How do I calculate my Financial Independence (FI) number?

Do you want to become financially independent long before the traditional retirement age but need help figuring out where to start? The first step is understanding your financial independence number and how to calculate one. 

What Is a Financial Independence (FI) Number?

Your financial independence (FI) number is the total amount of money you need to save and invest so you can live comfortably without depending on a paycheck. This financial milestone allows you to cover all your expenses throughout your lifetime and retire on your terms.

But what exactly does this number represent? Simply put, it is the total amount of money you will require to generate enough passive income to cover your annual expenses. Once you hit this target, you'll achieve financial independence. You'll have the freedom to work if you choose to, not because you have to.

According to a 2022 survey by the Federal Reserve, the average American has about $65,000 in retirement savings. While that is a good start, achieving financial independence is far less than needed.

Origins of the Financial Independence Number

The FI number is closely connected to the FIRE (Financial Independence, Retire Early) movement, which gained momentum in the 1990s and became popular in the early 2000s.

The FIRE movement was started by individuals who wanted to break away from the traditional approach to retirement and avoid the routine of 9-to-5 jobs. They aimed to achieve financial freedom at a younger age. Their strategy involved saving aggressively, spending wisely, and making smart investments to retire many years before the standard retirement age.

The FI number has become a crucial part of their strategy within the FIRE movement. It represents the money they must save and invest to sustain themselves without relying on a paycheck.

How Do You Calculate Your FI Number?

Step 1: Figure Out How Much You'll Spend in Retirement

Before you can plan your early retirement, you need to know how much money you'll need each year once you're retired. 

Always start with the basics. Consider the amount you spend on housing, utilities, groceries, and healthcare. You'll need to cover these essential costs no matter what. According to the Bureau of Labor Statistics, the average American household spends around $60,000 annually. But your number might differ depending on your lifestyle and where you live.

You'll then need to consider the money you'll spend on travel, hobbies, or dining out. A 2023 study conducted by AARP found that retirees spend an average of $7,000 per year on travel alone. Make sure that your annual estimate includes these extras, too.

Step 2: Use the 4% Rule to Calculate Your FI Number

Now that you've figured out your annual expenses, it's time to calculate your Financial Independence (FI) number. Traditionally, the 4% rule has been used to determine this number. The 4% rule suggests you can withdraw 4% of your investment portfolio annually without running out of money during retirement.

For example, if you've determined that you'll need $50,000 each year in retirement, you would multiply this by 25 (the inverse of 4%) to calculate your FI number. In this scenario, your FI number would be $1.25 million. This means you would need $1.25 million invested to safely withdraw $50,000 each year for the rest of your life.

Considering Different Withdrawal Rates Based on Time Horizon and Risk

While the 4% rule is a popular guideline, it's not a one-size-fits-all solution. The optimal withdrawal rate can vary based on several factors, including how long you expect to be in retirement (your time horizon) and your risk tolerance. 

Here's how these factors come into play:

• Shorter Time Horizons (20 Years or Less): When considering retirement for a shorter duration, such as 10 to 20 years, it may be feasible to consider a higher withdrawal rate. Financial experts say a 5-6% withdrawal rate is often deemed more appropriate for shorter retirement periods. This recommendation stems from the notion that the risk of outliving your savings diminishes when the funds only need to sustain you for a few decades.
• Longer Time Horizons (30 Years or More): For individuals considering an extended retirement period of 30 years or more, adhering more closely to the 4% rule, or possibly even opting for a lower percentage, could be considered a more cautious approach. With a lengthier time horizon, there is increased unpredictability due to factors such as market fluctuations and inflation. They are utilizing a more conservative withdrawal rate to safeguard against the risk of depleting funds in the later stages of retirement.
• Risk Tolerance: The level of risk you are comfortable with also significantly influences your decisions. A higher risk tolerance could lead you to consider a more assertive withdrawal rate, anticipating greater returns from a portfolio heavily weighted in stocks. On the other hand, a lower risk tolerance would lean towards a more cautious withdrawal approach, possibly reducing the withdrawal rate to secure a more steady and predictable income.

Balancing Growth and Safety

The 4% rule is based on the premise that investments will continue to grow over time, even as withdrawals are made. In the past, a balanced portfolio of stocks and bonds has delivered an annual return of approximately 5% to 7% before inflation. By withdrawing only 4%, individuals can benefit from the remaining growth compounding, thus ensuring their savings last throughout retirement. However, adjusting the withdrawal rate to match retirement length and risk tolerance can offer a more personalized approach better aligned with individual goals and circumstances. Considering these different factors, you can better determine the most suitable withdrawal rate for your retirement, ensuring your savings last as long as you need them to.

Why Does Your Savings Rate Matter to Reach Your FI Number?

Your savings rate is the percentage of your income you set aside for retirement. The higher your savings rate, the quicker you'll be able to collect the funds needed to reach your FI number. So, if you save 50% of your income, you put half of every dollar you earn toward your early retirement. 

Also, when you save more each month, you're giving your money more time to grow through compounding. Compounding is when the returns generated on your investments also start to earn more returns on their own. The earlier and more aggressively you save, the more time your money has to multiply. 

A higher savings rate significantly reduces the time to reach your FI number. If you're only saving 10% of your income, it might take decades to become financially independent. But, if you bump that up to 50%, you could reach your FI number in just 15 or 20 years. 

How Does Calculating Your FI Number Help You Retire Early?

Knowing your FI number gives you a clear view of your goal. It tells you how much you need to save and invest to retire on your terms. This clarity will help you stay focused and motivated. 

For example, if your FI number is $1.5 million and you save around $30,000 a year, you can quickly see how long it will take to reach your goal. 

You can use ReachFI's retirement planner to input your savings and expenses. The calculator will run a year-by-year projection, helping you realize what it will take for you to achieve financial independence. Unlock the powers of information to optimize your savings and investments, bringing your early retirement dreams within reach.