What’s Your Number? Calculate Your Financial Freedom Number

Imagine a life where you don’t have to work to cover your living expenses, where you have complete control over your time. Picture waking up each day and deciding how to spend your hours—not based on financial necessity, but on what truly brings you joy. Maybe you’d continue working, but on projects you’re passionate about, or perhaps you’d volunteer for causes close to your heart. You might choose to spend more time with friends and family, travel the world, or finally pick up that hobby you've been putting off for years.

To turn this dream into reality, you need the income or assets to support your lifestyle without relying on a paycheck. But how much money do you actually need to achieve this level of financial freedom? The answer lies in knowing "your number." This magic number represents the amount of money required to sustain your desired lifestyle.

Introducing the Safe Withdrawal Rate Theory

The safe withdrawal rate theory is a simple yet powerful concept. It’s the percentage of your investment you can withdraw each year without running out of money. The most commonly accepted rate is 4%, known as the "4% rule." This rule suggests that if you withdraw 4% per year of your investment (think share portfolio or superannuation, for example), your money should last for at least 30 years, assuming it’s invested with some growth assets in a balanced investment portfolio.

The Origin of the 4% Rule

The 4% rule comes from a groundbreaking study by financial planner William Bengen in 1994, which was further studied by three professors at Trinity University in the following years. This research, more commonly known today as the "Trinity Study," provided a robust framework for retirement planning and has gained a cult-like following known as the Financial Independence, Retire Early (FIRE) movement.

Step-by-Step Guide to Calculating Your Financial Freedom Number

Having a clear goal for your life and finances  is crucial for success so let's look at how you calculate your own financial freedom number. 

1. Determine Your Desired Annual Income

First, determine how much money you need to live on each year. Consider your current expenses, lifestyle goals, and how future plans may impact this. 

For example, if you want to live on $50,000 annually, this is your desired annual income.

TIP: A small leak can sink a big ship, so make sure you are being realistic when calculating your desired income and ensure it will cover your expenses now and in future. 

2. Factor in Tax

Depending on how you invest your money, there will likely be some tax to consider. If you have a share portfolio in your name, you’ll be paying tax at your marginal tax rate. If your investment is in superannuation and you’re over 60 when you access it, it’ll be tax-free. Tax is very important to factor in and can have a big impact on the annual income you need.

For example, if you expect to pay an average of 20% tax, your pre-tax income requirement would be $50,000 / (1 - 0.20) = $62,500.

TIP: If in doubt, allow for tax regardless.

3. Calculate Your Financial Freedom Number

Now, to apply the 4% rule, divide your desired pre-tax annual income (your number from step 2) by 0.04. 

For example:

$50,000 plus 20% tax = $62,500

$62,500 / 0.04 = $1,562,500

To live on $50,000 per year (adjusted for tax), you need $1,562,500 invested. This is your financial freedom number! 

TIP: You can also multiply your pre-tax annual income by 25 to get the same result.

Things to Remember on Your Path to Financial Freedom

- Your investments' performance plays a critical role. A well-diversified portfolio typically includes Australian and overseas shares, bonds, and other assets. Historical data suggests a balanced portfolio might return around 6-7% per year. Regularly review and adjust your investments to stay on track.

- Your spending habits and lifestyle choices impact your number, big time! Consider potential changes such as upgrading or downsizing your home, your travel plans, or healthcare needs. Flexibility and adaptability are key, so make sure you regularly review your expenses and always allow for a buffer.

- Achieving financial freedom is more than just numbers. It’s about mindset and motivation. Stay focused on your goals, make informed financial decisions around spending, and celebrate your progress along the way. Remember, every step you take brings you closer to financial independence.

Finally, calculating your financial freedom number is an empowering step towards a secure and fulfilling future. It gives you insights and goals to strive for, helping you confidently plan for the life of your dreams—without relying on the elusive 'man in finance.'