The Three Stages of Financial Independence

On the path to financial independence, I’ve often been asked if I have a goal in mind. Many people refer to this goal as “your number” – the magical line in the sand when you cross from being financially dependent to financially independent.

I’ve always thought the idea of a single number seemed silly. How could there be one special number that meant I reached the holy grail of financial independence? Life has rarely worked that way so far. Every time I reach a goal, there’s always another on the horizon, so it’s never made much sense to me that financial independence would be a clear “yes/no” proposition.

Regardless of my financial goals, my number is almost guaranteed to be different from your number. Your tastes, habits, and expenses are different from mine. We don’t have the same family. We didn’t start in the same place. That muddies the water even further.

In this article, I’d like to break down how I view financial independence and the various stages of financial independence. Here are the three ways I think about financial independence and how I plan to reach each stage. But, regardless of the three different stages to financial independence, they all have one basic thing in common: You don’t have to work to earn an income because your investment income covers all your living expenses.

Stage One Financial Independence: Median Household Income

The median household income in the United States is $57,617. The poverty line for a family of two is $16,460. If your family is making between $16,460 and $57,617, you are in the lower middle class by definition (although it’s debatable that we should be using the concepts of “lower middle class” and “upper middle class” but that’s a story for a different article).

It would take somewhere between approximately $425,000 and $1,450,000 in savings to reach Stage One Financial Independence assuming you could withdraw about 4% of the portfolio without ever need to touch the principal. This levels of savings would provide you with an income level in the lower middle class (keep in mind that it’s really your expenses that count, which we will soon see, but approximating the median income seems the best measure for Stage One Financial Independence since at this income level there’s not a ton of room for saving money anyway).

If you had an income in this range you would be able to cover all of your annual expenses in the majority of the United States. Your lifestyle might be lower than it is today – and you probably wouldn’t be living in a big city on the coasts – but you would no longer need to work to cover your basic living expenses.

In my view, Stage One Financial Independence is achievable by 99% of lawyers. The speed at which you obtain Stage One Financial Independence will depend on your income but the end result is simply a matter of when and not a matter of if, assuming that you decide to achieve it.

A lawyer that saves $10,000 a year over a 35-year career (from ages 30 to 65) can expect a nest egg of $1,250,000 in inflation-adjusted dollars. I don’t know too many lawyers that can’t save $10,000 a year. If that same lawyer manages to increase her savings rate to $20,000 per year for years 40 to 65 she’ll end up with $1,850,000 in inflation-adjusted dollars, putting her expected retirement income ahead of the United States median household income.

Many lawyers aren’t able to grasp Stage One Financial Independence because they either grew up in expensive areas of the country or are working in expensive areas of the country right now. If you have a portfolio of $1,000,000 generating $40,000 a year in income, it might seem far-fetched to imagine living off $40,000 a year in a city like San Francisco.

Stage One Financial Independence has a lot of flexibility though and is the most important stage of financial independence since it’s the baseline level where you can call yourself financially independence.

Once you reach it, you can do things like:

Decide to work at a non-profit for a tiny salary.

Explore a risky side-project or business and not worry about it failing.

Downsize by moving into a small house or apartment and stop working entirely.

Move to a lower cost-of-living location in the United States or somewhere else in the world where you can stretch each dollar farther.

Take a multi-year sabbatical to travel the world or spend time with your children between ages 0-5 before they start school.

Stage One Financial Independence is where a Biglaw Associate can find himself after 5-8 years of working. Or, for a household in Kentucky, it’s where they could find themselves after 15 years of saving $30,000 annually (expected inflation-adjusted portfolio at that savings rate would be $725,000). For that Kentucky lawyer, both partners need only use a 401(k) to reach $725,000 since $30,000 a year is less than the maximum space available to them each year.

Stage Two Financial Independence: Current Expenses Covered

If Stage One Financial Independence is the result that 99% of lawyers can expect to achieve in their lifetime, Stage Two Financial Independence is the outcome that confuses them the most.

Many lawyers assume that because they’re in their working prime, they’ll never be able to achieve “true” financial independence where investment income is covering their current expenses. Those lawyers forget that they could easily move to other parts of the country and be financially independent.

But let’s dream a little and imagine how much money it would take to cover your current expenses. If you’re following the Biglaw 1st Year Sample Budget, you’ll be spending about $60,348 to live in an expensive city.

You’ll also probably be living with roommates, so we’ll call this the low end of Stage Two Financial Independence (note that it’s still higher than the US median salary). If you’re a family of three living in NYC, it’s reasonable to think your expenses could be closer to $120,000 a year.

It would take somewhere between approximately $1,500,000 and $3,000,000 in savings to reach Stage Two Financial Independence assuming you could withdraw about 4% of the portfolio without ever needing to touch the principal. This level of savings would provide you with enough income to cover expenses in a big city.