June 28, 2021
Now that we’ve celebrated our Independence Day, you may want to consider another form of independence: financial. Financial independence is about having the freedom to work or not work as you choose because you're no longer dependent on income from working. If it’s something you aspire to, here are some steps you can take:
Define what independence would look like to you. Have fun and do a little daydreaming about what your life would look like. Where would you live? How would you occupy your time?
This is important for a couple of reasons. First, it's hard to plan for something if you don't know what that something is. Someone who wants to spend their time traveling the world might need more money than someone just planning to spend more time with their family. Second, having an exciting vision can help motivate you to take the steps to turn that daydream into a reality.
Put some numbers on your dream. How much would it cost to live that lifestyle today? (Don't worry about inflation at this point since a retirement calculator can adjust for that later.)
Rather than guestimate, you'll probably be more accurate by looking at your current expenses over the last few months and making adjustments from there. That's because people who look at their actual expenses are often surprised to see that their expenses are a bit different than they thought. You want to be surprised now, not when it's too late to do much about it. Don’t forget about health care costs, especially if you plan to be financially independent before qualifying for Medicare at age 65. You can use online calculators or work with your advisor to estimate the cost of purchasing health insurance through the Affordable Care Act based on your taxable income and to estimate your out-of-pocket healthcare costs once you’re eligible for Medicare.
Find out how much income you'll receive. You can get an estimate of your Social Security benefits based on what you've paid online. Run projections for any pensions you're fortunate enough to be eligible for as well.
Add up your retirement assets and contributions. This includes your employer's retirement plan, any retirement plans from previous jobs, IRAs, and other retirement investments. Don't include your home unless you plan to use it for retirement income by selling it or taking a reverse mortgage. Do include your spouse's assets if you're planning to coordinate your finances together. For contributions, don't forget any contributions you get from your employer like matching funds.
Run a retirement calculation. (Yeah, the word "retirement" may not quite capture the image of your financial independence, but it's essentially the same thing.) You can use an online calculator, but it's better to work with your advisor for a complete picture.
Another thing to keep in mind is the old adage: garbage in, garbage out. Be sure to use conservative assumptions. That means a life expectancy of at least 90 (roughly half of people live longer than average), a 3% inflation rate, and rates of return of between 4-6%, depending on how aggressive an investor you are .
If you're not on track, talk to your advisor to see what you need to do to get on track. This may mean saving more, pushing your financial independence day a little later, or a combination of both. Note that reducing expenses can both increase your current saving and reduce the amount of income you'll need in retirement. Also, delaying your financial independence can mean higher asset values and Social Security and pension payouts and fewer years to spend down those assets.
Take advantage of tax-advantaged accounts. Examples would be your employer's retirement plan(s), IRAs, and even an HSA if you're eligible, since an HSA can be used tax-free for qualified medical expenses in retirement (including some Medicare and long term care premiums) and penalty-free for other expenses after age 65. If you plan to be financially independent before qualifying for Medicare at age 65, be aware that having income from a Roth IRA and other nontaxable money can help you qualify for higher health insurance subsidies since they’re based on taxable income. A Roth IRA is also helpful before age 59 ½ because you can withdraw the contributions tax and penalty-free.
Make sure your portfolio is properly diversified and low cost. Believe it or not, investing is the easiest part of this process, and you don't necessarily need to pay an advisor to help you. Your employer's plan may offer a simple all-in-one fund like a balanced or target retirement date fund. It may also provide free tools to help you determine how you should be allocated based on your personal comfort with risk and time frame.
Automate your saving. If you need to save more, have the savings deducted from your paycheck by contributing to your employer's retirement account(s) and/or setting up an automatic transfer from your bank account to an investment account. You may even be able to have your contributions to your employer's plan increase automatically each year if you can't afford to save enough right away. This is one of the most powerful and effective ways to build wealth over time.
Protect your independence from long term care expenses. You can do everything perfectly correct only to see a lifetime of saving and investing wiped out by long term care costs. That's because Medicare doesn't cover long term care and Medicaid requires you to spend down practically all of your assets to qualify. If you're in your 50s to early 60s and have between $200k and $2-3 million in assets, you may want to consider purchasing a long term care policy. In particular, see if your state has a long term care partnership program that provides additional asset protection.
Seem like a lot? Well, think about how much time you spent planning for your last vacation and consider that financial independence is basically like a vacation for the rest of your life. The best way to tackle it is to break it down and take each step one at a time. The end result is that you can celebrate your own personal Independence Day...just probably without the fireworks.
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