupt your passive income. For example, the COVID-19 pandemic in 2020 prompted many ASX companies to reduce their dividends — or pay none at all — depending on how badly their businesses were impacted by the pandemic and associated lockdowns.

Boredom

Another potential pitfall of early retirement is boredom. When you have no obligation to work, there is a risk that you may have too much time on your hands! Although this is not necessarily a bad problem to have, it does mean that you will need to find ways to fill your extra time. 

Some people choose to continue working, perhaps part-time, to add interest and structure to their lives. The benefit of financial independence is that you don't need to work. However, you can choose to do work that is meaningful to you. 

For some people, this involves volunteering and charity work. For others, it is a chance to explore a new industry or calling. What was previously a hobby may become a whole new career opportunity! Continuing some form of work in early retirement can also provide some supplementary income. 

Whatever you choose to do, the important thing is that the choice is yours. Being financially independent gives you the ability to pick and choose how you spend your time. You are not beholden to anyone. 

Why should you make financial independence a goal? 

Financial independence is a fantastic goal. Not only does it offer the prospect of early retirement, but it can also help you organise your financial affairs right now. 

For many people, the decision to aim for financial independence involves a shift in mindset. This can be a powerful and positive change. Striving for financial independence and early retirement requires taking control of your financial affairs and gives you a clear goal to work toward. 

You will need to educate yourself about financial products and markets, make and adhere to a budget, and monitor your investments. All of these things can make you smarter, richer, and happier — which is our whole philosophy here at The Fool. Check out our free Education Hub to guide you through your investment journey.

Foolish takeaway

Even if you don't quite reach the goal of financial independence, you should gain added financial stability. Whether you are planning a traditional retirement or an early retirement, aiming for financial independence can result in more money in your bank account, which gives you greater freedom. 

At the same time, it is important not to totally sacrifice the present in favour of the future. Life is to be lived, and the goal of financial independence should not get in the way of this. You must balance your current and future needs. 

Aiming for financial independence does not mean completely giving up your current comforts. While investing for the future is hugely important, so is enjoying the journey. Be realistic about what is required to achieve financial independence and what you can afford to contribute toward this goal today.