3550: [Part 2] How I Measure Progress Toward Financial Independence by Craig Stephens of Retire Before Dad

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[00:00:47] This is Optimal Finance Daily. How I Measure Progress Towards Financial Independence, Part 2 by Craig Stephens of RetireBeforeDad.com. Start with annual spending. Late last year, I demonstrated how I track annual spending using Excel and its pivot table functionality. That method gave me the exact amount our family spent in 2018.

[00:01:17] Start with annual expenses. In this example, I'm going to use the number 65,000 for annual expenses. For someone whose annual spending is $65,000, their fine number, based on the math of the 4% rule, would be $1,625,000.

[00:01:37] Invested assets or net worth. Remember, the fine number goal is to build a lump sum of savings and investments or invested assets equal to the amount. That's different than net worth. Some people simply calculate their net worth and use that to measure progress towards financial independence.

[00:01:57] Using net worth is less accurate because it includes the equity in your primary residence. Unless you plan to liquidate your home and move to Guatemala, you're going to need the home. Best practice is to use invested assets to measure progress towards financial independence instead of net worth. Adjust for Sustainable Investment Income. Okay, so I'm using a combination of the fine number and investment income. How does that work?

[00:02:26] I share with you my forward 12-month investment income or F12MII every year. F12MII is my own term, so if you Google it, you'll probably end up right back here. Other people call it passive income or forward dividend income.

[00:02:45] F12MII is the estimated income I'll earn from my dividend stocks, real estate crowdfunding holdings, high-yield interest on cash, and rental property over the next 12 months. This is money I earn whether I'm employed or not. For this example, let's make it a round number and use $12,000, generating income of $1,000 per month. Some of that $12,000 income, especially from the real estate, is taxable.

[00:03:12] So I'm going to make a ballpark 15% adjustment for taxes. That comes to $10,200. However, one of the most beautiful aspects of dividend investing in the U.S. is that qualified dividends and capital gains are subject to a 0% tax rate for income up to $38,600 for singles and $77,200 for married couple filers in 2018.

[00:03:39] Dividends and capital gains are not taxed below those thresholds. So dividend income generated for a married couple with total income below $77,200 is tax-free, but we'll still make the 15% adjustment. Now that we've made an adjustment for taxes, we'll subtract net investment income from annual expenses. So $65,000 minus $10,200 is $54,800.

[00:04:09] When adjusted for investment income, that is the F-12 MII, the retiree in this example now only has $54,800 of expenses to cover from safe withdrawals from savings. We'll use this as our new baseline to calculate our adjusted fine number. Recalculate fine number. With our new expense coverage requirement, we can recalculate our updated fine number.

[00:04:37] Instead of $1,625,000, the fine number in this example is lowered to $1,370,000. After adjusting for passive income streams, we'll need that much savings and retirement accounts to reach financial independence. The money invested that enables us to earn $12,000 in passive income is excluded from the FI savings number. This includes equity and any rental properties.

[00:05:07] I also exclude college savings. The obvious shortcut. Before we go on, I should mention the obvious. Earning $12,000 in investment income requires a lump sum invested in taxable accounts. Why not just use that amount towards your FI number? For example, to earn $12,000 in passive income, you'll need about $342,000 of invested assets yielding 3.5%.

[00:05:34] The difference between your original FI number and the adjusted FI number is $255,000. So why not take the easier road and add the $342,000 to the FI number and declare financial independence sooner? Because most of us are more concerned about a secure retirement rather than a more eminent one.

[00:05:56] I prefer to keep taxable passive income assets and retirement savings separate because I don't want to draw down the principle of my sustainable income streams. Keeping stable income streams without drawdowns will help me live my ideal retirement. Chart it out. Let's recap the numbers then chart this sucker out. Keep in mind this is all for illustrative purposes only. Annual spending $65,000.

[00:06:24] FI number $1,625,000. Annual investment income $12,000. Annual investment income adjusted for taxes $10,800. Adjusted fine number $1,370,000. Without any passive income, you'd need to save $1,625,000 worth of total invested assets in our scenario.

[00:06:50] If you earn $12,000 of annual passive income from investments, you'll need to save $1,370,000 in invested assets, probably in retirement accounts, aside from those assets generating income in taxable accounts. Since net worth is an easy number to get, I'm going to use it in our chart to add a second line for comparison. But remember, net worth includes the assets that make up investment income plus the equity in your primary residence.

[00:07:19] You'd want to plot net worth against the original fine number, $1,625,000. And it's still less accurate. But we're going to cheat and plot it against the adjusted fine number anyways. The last thing we need to do is add up retirement savings and any assets not contributing to taxable investment income.

[00:07:40] This is the amount of savings in IRAs, Roths, 401ks, 403bs, or any other tax-friendly account and other non-income producing assets. I use personal capital to aggregate all of my accounts in one place. It automatically calculates my net worth when I log in every day. It also makes it easy to grab the current balances of my retirement accounts for this exercise.

[00:08:05] I then sum up my retirement savings at the end of each month and plot it against my fine number, both as a percentage and by the total dollar amounts. This is a fairly new exercise for me, so I only have a few months of data. But I've dummied net worth and retirement savings to illustrate what the charts would look like after tracking our previous example for a year.

[00:08:27] In the chart pictured in this article, the purple line represents our fine number, green net worth, blue retirement savings chasing the fine number. When the blue line crosses the purple line on my real charts, I've reached financial independence. You can do this with a net worth of zero or a million or more. Don't be discouraged if your numbers aren't great today. Start tracking anyway. You'll be amazed with the amount of progress you can make in a year or two.

[00:08:57] The only way you'll see it is with a chart. Dynamic Chart Once a spreadsheet is set up with the tables and charts, all you have to do is collect the data each period. Could be monthly, quarterly, or yearly. I'm planning to use a static annual spending number for the entire year, then update it fresh each January. However, you could make a moving fine number using trailing 12-month spending data.

[00:09:23] That would encourage you to spend less each month, bringing the purple line or your fine number down and moving you closer to financial independence. Lowering the purple line is a big opportunity for us as our preschool costs decrease and our F12MII rises over the coming years. Then, as our retirement accounts compound, our rental properties appreciate and misses retire before dad starts to earn again.

[00:09:50] The blue line should accelerate upward. But since I've only recently started tracking to this detail, I'm not ready to forecast our FI date. And it's hugely market dependent. As I build out this chart over the coming years, our financial independence date should come to light. I'll eventually see the green line surpass the purple line. Then one day, the blue line will cross the purple, indicating that I've officially reached financial independence. At which point, I'll go right back to work.

[00:10:24] You just listened to part two of the post titled, How I Measure Progress Towards Financial Independence, by Craig Stephens of retirebeforedad.com. Summer's almost here. And honestly, I want to be planning a vacation, not stressing about whether I can actually afford it. That's why I keep my finances organized with Monarch, so I can enjoy my summer knowing my money's taken care of. Monarch is the personal finance app that tracks everything,

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[00:12:47] I thought this article was a great summary of how to track your progress while pursuing financial independence. I'd like to add here that your FI number of 25 times your yearly expenses is only as good as your assumptions behind how much money you'll need. Budgeting and tracking your expenses does help you make an educated guess, though. If you retire at 30, it's really hard to know with any certainty what your yearly expenses will be at 60 years old.

[00:13:15] But you can start with your current expenses, pad your numbers, and think through worst-case scenarios and backup plans. This article reminds me of how I was pursuing FI when I first got started. But don't be surprised if you change your approach over time as your circumstances change. I'm currently taking a much more flexible approach with my FI plans, because the reality is, the only guarantee in life is that everything always changes.

[00:13:42] I like to call it FI-lexibility because I simply can't help myself when it comes to making up and misspelling words. So please forgive me. In short, FI-lexibility is about gracefully navigating the unknowns, and maybe more importantly, seizing the opportunities that present themselves on the path to financial independence. I often remind myself when I'm dreaming up a goal or developing a plan to reach that goal, financial or otherwise,

[00:14:10] that I can't possibly anticipate today the opportunities that present themselves tomorrow. Goals are great. They help us chart our path. But if we're so rigidly focused on them, we might miss out on some amazing opportunities along the way. And that's going to do it for today. Thanks so much for tuning in and listening to both parts of this great post. And I'll see you tomorrow where your optimal life awaits.