The 3 Stages of Financial Freedom

Finance district

Image by Jo@net via Flickr

Last week, I talked about the three stages of financial despair. We all want to get out of the rat race, but before we get there, we need to get out of the hole and onto level ground.

Financial freedom

Financial independence is one of my life-long dreams. I don’t really believe in the “traditional paradigm” of working until your mid 60s, and then rushing to catch up on everything that you missed during the preceding decades.

I also don’t believe in the minimalist approach to financial independence. I think it’s great if some people are willing to live in a trailer, or carry all of their possessions in a couple of suit cases. If you want to achieve early financial independence, then you will need to be a bit more extreme about it. This approach has its merits, but I am not willing to be that minimalist.

My philosophy of financial independence

My approach to financial independence is rooted in the following philosophy:

I personally think that it’s amazing that people today even have the opportunity to achieve financial independence and retire early. We have access to an amazing set of opportunities that our forebearers could only have dreamed about. We truly stand on the shoulders of giants.

The tools you will need

Whether you make a large income or a small income, the absolute most important component of achieving financial independence is spending less than you earn. It just takes some saving and investing.

I have originally recommended a savings level of at least 10%, just so that you can stay out of hot water, but if you want early financial independence, you will need to be more aggressive than that. I believe that 50% of net income is a tough, but good target to aim for.

What if I’m wrong about the current trajectory of the world? What if we are actually drawing down on capital, which means that living standards will be lower in the future? Even if my optimism here is misplaced, you will still be in much better shape if you save a significant portion of your income. In a world deprived of capital, savings will be much more valuable. Debt, on the other hand, will be that much more punitive.

Saving a significant amount of your income and investing it in various buckets is a win-win situation. Just be sure to stay out of trouble (for instance, don’t use a zero percent loan just to increase your consumption).

The three stages of financial freedom

Neutral stage

As I mentioned last week, the neutral stage is characterized by a steady state where you are living paycheck to paycheck. You might be earning enough to pay your bills, and you might be saving just enough to pay any unusual expenses that might come along. Otherwise, you are basically at a crossroads, stuck in neutral, and not really going anywhere. You have the choice of either following the road toward financial freedom or the road toward financial despair, but it all depends on what you do next.

Stage 1

Stage one begins when you start to live below your means and you start to save money for your future. You are now heading down the road of financial freedom, but how far you go and how long it takes is up to you.

I recommend 10% as the absolute minimum, but the more, the merrier! There are reasons why you would want to squirrel away your money beyond simply achieving financial independence. Having a cushion of savings will leave you better prepared for the future, the present, and the unknown.

Stage 2

Building up your savings isn’t the only way toward financial independence. Building up side income is also a great way of closing the time gap and striving toward financial freedom. I believe that diversification is important when it comes to wealth, but I also believe that it’s important when it comes to income as well! Stage two begins once you earn enough side income to pay down your mandatory expenses. This means that you are no longer obligated to work at a day job to survive.

Too many of us are entirely dependant on our jobs, which leaves us subject to the whims and vagaries of our employers. A job and a career is a very important wealth building tool, but if you depend on it your whole life, you will be leaving your destiny in the hands of others to control.

I used to call side income “passive income”, but I think the only income you can truly call “passive” is the type you would get in the form of dividends or capital gains from a broad market index fund. Therefore, you are still obligated to work in stage two, but at least you have the freedom to work for yourself and be in control of your own destiny. To many people, including myself, this is already a great level of financial freedom.

Stage 3

To enter stage three, you need to have enough capital to never have to work another day again in your life. To me, this is the ultimate definition of financial freedom, though you already start receiving many of the benefits as you enter stage 2.

To find out how much capital you need, divide your yearly expenses by 3% if you are conservative, or 4% if you are more aggressive. This is the percentage of funds that you would withdraw from your portfolio each year.

A 4% withdrawal is more aggressive because there are periods in history where this would have led to a rapidly diminishing portfolio. A portfolio with a 3% withdrawal rate, on the other hand, has historically never gone bust after 50 years of withdrawals, not even through the great depression. A portfolio at a 3% withdrawal rate is basically an infinite portfolio, with income going up during the good years and declining less during the bad.

Eliminating your personal debt will make it easier to achieve stage 3. For example, after adding up housing expenses, food, transportation, utilities, and health expenses, I estimate that my mandatory monthly expenses run at about $1,500. Without a mortgage, though, my mandatory expenses would only be around $1,000.

How much capital would I need to achieve stage three?

 Capital required at given withdrawal rate 3.0% 3.5% 4.0%
With mortgage debt $600 000 $514 286 $450 000
With no debt $400 000 $342 857 $300 000

Interestingly enough, the difference between the amount required between “mortgage debt” and “no debt” is similar to the actual amount of my mortgage.

These are substantial sums for an individual to achieve, but remember — this is assuming that you never work a day again in your life. They also don’t include taxes, but you won’t be paying much taxes (if any) withdrawing $12 000 – $18 000 per year for your basic expenses.

Therefore, to me, while stage three is the ultimate stage of financial freedom, it is also a conservative one. I would actually want to continue working in some form, and therefore my actual requirements would be lower.

My story

When I was a student, I was mostly stuck in neutral, and spent some time in stage one on the road to financial despair. When I was a child, our household entered stage two on the road to financial despair, and we went bankrupt. It was mainly our fault, and it was a hard and miserable time.

These experiences have had a profound impact on my personality and on my life, and these memories are a strong motivation to never go back down that road again.

I am now currently somewhere in-between stage one and stage two. Since graduating university, I have been able to start putting some money aside in the form of savings. I have also taken on a significant amount of mortgage debt, but at the same time, I have eliminated all of my other debt.

Two years ago, a friend and I discussed working on a project on the side and then making the jump to full-time. We learned a lot in the process, but it ultimately wasn’t the right time as we bit off more than we could chew, and neither of us had the savings or means to survive for long without a job.

This year, I have started to build up side income. This side income has not yet been proven over the long term, which is why I do not yet consider myself to be in stage 2, but at the same time, I work in a field that has high demand and I am now confident that I could find ways to increase this side income.

Unlike two years ago, I also now have a fallback of more than half a year of expenses in savings, assuming I don’t make another dime. The worst case would see me re-entering the job market in my chosen field of specialty.

I see the three stages as a progression — it is necessary to enter a job and career in order to gain the necessary initial experience and savings to proceed to the higher stages, just like it’s necessary to gain an education and life experience in order to get out of the stages of financial despair. These steps will eventually lead to financial independence.

It’s about income

Ultimately, financial independence is about having income to secure your expenses, so that you are not wholly dependant on your day job to survive. Some have said that debt is a master; well, I also believe that a job can also be a master, if you can’t survive without it. Both situations are wholly unenviable.

Stage one income

In stage one, your income will primarily come from your job. This is the time to be securing promotions and to increase your level of expertise. It’s also the time to be aggressively saving as much as you can and to explore areas of increasing your side income, so that you can progress beyond this stage and move on to stages two and three.

Stage two income

To reach stage two on the road to financial freedom, your income should ideally come from something you are passionate about and something that you love. It could be writing, it could be developing code, it could be photography, or whatever.

It ultimately doesn’t matter, so long as it’s both something that you can have control over on your own terms, and it’s something that you love and have passion for.

Stage three income

To reach stage three of financial independence, you need to have enough capital assets to generate enough income so that you never have to work another day in your life. This doesn’t mean that you won’t work another day in your life; it just means that you now are no longer dependant even on your side income! To truly qualify as passive income, it should be cost-efficient and consume no more than a couple hours of your time per week.

These capital assets should be income-producing investments. This income can be in the form of capital growth and income from low-fee broad market index funds, which is the approach of millionaire teacher Andrew Hallam; it can also come from a dividend reinvestment plan, which is the approach of DRIP advocate My Own Advisor. There is no one-size-fits-all approach, and how you secure your income is up to you.

This is an important distinction from equity in the form of home value or savings in the form of currency or precious metals. I believe that both are also important forms of wealth, but their primary purpose is to provide savings and security; they are less suitable as a source of income.

It’s about personal motivation

I used to be scared to death of the idea of not having regular full-time employment. This was back in the days when I was less marketable because I didn’t have the experience, and more ignorant because I didn’t have the life experience of going through university, graduating, and working in the job market for a few years.

I am still somewhat scared of the idea of making a leap, but I think at some point, you need to jump into the pool. Knowledge and preparation helps to reduce the fear. Now that I am no longer a complete newbie and have more of a network in place, I know that I will not be locked out of the market. Now that I have savings in place, I know that I can also survive for a long time without eating into my long-term assets.

Now, it’s all about execution and strengthening my personal character to continue the progression toward stage two and stage three of financial independence.

It’s about the journey

Why do I want to achieve financial freedom? In my view, life is about the journey, and not the destination. I want to enjoy life now, as well as in the future. To put it in poker terms, I want to maximize my life’s expected value. We have such amazing opportunities today, and I believe it would be a waste of what I’ve been given if I did not take full advantage of these opportunities.

Dear reader, what is your take on financial independence? Why do you want to achieve financial freedom, and where are you on the road that leads to there? I’d love to hear your thoughts. :)

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  1. says

    Nice article Kevin! I like how you’ve defined the three stages to financial freedom! Per your formula, I’m still working on step 2. I make a decent amount from my own personal financial blog and have done a few feature articles in industry magazines (maritime industry mostly). Fortunately, I’m also very passionate about my day job so that gives me a slight advantage over someone who may not enjoy what they do each and everyday!

    • says

      Thanks, Benjamin! I’m working on step 2, myself! That is cool that you have gotten featured in industry magazines. If you love your day job that’s even better since you can use this time to build up the assets needed for steps 2 and 3 without compromising on quality of life.

  2. says

    What a well thought out plan Kevin! It is about the journey. I’ve seen so many people work hard their whole lives with the goal of living it up and enjoying their retirement only to have health problems or pass away within a few years of working to 65 or 70.
    Having balance and perspective is awesome.

    • says

      I agree! Great job, Kevin. I enjoyed this article. Saving IS important, but enjoying life is essential too. What will it matter if you accumulate a bunch of wealth, but then don’t live use it? I plan on doing medical missions when I become financially secure.

      • says

        Thanks guys! I agree, we need to find the right balance to maximize both the present and the future. Living for the present *only* is counter-productive, but so can be leaving everything to the end.

    • says

      Well, we never know what will happen, but historically this is how it’s panned out! Of course you can always go out and generate income; even when I’m old I hope to be able to work, and if I really can no longer, then I can probably withdraw more than 3% as my time is probably near!

  3. Sunil from The Extra Money Blog says

    I like the emphasis on balance, and enjoying one’s today as well as tomorrow.

    Net worth holds less emphasis to me compared to cash flow. Cash flow can be from a component of net worth (a saving / portfolio) or income streams established from various online / offline endeavors.

    One can achieve financial freedom if the cash flow from income streams is enough to cover day to day expenses and indulgences one enjoys

    • says

      This is true. A large capital base is only necessary only if you plan on not working at all. If you can generate income then it becomes more of a backup and less of a main necessity, though without it I would still consider someone to only be in stage 2.

  4. says

    I think stages change over time too. When you don’ t have kids, it an be a lot easier to live off a more ‘passive income’. However, as expenses grow, it can be really hard to support a family without a ‘typical’ job without spending a lot of time building it ahead of time. Not to mention the higher dependence on insurance and such. I read a lot about people that have accumulated so much and I get down on myself somewhat. However, we started our family young and our expenses grew really quickly. When I am 52, all my kids will be done with college and we will save so much money. I wish we could have done that sooner, but I am also glad we had our kids when we did.

    I guess the point of all this rambling is that some phases of life are easier to save during and establish your own business than others. We can totally not use my salary, but we would die without my husband’s. Now, if the kids were gone, we could probably build up enough online presence in a year or so and could ‘retire’ at 45. But, that is not in the cards.

    • says

      I have no doubt my base expenses will be higher once I have kids, though I would still be working, too. Nothing wrong with 52 — that is still young enough to enjoy life, and hey, things are getting better so when you hit 60 it will be the new 40. 😉

  5. says

    I admire the fact that you are thinking through these stages at such a young age. You are correct in thinking that you need to enjoy the journey. Anyone that always lives for the future isn’t living. However, moving to stage three can be a bit more complicated than you describe and I believe that the capital you mention is way to low – most folks would want more to spend than 18K a year.

    • says

      Hi Marie,

      You’re right – most people would want to spend more than 18k a year, myself included! However, these people can rest assured that even if they fall flat on their face, their capital assets would be enough to sustain them without facing capital consumption. This is really what stage 3 financial independence is about. It’s having that true independence where you could not work another day in your life, but your assets are enough to provide you a home, a regular , etc… without capital loss. That’s pretty sweet. Keep in mind also that 3% is conservative — it’s designed to keep you from shrinking your portfolio too much during the bad times. During the good times, your portfolio will grow and that 3% will be rising at 5%-7% per year. Getting a 5% – 7% raise per year isn’t too shabby.

      It’s not “financial luxury”, true — you need more assets or you need to continue working if you want luxury. But, I’m fine with that. 😉

  6. says

    First off, thanks for the mention Kevin!

    Secondly, financial independence is one of my life-long dreams as well. I don’t really believe in the “traditional paradigm” either. You and I are the same there my friend. I really want to make good investing decisions today so I have the freedom I desire tomorrow.

    I’d like to think I’m firmly in stage 2, moving slowly into stage 3.

    While I’m passionate about some areas of my job, that certainly can’t be said for all of it. I’m definitely yearning to have more control, on my own terms.

    Unfortunately to reach stage 3, I’m about $25,000/year in passive income short of my goal. My goal is $30 K, in today’s dollars.

    Hopefully I can achieve this goal through my blend of market index funds and dividend-paying stocks. No doubt I’m working hard to “get there” while trying to live and enjoy life today. Definitely all about balance for me :)

    Great post. Will include this article in my Weekend Reading roundup later this week!


    • says

      My stage 2 is not quite yet enough to cover all the base expenses, but it’s getting there! I am probably a while away from stage 3, but a sustainable stage 2 is pretty cool to me and can always be ramped up!

      $30k in passive income is huge. I would be happy with just $18k in passive income if it was truly passive, i.e. from index funds or dividend stocks. The good thing about 3% withdrawal is that it’s conservative, so much of the time you will be getting a 5% – 7% raise year after year. Sure some years you’ll get a 30% – 40% paycut, but there are more good years than bad so at some point your 3% will be much more than necessary to cover base expenses!

  7. says

    Great post. I have been making an effort like you to enjoy the journey. I am definitely a forward thinker but I have been trying to focus on the present. I don’t want my days to just go by unnoticed. Who knows what the future is going to hold right? I need to enjoy today.

    • says

      Yep the drawback of thinking too much in the future is that we can forget about the present, while thinking too much about the present and we can forget to plan for the future. Definitely need the right balance between the two.

  8. says

    Great post Kevin!

    Really liked this one. I thought I left a previous comment – but maybe it didn’t take for some reason? Or, you’ve blocked me!

    First of all, thanks very much for the mention!

    Secondly, loved the 3 stages. I’d like to think I’m firmly in stage 2 and working hard towards stage 3. Where I struggle is in two areas. One, ideally my income should come from something I’m passionate about. That doesn’t happen with my day job. Hopefully I can improve on that over time. Two, I find it hard always to save for tomorrow. I want to live for today, and strike a balance between having fun today and investing for my retirement. Sometimes I get distracted but I eventually get back into balance :)

    Great post man.

    Will definitely include this one in my Weekend Reading roundup later this week.

  9. says

    We have taken very similar paths so far in live Kevin. I too found that bit about the withdrawl rates interesting. Another thing we share is our love of early financial freedom. I’m not quite making the the 50% savings mark (unless you count some of the capital I’m building through my mortgage payment), but my significant other will be done school in a year and a half, and at that point we figure to easily save 50% of our household income. I personally hope to go into semi-retirement around 45. I’m sure I’ll supplement my passive income to some degree after this, but I want to be out of the rat race long before most people!

    • says

      My approach is that paying down principal counts, but market value increases don’t. That way you are measuring your direct savings only. Market increases are a great thing but they should not be counted as direct savings since otherwise you will save too little during the good years!

      45 is an awesome age for semi-retirement, and either way you slice it near 50% savings is very impressive. :)

  10. JS says

    Does your estimate of mandatory monthly expenses include the cost of health insurance as well as your property taxes?

    I dream about financial independence but these cash flow drains are a huge obstacle. You could always sell the house, but private insurance is so expensive and unavoidable unless you’re willing to risk it.

  11. 101centavos says

    Good thoughts, Kevin. Besides side incomes, we’re going to try and focus on acquiring some productive assets.

  12. MypayPayday says

    It is true that building up our savings isn’t the only way toward financial independence. Diversification is really important .I am completely agree by you.


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