Money buys freedom. Yet most people don’t know how much their freedom actually costs.
My favorite personal finance concept is F-You Money, which is the amount of money required for a person to achieve full financial independence. That is, for said person to choose to start a business around a passion, choose to work in a cube, or simply choose to sit on her couch for the rest of her life.
F-You money varies greatly depending on the individual. This article teaches you how to calculate the exact amount of wealth you need to buy your freedom.
Why should I care about my F-You number?
How the hell do you expect to retire someday when you don’t even know how much money you will need?
Personal finance education is not taught in the United States, and as a result most Americans don’t have a clear sense of what it takes to retire comfortably. Don’t feel bad if this is you, I didn’t know what my F-You number was until two years ago (when I was 30) and forced myself to start researching financial freedom strategies.
Knowing your number sets a goal post. When you have a number in front of you, you can then create a strategy to buy your freedom.
First, some important assumptions
The following are assumptions that I use to personally guide my F-You calculation:
1. Most of your wealth will be held in a well-diversified set of index funds. Index funds are basically low-cost mutual funds that can represent various market/asset segments, such as real estate (REITS) or large Fortune 500 companies (S&P 500 Index).
Still confused? No problem, read Jim Collins’ epic series on stock investing for more background.
Too lazy to read all that? No problem, park your money in Wealthfront (affiliate link) and automatically get your investments diversified for you in a low-cost way.
I strongly believe that investing in the market, via holding diversified index funds, is one of the most effective ways to create wealth. Read up on Modern Portfolio Theory to understand this perspective some more.
Also, for the purposes of this article, do not consider the value of your primary residence as part of your wealth or net worth.
2. By parking your wealth in the market (index funds), you will enjoy a 7% average annual return across your investments. The key word here is average. Sure markets go up and down year to year, but over longer periods of time (10+ years), markets consistently have moved up and to the right.
Take the S&P 500 index for example. The S&P 500 is an index representing 500 large companies listed in the NYSE and NASDAQ. From 1975 thru 2013, the S&P 500 Index has returned an average of 10.14% annually. Keep in mind that this 10.14% annual return includes three catastrophic financial events: Black Monday (1987), the Dot-com Crash (2000), and the Great Recession (2008).
You should expect volatility, but I don’t think it’s a stretch to assume that a diversified portfolio of index funds can perform well over the long-run. I’m not alone in assuming 7% annual returns as a benchmark.
3. Inflation will be 3% on average. Inflation is a bitch. If you’re not familiar with the concept, it’s the idea that the stuff you buy goes higher and higher in price over time.
It makes your money worth less and essentially eats away at your gains. If you have a 7% annual return one year, then with 3% inflation your money actually grew only 4% (7% – 3% = 4%).
Like the stock market, inflation is somewhat volatile year to year. But since the mid-1980s, the Federal Reserve has developed some good techniques to tame inflation. From 1985 to 2012, annual inflation has ranged from -0.4% to 5.4%. For most of the past 20 years, annual inflation rates have hovered between 2% and 3%.
I feel comfortable assuming that 3% is a good annual rate for the future.
4. You will live off 4% of your portfolio until you are dead. Mr. Money Mustache has an awesome article about the 4% Rule. This is the concept that for each year that you are “retired”, you will skim 4% off your total portfolio to pay for your living expenses.
Example: let’s say that you have a $1,000,000 portfolio of wealth that is resting in a nicely diversified set of index funds. Applying the 4% Rule gives you $40,000 to live on each year, pre-tax (we’ll talk more about tax in a moment).
But what’s really amazing about the 4% rule is that it allows you to skim money from your portfolio but still keep your wealth intact, even with inflation eating away at your gains. Just to recap:
- Assume your portfolio is growing by 7% each year annually.
- You are skimming 4% to cover your annual personal expenses.
- What’s left is now: 7% – 4% = 3%, which are the gains your portfolio will make to offset inflation!
So let’s go back to that example of the $1,000,000 portfolio:
- At a 7% annual return, you will make $70,000, making your total portfolio size $1,070,000 at the end of the year.
- You are skimming 4% for your own personal expenses, which is $40,000.
- That leaves $30,000 in gains that will stay in your portfolio, leaving your total wealth to be 1,030,000.
- That 3% gain of $30,000 in your portfolio will perfectly cover the 3% annual inflation that everyone loves to see eating away at their wealth each year! (cough, sarcasm)
Assuming these assumptions hold, then in theory you would be able to live forever from your portfolio, allowing you to maintain your quality of life of annual expenses AND adjust for inflation over time.
Again, read Mr. Money Mustache’s article on the 4% Withdrawal Rate, he explains the principle way better than I ever could.
5. You will have to pay taxes. Today the federal capital gains rate (that is, the taxes you pay for selling assets you held onto for over a year, like stock) is 20%. And, you also have to pay state taxes, which vary a lot depending on where you live.
Where I live in California, that additional state tax can be as high as 13.3%. But there are other states, like Nevada, which have no state income taxes.
Figure out your own state’s tax rate and adjust your total tax rate (state + federal) as appropriate. Also understand that in the future, your federal and state congress may choose to hike up or down your capital gains tax rate at any time. So that sucks.
6. Final assumption, I am oversimplifying things a lot. You might have access to other assets that produce wealth for you, other than stocks, bonds, and index funds, like: renting out real estate, Bitcoins, pensions, and precious metals. Maybe Social Security will even be around for us when the Millennial generation gets old (though I wouldn’t count on it).
There is no one-perfect financial strategy for everyone. Note that I am not a financial professional, just someone passionate about freedom.
Alright, how do I calculate my F-You number?
Here’s the formula:
Let’s break this formula down:
- Amount of money to live comfortably for a year – This includes expenses like your mortgage, clothes, travel, going out to eat — everything.
- Multiply by 1.5 – We’re adding a 50% premium to what you need to live comfortably because of the fact that you need to pay taxes on the money you withdraw, fix your old roof, take care of unexpected health problems, etc.
- Multiply by 25 – This is an important step to represent the fact that you will be drawing only 4% out of your total F-You pot each year to live your life.
- F-You! – aka, freedom!
Let’s see an example of someone who determines that she needs $100,000 per year to live well:
In this example, you’ll see that this person’s F-You number amounts to $3,750,000. If she has this number today, she will be financially free to do whatever she wants for the rest of her life, so long as she keeps within a $100K/year budget.
And that’s an important caveat, which is that this formula only works when you stay within a specific lifestyle. If you reach your F-You number for a $100K/year lifestyle, but then suddenly decide to spend $800K for one year, then your financial freedom will no longer be sustainable.
So, if this person skims 4% from her $3,750,000 nest egg, that leaves her with $150,000, which should give her $100K to live on, plus $50K to pay her taxes and cover other unexpected expenses that happen in her life.
Don’t forget about inflation
Let’s carry on with the example of the person who says that she can comfortably live on $100K/year forever. Let’s say that she gets excited by seeing the $3,750,000 number because she thinks she can hit level that in 10 years with aggressive saving and investing.
Sorry to dash your dreams, but you have to remember that inflation makes your F-You number grow each year. In the assumptions outlined earlier, we target annual inflation as 3% per year.
Thus, $3,750,000 today is equivalent to 5,039,686 in 10 years, assuming 3% annual inflation.
To calculate what your F-You Number will be in some number of years into the future, use this formula:
(F-You Number) x (Inflation Rate)^(Number of Years) = F-You Number in the Future
Here’s the calculation showing the equivalent value of $3,750,000 in 10 years, assuming 3% annual inflation:
$3,750,000 x (1.03)^(10) = $5,039,686
I understand the formula to calculate my F-You Number, but what exactly is my F-You Number?
The only piece of data you have to provide is the amount money you need to live comfortably for one year. It’s going to take some work to figure this out.
1. Sign up for a Mint.com account. Mint.com is an awesome tool to help you track and report your expenses and earnings over time. It’s free, so sign up for an account and connect all your banks, credit cards, and investments into the software.
2. View reports of your spending over the past year. After you log into Mint.com and connect your accounts, you can go to the “Trends” tab at the top of the page to view reports. The “Spending Over Time” report should give you a report on your expenses. You can pick a one-year time frame to see what one year’s worth of spending looked like for you.
Extra Credit: you may want to invest some time in Mint before your review these reports to tag your transactions individually over the past month (or even better, the past year). This will ensure that your reports are much more accurate when you run them. Sometimes Mint gets a bit buggy, auto-categorizing transactions like a bank transfer from one account to another as an expense. Tagging your expenses will make sure you catch these errors so they don’t get reported.
3. Plug and chug. Take your annual spending number from Mint, bring that number up or down based on your judgment of what you need to spend each year to be comfortable, and apply that number to the F-You formula above.
You may need to re-visit your F-You Number several times in your life. For example, if you decide to have kids in the future this may change your spending assumptions.
If you are not at your F-You Number today, there are two techniques to help you get to your freedom quicker:
- Earn more. Obviously, the more money you earn, the more you can save and invest. For inspiration on how you can make more money I highly recommend reading Ramit Sethi’s blog, I Will Teach You To Be Rich. And read Jim Collins’ blog to learn how to invest and retire well.
- Spend less. Spending less money gets you to a lower F-You Number. To learn how to super-optimize your spending, read Mr. Money Mustache’s blog and see how he lives like a king and supports his family with less than $25K/year.
I wish I could take credit for inventing the F-You Number principle, but really all I’ve done in this article is re-state concepts I’ve learned from many other resources; especially from the three bloggers mentioned above. Read these blogs and definitely do your own research.
A big thank you to Stacey Ferreira, a rockstar 20-year-old entrepreneur, who inspired me to write this article due to a personal finance Facebook thread she started a few months ago.
If you have any questions about the concepts shared in this article, please leave a comment and I’d be happy to clarify.
Special thanks to Vincent Pham for reviewing and providing feedback for this article!