Financial Independence - What "Counts"?

[Duke_of_Kent]

Hello all,

I mustache you a question...

I've read that the simple formula for "Financial Independence" is reaching the point where your net worth is 25x your annual expenses (i.e., the 4% rule).  While I am approaching that point, I certainly don't feel as if I'm reaching independence.

Here's why: Approximately a quarter of my net worth is the value of my home.  That's not exactly a liquid asset that can be drawn down.  Similarly, another 45% or so is tied up in my 401(k) and Roth IRA.  Since both of those investment types have age restrictions to access the funds, I can't touch them for another few decades.  And while I am one of the lucky few who have earned a pension (albeit a small one), it too has age restrictions for access, so I don't even count it in my net worth estimate.

Considering these restrictions, should a modified net worth calculation be used when estimating FI?  Should I only be counting liquid assets?  Depending upon how I choose to run the numbers, I am either very close to FI or very far away.

[RyanAtTanagra]

Don't count your home unless you're planning to downsize for retirement.  It's 25x your expenses in investments.

For the IRA/401k concern, look up roth conversion ladders and 72(t).  There are a couple (easy) ways to get access to your money without paying penalties.

For your pension, you just spend down your other buckets first.  You don't have to spend all buckets equally.  Calculate how much you need to tide you over until pension age.

[2Birds1Stone]

What Ryan said.

If you don't plan to sell your house and move, I would not count that equity in the 4% rule.

If you have a paid off house worth $1M, and your spending is $40k......you would be FI if that house was your only asset. It doesn't work like that in the real world.
 

[FireHiker]

Even though we plan to downsize, I don't consider home equity towards my FI number. Since my husband is older enough than I am that we'll be able to pull from his 401k, we don't have the same complication you do with timing. If we did, we'd do the roth conversion ladder.

[effigy98]

I track the home equity as my total portfolio percentage so I do not become too overweight in real estate. I also track the equity in the home seperate as the "fall back plan" if stuff really goes wrong with the other part of the portfolio because I can always downsize if needed or geo arbitrage. People say in this environment to count on 3.5% instead of 4, but with so much home equity, I feel like I can stick with 4% (or even go up to 4.5%) with very little chance of failing.

[SwordGuy]

You have to use your common sense in this.  Everyone's situation is somewhat different.

First of all, only assets that make you money count.

Second, if you have to sell or rent an asset to make money off of it, and you are unwilling to do so, it does not count, either.

So, you can own a $25,000,000 home free and clear, but if you won't sell it and you won't rent it out and don't receive money for it for some other reason, it doesn't count.

If mom gave you a Picasso painting worth $20,000,000 but you won't sell it, it doesn't count.

Third, what matters in FIRE is reliable passive INCOME, not net worth.

That income shows up from different sources.   Each source may have different characteristics and therefore, should be counted differently. 

Example:  A $10,000,000 property you will NEVER sell for sentimental reasons, that rents for $100 a month profit, is only worth $1200 a year towards your FIRE number.

Or, a $500,000 house you own free and clear, which will be sold at retirement and replaced with a cheaper house that leaves $300,000 in your pocket, that $300,000 counts towards your FIRE goals.  But how does it contribute?  That depends on what you invest it in.  If you invest it in the stock market and intend to withdraw it at a 4% safe withdrawal rate (SWR), it can be counted on to provide  $12,000 in income.  If you invest it in a rental property that provides a $15,000 profit, it will count as $15,000 in income.   Likewise, if that rental will only make $5,000 a year in profit, then it only counts as $5000.

You can't have a basket of investments with different characteristics, add up their sale value, divide by 25, and call it a day.

Let us know what kinds of income sources and investments you intend to have (or have now) and folks will be glad to help you figure out what % of the way towards FIRE you are.

Hope that helps!

FYI, if you replace that $500,000 house with a $600,000 house, it contributes nothing. 

[market timer]

I'd include home equity in net worth (FI) calculations. You can tap into home equity in many ways: mortgage, HELOC, reverse mortgage, downsizing.

I'd also include retirement accounts, which can be accessed penalty-free: Substantially Equal Periodic Payments, Roth conversions and withdrawals (after 5-year seasoning period).

[LWYRUP]

I track home equity for my net worth but only portfolio (excluding home equity and a 3 month "ready cash" savings buffer) for purposes of hitting the 25x expenses test and declaring myself FI.  (Won't RE until after that, probably 33x expenses).

Home equity is helpful because once you have your mortgage paid off then your expenses go down.  So your "number" for purposes of the 25x expenses test is lower.

If you can sell your house and move to a LCOL area then it would be appropriate to count the net (e.g., difference between current expensive house and LCOL house) as part of your number, but I would probably buffer it a bit for comfort. 

I do count retirement accounts.  Like other posters noted, there are ways to tap those funds early. 

[AnswerIs42]

You could use the 4% of the total, but deduct from that the imputed rent you're effectively paying yourself for living in your house. It's easier to ignore the value of your house, though.

I have three figures on my spreadsheet:

1 - 4% of net worth, including house. If I sold it and ended up paying rent, this would be the effective "salary".
2 - 4% of net worth minus house value. This is the money I could live on long term, without having to pay for housing.
3 - Net worth, minus house and retirement accounts, divided by the number of years before retirement accounts are accessible.

#3 is pessimistically assuming zero real growth in that time, to ensure bad periods don't derail the plan entirely.

Once both #2 and #3 are greater than the amount I need to live on, I'll consider myself properly FI. My #2 figure has already gone past the bare minimum that I need, but my #3 figure still has a way to go.

[Greenback Reproduction Specialist]

Its really simple,

FI = Passive income from invested assets is greater than expenses.... Period

Where the 4% rule comes from is people using stocks and mutual funds to almost exclusively fund their retirement. This premise somewhat assumes that almost all of the invested assets reside in mutual funds which pay very little in the form of dividends. With this rule you would not necessarily meet the definition I gave above for FI because being invested in all mutual funds you would not generate 4% in dividends. There might be mutual funds that pay more than 4%, but most of the time when talking about the 4% rule people are using a S&P fund that does not pay 4%. So that means with the 4% rule you are possible drawing on some dividends and some of the principal. This works, and has been theoretically tested to prove it to the greatest extend one could.

Here is the kicker, your house has an impact on how much you need to fund in order to meet the 4% rule. You have to make house payments if you have a loan, you don't make payments if you own it outright. So lets say you pay $1200 per month currently and $1000 goes towards principal and interest. Using the 4% rule you can find that you need $300,000 just to cover your house payment in retirement. Eliminate the loan and you can shrink your nets egg requirement by $300,000.

So the house plays a role, but I would not count the equity or value of the house as going towards your 4% goal because it does not produce income. Rather, it is an expense that plays into how much you need to save.

Hope that helps.

[Mustache ride]

Its really simple,

FI = Passive income from invested assets is greater than expenses.... Period

Where the 4% rule comes from is people using stocks and mutual funds to almost exclusively fund their retirement. This premise somewhat assumes that almost all of the invested assets reside in mutual funds which pay very little in the form of dividends. With this rule you would not necessarily meet the definition I gave above for FI because being invested in all mutual funds you would not generate 4% in dividends. There might be mutual funds that pay more than 4%, but most of the time when talking about the 4% rule people are using a S&P fund that does not pay 4%. So that means with the 4% rule you are possible drawing on some dividends and some of the principal. This works, and has been theoretically tested to prove it to the greatest extend one could.

Here is the kicker, your house has an impact on how much you need to fund in order to meet the 4% rule. You have to make house payments if you have a loan, you don't make payments if you own it outright. So lets say you pay $1200 per month currently and $1000 goes towards principal and interest. Using the 4% rule you can find that you need $300,000 just to cover your house payment in retirement. Eliminate the loan and you can shrink your nets egg requirement by $300,000.

So the house plays a role, but I would not count the equity or value of the house as going towards your 4% goal because it does not produce income. Rather, it is an expense that plays into how much you need to save.

Hope that helps.

Dividends do nothing but take away from the principle. If a stock or fund pays out a 4% dividend, the stock price drops by 4%. All it is doing is shifting the burden of that money to you whether you want to take it or reinvest it. You can create your own dividend by selling off the principle, it's the exact same thing. The 4% rule says nothing about only using dividends. In regards to the house, and in fairness your information is not incorrect, but I find it a bit misleading. Sure you can pay off a house before retirement,and therefore, wouldn't have as high of yearly spend and need as big of a nest egg. The issue is the money that you would be putting into the market is instead going into the mortgage. You would then take just as long (or longer) to get to the required nest egg size needed. I'm not going to argue the pay off mortgage vs invest because that has been debated endlessly, but I think it needs to be mentioned so new folks and people don't read this as fact.

[Scortius]

Its really simple,

FI = Passive income from invested assets is greater than expenses.... Period

Where the 4% rule comes from is people using stocks and mutual funds to almost exclusively fund their retirement. This premise somewhat assumes that almost all of the invested assets reside in mutual funds which pay very little in the form of dividends. With this rule you would not necessarily meet the definition I gave above for FI because being invested in all mutual funds you would not generate 4% in dividends. There might be mutual funds that pay more than 4%, but most of the time when talking about the 4% rule people are using a S&P fund that does not pay 4%. So that means with the 4% rule you are possible drawing on some dividends and some of the principal. This works, and has been theoretically tested to prove it to the greatest extend one could.

Here is the kicker, your house has an impact on how much you need to fund in order to meet the 4% rule. You have to make house payments if you have a loan, you don't make payments if you own it outright. So lets say you pay $1200 per month currently and $1000 goes towards principal and interest. Using the 4% rule you can find that you need $300,000 just to cover your house payment in retirement. Eliminate the loan and you can shrink your nets egg requirement by $300,000.

So the house plays a role, but I would not count the equity or value of the house as going towards your 4% goal because it does not produce income. Rather, it is an expense that plays into how much you need to save.

Hope that helps.

Dividends do nothing but take away from the principle. If a stock or fund pays out a 4% dividend, the stock price drops by 4%. All it is doing is shifting the burden of that money to you whether you want to take it or reinvest it. You can create your own dividend by selling off the principle, it's the exact same thing. The 4% rule says nothing about only using dividends. In regards to the house, and in fairness your information is not incorrect, but I find it a bit misleading. Sure you can pay off a house before retirement,and therefore, wouldn't have as high of yearly spend and need as big of a nest egg. The issue is the money that you would be putting into the market is instead going into the mortgage. You would then take just as long (or longer) to get to the required nest egg size needed. I'm not going to argue the pay off mortgage vs invest because that has been debated endlessly, but I think it needs to be mentioned so new folks and people don't read this as fact.

If you are carrying a mortgage, the quick and easy way to calculate the necessary stash is to take your non-mortgage annual expenses and multiply by 25 and the simply add then remaining amount of your mortgage on top (both principal and interest). As you gradually pay down the mortgage, this amount will eventually go to zero.

[RyanAtTanagra]

Dividends do nothing but take away from the principle. If a stock or fund pays out a 4% dividend, the stock price drops by 4%. All it is doing is shifting the burden of that money to you whether you want to take it or reinvest it. You can create your own dividend by selling off the principle, it's the exact same thing. The 4% rule says nothing about only using dividends. In regards to the house, and in fairness your information is not incorrect, but I find it a bit misleading. Sure you can pay off a house before retirement,and therefore, wouldn't have as high of yearly spend and need as big of a nest egg. The issue is the money that you would be putting into the market is instead going into the mortgage. You would then take just as long (or longer) to get to the required nest egg size needed. I'm not going to argue the pay off mortgage vs invest because that has been debated endlessly, but I think it needs to be mentioned so new folks and people don't read this as fact.

Thanks, I wanted to say the same regarding both, but was too lazy :-)

[simonsez]

Here is the kicker, your house has an impact on how much you need to fund in order to meet the 4% rule. You have to make house payments if you have a loan, you don't make payments if you own it outright. So lets say you pay $1200 per month currently and $1000 goes towards principal and interest. Using the 4% rule you can find that you need $300,000 just to cover your house payment in retirement. Eliminate the loan and you can shrink your nets egg requirement by $300,000.

So the house plays a role, but I would not count the equity or value of the house as going towards your 4% goal because it does not produce income. Rather, it is an expense that plays into how much you need to save.

Yes, even a paid off house will take quite a bit in utilities, insurance, taxes, and applicable HOA fees.  Payments toward maintaining a house are omnipresent.  So yeah, don't count the house toward part of your stache even if the mortgage is gone.

[Tabaxus]

I don't include my house in my FI number because it doesn't feed into my withdrawal rate, since I wouldn't be willing to do a reverse mortgage or a HELOC to unlock the value to support spending (if I was in the position of ever having to do that, that would be a sign that expenses are unsustainable). 

Similarly, I won't include 529 plans in my FI number.  Doesn't factor into my withdrawal rate.

That said, both things go into my net worth calculation.  But as it turns out, net worth is mostly irrelevant if it doesn't supply a real form of cash flow.  The only thing it's good for is seeing that, at least on the net worth (a strict assets minus liabilities) perspective, I'm closer to milestone X (e.g., millionaire, which I might cross this year based on strict net worth, even though I won't cross it for years in terms of assets that support a withdrawal rate).  And those milestones are also mostly irrelevant.