12 Steps To Financial Independence
Alcohol Anonymous is famous for their 12-step program. It’s helped millions, if not tens of millions of people reach sobriety and transform their lives for the better. So in salute to the original 12-step program, in this post we are going to review the 12-steps to achieving financial independence.
01 - Build Career Capital
Cal Newport, the author of “So Good They Can’t Ignore You” defines career capital as the following:
“The skills you have that are both rare and valuable and that can be used as leverage in defining your career.” - Cal Newport
When we talk about personal finance and growing our net worth, it's important to talk about budgeting and investing, but the key fuel to start all that begins with income. If you have low income, it's really hard to jump start your pathway towards growing your net worth. You can only cut so much from your budget.
And if you don’t have a decent amount of capital you can invest into the market, it doesn’t matter how much returns you get on your investment, a 100% return on $10 dollars will only be, $10 dollars. Therefore you must have solid income, and that starts with solid career capital. Something that you can offer to the market in return for high income and salary.
I’ve seen too many people who are still exploring career options far into their adulthood. Still trying out this job and that without really sticking to one. Not giving it enough time and persistence to maximize its income potential. I know people who have tried 5 different career paths, spending money in education, but still not having made much traction in any of them in their mid thirties.
And without a strong career path, your income potential is limited. And this limits your ability to save and invest more towards building wealth. This doesn’t mean you should choose a soul sucking job just because of money. But you want to find a career that can really well support your financial goals while enjoying the occupation. Here are a few things to keep in mind if you are just starting out in your career search. Or even a career change.
One - Is there high income-earning potential? Even if you’re not making your ideal salary from the start, make sure there's an opportunity for your income to increase as your value increases.
Two - Can you grow in this career path? Are there opportunities for you to move up and grow professionally as well as personally?
Third - Do you enjoy the work? Don’t invest in a career you will end up hating. This one is a tough one, but spend some time to find something you’re interested in that allows you to use your gifts and skills to full potential.
02 - Master Budgeting
This is probably one of the least exciting topics when it comes to personal finance, but it is crucial. Think of a budget like directions when you are driving. Without clear cut directions, you will waste an inordinate amount of time trying to reach your destination. Or worse yet, never reach our destination.
In the same way, we could never reach financial independence if we don't have a written plan for our money. When we operate without a budget, we will find ourselves wondering where our money went at the end of every month. Feel free to use online tools like Mint.com, a simple spreadsheet or even a blank sheet of paper. What is important isn’t the tool, rather the plan.
If you’ve never had a budget, get in the habit of giving every dollar an assignment before the month begins and track your spending throughout the month. If you consistently overspend or underspend in certain areas, you can always adjust the amount in those categories. Trust me, the more you do this, the easier it will get. Nobody gets to the top of Mt. Everest without a plan. And you won’t achieve financial independence without a plan either. Budgeting is the blueprint for that journey.
03 - Hold Cash
My wife and I prefer at least 6 months. Ideally 12 months given we are more risk averse when it comes to preparing for unexpected events. But the key is to have enough cash in your checking account to act as a buffer between you and the unexpected life events that will happen to all of us. Events like job transitions, broken appliances or real emergencies like medical deductibles.
The pursuit of financial independence will be filled with alot of road blocks. Just like in life, things will never go as we planned. But when you have enough cash to weather the many months of storms life will throw at you, they will just be speed bumps rather than boulders that will halt your progress cold.
In addition, in this my favorite reason to hold cash, they will give you both the mental and emotional breathing room. The room to think when you face setbacks and room to take a breather when you hit a rough spot.
04 - Pay Off High Interest Debt
I would say high interest is anything over 5%. This most often includes credit cards, student loans and car loans. The income that you generate from your solid career capital is your most powerful wealth-building tool and that income is what will allow you to reach financial independence one day. However if your income is bitten off little by little with credit card bills here and student loan debt there, it will be extremely hard to achieve financial independence.
You can follow either the Debt Snowball or the Debt Avalanche method to tackle this step. Whichever one that most motivates you. The bottom line is throw all the extra cash you have at it until it is gone. Paying off debt is extremely hard - I know because I spent 3 and a half years working with my wife to pay off $105,000 of student loans after we got married. But once it is gone, there is nothing more refreshing and freeing than getting to keep that money you bring in every month versus sending it off in debt payments.
05 - Master Your Expenses
When you’ve completed step 4, you did something amazing that millions of Americans struggle with. You are essentially debt free with the exception of a few low interest debt most likely your mortgage.
Now what happens to many people at this stage, and my wife and I started to experience this too, is that you feel the temptation for a little lifestyle creep. It's natural. You worked so hard. Sacrificing your desires so you could be debt free. So you might feel the need to treat yourself a bit.
Now a little bit is ok because you don’t want to go into deprivation mode - eating only beans and rice for the rest of your life in the spirit of financial independence. That is no way to live. That is unless you really like beans and rice. You want to maintain that self-discipline that brought you this far by continually saying no to the consumer oriented world we live in. Ramit Sethi, the author of I’ll Teach You To Be Rich has a saying:
“Spend extravagantly on the things you love, and cut costs mercilessly on the things you don’t.” - Ramit Sethi
I firmly believe in this statement when it comes to mastering our expenses. Having the ability to spend money on things we love is the reason why we work so hard - but this can only happen if we are willing to cut back mercilessly on things we don’t care too much about. If you love fancy shoes, get the one that sparks the greatest joy. But then you need to be willing to cut back on everything else. Be willing to drive a 10 year old car. Be willing to pack lunch. Be willing to live in a smaller home regardless of what anyone thinks. If you can do this, then enjoy that fancy pair of shoes.
06 - Hold Right Insurance
I know, you might be eager to jump into investing as soon as possible but you don’t want to skip this step. And you might also be asking, what does insurance have to do with achieving financial independence. Quite a bit actually.
When you look at world champion level soccer teams, it isn’t just their offense that wins the game. They require strong defense because what’s the point if your striker scores 6 goals when your weak defense just gave away 7. Your team lost because you were only focused on scoring and not defending your goal. Think of insurance as a strong defense. Defense that will protect you on your journey to financial independence.
A study published in the American Journal of Public Health found that 66.5% of bankruptcies in the US are due to medical issues. Serious diseases or injuries easily result in hundreds of thousands of dollars in medical bills. When we don’t have adequate insurance like health insurance, these bills can easily wipe out savings and retirement accounts, college education funds, and home equity. All important foundations for achieving financial independence.
The bottom line is that while good financial habits like budgeting, saving and investing will one day help you reach financial independence, adequate insurance will protect your journey with good defense. I believe the four must have insurances that we can’t live without are the following: Homeowner insurance, Auto insurance, Health Insurance and Term Life Insurance. Make sure you have the appropriate insurance and coverage to protect you.
07 - Ramp Up Your Savings Rate
With good income from a solid career capital, no high interest debt and your expenses under control, you are ready to start dialing up that savings rate. When it comes to how much to save and how much to save for retirement, there are alot of general rules of thumbs.
The Richest Man in Babylon by George Samuel Clason made famous the 10% savings rate.
Then came Dave Ramsey with his baby steps and said we should save and invest 15% of our household income in retirement.
Then Senator Elizabeth Warren and her daughter popularized the 50/30/20 budgeting method in their book All Your Worth. 50% on needs, 30% on wants, and putting away 20% to savings.
But you know what I say? Why stop at 20%. If you are serious about achieving financial independence, save as much as you can. Mr. Money Mustache, one of the most well known financial independence bloggers, shared an article titled “The Shockingly Simple Math Behind Early Retirement” in 2012.
Essentially what he said in the article was that savings rate and financial independence are directly correlated to each other. When our savings rate goes up there are two things that actually happen. One, we are saving more and growing our investments. However, the second, more overlooked part is where the magic actually happens.
We spend less. And when we spend less, the amount of money we need to reach financial independence goes down. For example, let’s say our annual income is $100,000 and our lifestyle costs us $80,000. This means we have a 20% savings rate. Because you need to build a nest egg that can fund $80,000, at a 8% estimated annualized return, it will take you approximately 28.5 years before you can retire.
However, let’s say you go buck wild and cut your lifestyle to $50,000 a year. Forget the after school for kids and you travel hack your way into never paying for vacations again. You essentially increase your savings rate to 50%. You are saving more and you need less to fund your new lifestyle now. How long will it take for you to reach your financial independence number? About 14 years. You cut your retirement time by half. When we look at it this way, you start to think that the after school program was overrated anyways. Right?
08 - Max Your Tax Advantaged Accounts
These include buckets like 401k, Roth IRA, HSA, Traditional IRA, etc. The specific accounts might be different based on your employment status, but the bottom line is that if you have tax advantaged investments available to you, max them out before you even start looking at taxable or other investment vehicles. The tax advantage allows you to either contribute more into the market because they are pre tax or allow your investment to grow tax free.
Now I heard some people arguing against maxing out their tax advantaged accounts because they want to reach financial independence before the standard retirement age. In case you didn’t know, there are penalties for withdrawing money before you turn 59 and a half. And penalties that make sense because these accounts are for retirement and the government wants to discourage you from spending the money early - on things like a yacht or a trip to Italy.
However, when we step back and look at the big picture regarding early financial independence and retiring early, what many of us overlook is that normal retirement is part of early retirement. Even if you hit financial independence at an early age of 45, you will eventually get to the age of normal retirement within 15 years.
I’ve heard some people say they aren’t contributing to their 401k because they plan on reaching financial independence sooner. I feel that is a big mistake. Even if you plan on retiring early, you still need money to live on in your later stages of life, when your tax advantaged accounts will really come into play. Now with that said, if you want more details on the specific order of investment, check my video here on Optimal Order of Investing Your Money to find out more.
09 - Build Taxable Investment Account
The crucial note I want to highlight again is that you want to ensure you are really completing step 8 before moving to step 9. Maxing out all your tax advantaged accounts like 401k, Roth IRA, HSA, etc. If you are in a high income bracket, maxing out your 401k will literally save you thousands of dollars in taxes, allowing more of your dollars to work for you sooner.
But once all those accounts are maxed out, then start a regular taxable account. Now this won’t have tax advantages, however it will serve as a good bridge to fund your life until you can safely access your tax advantaged accounts. And this is also a good spot in the post to tell you the importance of investing in low cost, well diversified index funds when it comes to both your tax advantaged and taxable accounts. Here are a few of my favorites:
All these funds are variations of the total market or the S&P 500 index and all excellent equity funds to hold in your portfolio. If you would like to learn more about how to construct your own 3-fund portfolio, one of the most popular investment portfolio strategies, please check out my post here.
10 - Diversify Your Investments
Now I want to highlight here that this step isn’t quite necessary. However if you’ve successfully achieved everything up to step 9, then I would say why not. It’s always good to add additional diversification to your wealth if you have room. Personally I like real estate, so once my wife and I got to this stage, we decided to invest in rental properties.
However I would like to say that unlike what many tiktok personal finance personalities espouse about real estate, it's not all unicorns and roses when it comes to owning rental properties. For one It requires a lot of hands-on activity; finding good tenants, managing the property, dealing with repairs, and all sorts of other things. And second, tons of paperwork. Way more than a simple index fund.
But if you are at a comfortable stage in your finances and you have a strong foundation on index funds in tax advantaged and taxable accounts, looking at diversifying your investments could be a good idea. The most common areas I’ve seen are, as I mentioned earlier, real estate, but I’ve also seen other individuals invest in small business or syndicate deals with other investors.
11 - Buy Back Time
Many assume that financial independence is a black or white proposition. You can’t have freedom until you reach your ultimate number - 25x your annual expenses. However, I don’t see it that way. As you move through these steps and you acquire more assets under your name, you can start buying back your time little by little with each step.
Once you have a sizable emergency fund, maybe you can negotiate a work from home arrangement because you aren’t afraid of talking to your boss anymore. Once you have a sizable amount of money in your taxable investment account, maybe you can transition to working part time? In the Financial Independence world there are tons of terms people use to describe these options. Coast FI, Barista FI, Slow FI etc.
The bottom line is that don’t think of financial independence as a black or white proposition. Be willing to buy back time, even a little bit of it, as you can afford it in your journey towards financial independence. And this segways nicely to our final step in our journey to financial independence.
12 - Define Your Ideal Lifestyle
This goes hand in hand with step eleven. As you start buying back your time little by little, you want to use the extra time to start defining your ideal lifestyle. For many of us who might never have had the opportunity to define our ideal day or our ideal week, this could be a really hard exercise to do. If I could wave a magic wand and do whatever I wanted, what would I do? How would I spend my time? If we are faced with this question for the first time, many of us will struggle. We’ve lived our whole life being told what to do. By our parents, our teachers and our bosses.
But once you are able to buy back a bit of time, it is very important that we also work simultaneously to define our ideal lifestyle and design our days. In a way, the whole point of pursuing financial independence is to define and live out our ideal lifestyle. Because what is the point of having all the money in the world if we can’t design the lifestyle we want?
If you want to learn more about this concept of lifestyle design within the scope of financial dependence, check out my friend Jessica’s website, the Fioneers. She has some great resources to help us design the life that we want.
