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Tuesday, June 26, 2012

The Critical Difference Between Wealth And Financial Independence (Part 1)

This article first appeared in our newsletter, Wealth Building Insights. You can have first access to this and more if you subscribe to our newsletter using the sign up form on the right >>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>
Wealth and financial independence…are they the same thing or not?

You see these two terms frequently used together or interchangeably but I am of the opinion that they are not the same. Although they are related, financial independence has to do with money…having enough of it, making sure it lasts and does not run out, using it wisely and keeping track of it.

When you are financially independent the income you receive from your savings, investments, pensions, retirement funds, etc. is more than your expenses. Basically you don’t have to go out there and work for money. You can work if you want to but you don’t have to…a big difference.

On the other hand wealth has to do with using money to provide  the quality of life and the lifestyle you want…

So you can travel if you want to…
Wake up every day at 10am if you want to…
Go to the corner coffee shop and read the paper every morning if you want to…
Spend time with family, friends or your poker club when you want to…
Be able to volunteer at the hobby shop, children’s hospital or boy scouts when and if you want to…

Never again have to say “I don’t have the time”… to work out or pursue a hobby or volunteer in the community or tend your garden or paint the house or…

Do whatever it is that fulfills you, that which your life’s purpose calls you to do!

Wealth has to do with not having to worry about money for a living and then having the time AND resources to live the life you want. Whatever that life may be…

On the other hand financial independence is more of a numerical target, both in income and in savings and is part of the road to wealth.

I cannot give you a clear formula for achieving wealth in your life because the definition of wealth in your life is up to you. However, I can give you some concrete steps that you can use to achieve financial independence.

There are certain numbers you need to know as part of your financial planning in order to achieve financial independence. The good news is that they are not secret or complicated. You can figure them out all by yourself and here is how.

How Much Money Do You Need to Live the Life You Want?

This one has two components to it:

1. How much income do you need?
2. How much income do you want?

You first figure out how much money you need on a monthly and annual basis to cover your expenses. If you keep a budget this should be fairly simple to do. Just add up all your monthly expenses for a year.

Be sure to differentiate between those expenses that you need (groceries, the water bill, etc.) vs. those expenses that are nice to have but not necessary (cable TV, excess entertainment, cell phone, etc.).

What you want is to figure out how much money you need in a year to live on.

Note that this might not be the same as your current income from your job. Just because you make $X amount of money per year does not mean that is the amount you need. You could need less or more depending on lifestyle and preferences.

Now you want to figure out how much income you want to have when you are financially independent.

Look into your crystal ball and think of the life you want to have when you are free from working for money. When you do this you might want to consider the following:

  • If you don’t have to go to work every day you will have less commuting expenses and less wear and tear on the car. Less need for clothing and dry cleaners. You will not need to go out for lunch every day. Less stress in your life so less need for stress alleviating activities (vacations, shopping, etc.) Less need to keep up with the expense lifestyle of your piers at work and so on.
  • You might want to do things you currently don’t do now like travel, a new hobby, play more golf/tennis/soccer/bowling etc. Think of the lifestyle you will want to have and how much it will cost
  • Medical costs – to cover insurance, medications, treatments, etc.
  • Your house – will it be paid off or not? Will you rent? Will you be living in the same house, city, state, country as you are right now?
  • Cost of living – will you eat out more or less? Grow your own vegetables or be able to go to the farmers market instead of eating out or buying at the supermarket?

The Financial Stages of Parenthood
When you pick your target date for becoming financially independent think of what stage you will be in raising children.
  • Will you be getting started? At this stage children do not form a big part of your expenses but you have to prepare for the next stage.
  • Raising children? In this stage your income needs will probably be the highest in your life because you and/or your spouse need to provide living expenses for all family members. On top of the numerous expenses associated with growing children add the savings you should be putting away for college funds.
  • Are they in college? Expenses at this stage should start going down if you built college funds. Whether they are in college or not they can also start covering at least part of their own expenses.
  • Independent children? Once they have left the home and are on their own your expenses should go down significantly but that those not mean they will go down to pre-children levels. Inflation, lifestyle choices, tastes and preferences can all contribute to the need/want for a certain income.
You should consider the above as they pertain to you in order to calculate how much income you need to become financially independent. Consider the income you need now and plan for those stages that you have yet to go through.

So how much is enough?

When you think of the life you will want to have and what income you need to sustain it I recommend you plan on living in such a way where you have enough and then some…

If you want to live the country club life then plan for that…

If you want to live like you do now, however that is, then plan for that…

Just make sure you differentiate between those things that cost money and add value to your life vs. the ones that don't and in the end are money down the drain.

Only you will be able to determine what kind of life and activities will be fulfilling to you once you are free from the burden of having to work for money. Just understand that the higher the income needs you come up with the bigger the “pot of gold” you need to create.

So when you think about it, by the above definitions then you don’t have to be rich to be financially independent…say what!

That’s right. You would not need a million dollars, not even close…

For example, if you lived in such a way where you only need $1,500 per month to cover your expenses and you had $500,000 in the savings and investments making you a 6% return, then you would be getting about $2,600 per month in income just from your savings…without “working”. You would be financially independent at that point.

Now, I know what you are thinking…who can live on $1,500 per month?

The answer is a lot of people. Think about it. If you are debt free – own your car, your house, owe nothing on credit cards, etc – and live a frugal lifestyle (meaning not wasteful) then yes you can live on $1,500 per month. And if you live somewhere with a low cost of living, even if it’s outside the USA, then it’s even more possible.

Now, this was just an example so don’t get hung up on the numbers. The point is that becoming financially independent does not mean you have to be a multi-millionaire…unless you want to.

The next step then is to put together the plan for creating the income and money you need to live the life you want, go to part 2 of this article>>>>>>>>>>>>>

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