A few readers have had the question of what does financial independence actually mean and how do you know if you can retire early. We are out camping with the kids and enjoying the beautiful BC and Alberta scenario for a few weeks. I can’t really do any calculation specific posts due to time constraints, so I thought I would do a quick post to cover the FIRE topic.
FIRE/ financial independence typically implies you have enough income producing assets that produce cash flows which are sufficient to cover your family expenditures in perpetuity. This may seem like a difficult amount of assets to obtain and also to predict what is needed in the future. There are some general rules to follow that help to frame the picture.
3-4% Safe Withdrawal Rate (SWR)
Traditional retirement calculators will often show that a 5-6% withdrawal rate will almost always provide a reliable 30 year withdrawal period from your savings. This implies that if you retired at age 65, your nest egg should last till about 95 years old, then run out. If you die before then, you will have an estate to leave to your family. But how much can you take from your portfolio each year if you are retiring way before 65 years old?
The SWR rule implies that if you sell between 3-4% of a portfolio/year which is invested in a well structured portfolio, you should be able to continually draw this amount without significantly impeding the total portfolio value indefinitely. This is because the value of that portfolio will be going up via general growth in the 6-8 % range/year long term over that same withdrawal period. Inflation cost increases in the 3-4% /year range which leaves 3-4%/year available to spend every year.
Another way to look at the SWR would be based on your annual expenditures. At a 4% withdrawal rate, you would need exactly 25 years worth of current yearly living expenses to be financially independent. At 3% it would be 33.3 years worth.
You can quickly tell that it is your after tax spending that will create widely different demands on the portfolio size you need to achieve financial independence (FI). If you have a frugal lifestyle of $50,000/year, you need $1.25 to $1.665 million for FI. A spending range of $100,000/year will need $2.5 to $3.33 million and $150,000/ year needs $3.75 to $5 million/year for FI.
All doctors and professionals can achieve a $2-3 million portfolio within 15-20 years of work with the basic financial principles we have been discussing. 10-15 years to financial independence is achievable for most professionals that apply aggressively all the savings and investing techniques we will discuss.
Cost of Living Inputs Change in FIRE – You Need Less Than You Think
There could be multiple costs that adjust as soon as you have achieved financial independence. The reductions include:
1. No Insurance Cost – once you have a huge nest egg, life insurance is of little purpose. The main point of life insurance is to cover the expenses for your dependants if you are dead and can’t earn an income. Your financial independence portfolio already does that job quite well by itself. Disability insurance doesn’t do much for you if you are no longer working. My family saves about $3000/year now that we don’t carry life insurance or excess disability insurance beyond the basic plan we get through our medical association benefits.
2. Eliminate Child Care Cost – Our family would save close to $30,000 if we no longer worked since we have a nanny.
3. Debt servicing (mortgage or other) are often low when financially independent.
4. No Professional Expenses (College Licensing, Professional Education and Malpractice Insurance) – about $15,000/year for both of us.
5. No Ongoing Allocation to Retirement Savings Required – once independence is achieved, ongoing savings via TFSA/ RRSP etc aren’t required. I still allocate for RESP $2500/child contributions since that is a $500/child from the government as a match. Stopping RRSP/TFSA contributions would save us $20,000/year that we currently contribute to both/year (I will address why we don’t maximize the RRSP fully in the RRSP post – it comes down to incorporation and tax efficiency)
6. Reduced Income Taxes – there are taxes when selling investments, but these will be far less than during your standard income tax years – more on this below. Remember that you won’t need to replace your full working income in order to retire.
There are some potential increases in spending at early retirement that may include:
1. More spending on travel or hobbies during the excess free time
2. Education for children during university years
3. Investment into a new endeavour for professional purposes such as starting a new business or project.
Overall, most individuals that have experienced early financial independence find that their expenses lower significantly from their working years. In my family’s particular case, stopping working during FIRE would correlate to about $50,000 in reduced personal after tax expenses. To spend $50,000 beyond your basic living costs personally, you would need about $80 to 90K pre tax income assuming 35-45% personal tax brackets. Let’s review a bit about how personal taxation can change in early retirement.
Reduced Taxes and Optimal Corporate Withdrawal
A huge advantage of having a professional corporation with a significant amount of assets is the ability to control your corporate withdrawal process. This is a complicated topic that will be discussed further in the corporation posts. A big reason why our family can be in a financial independence setting is because of the financial flexibility that a corporation provides. Generally speaking, it is easier to quickly build assets in a corporation, because you pay less initial corporate tax (often around 14-18% depending on which province you are in) than if you paid out your income earned all personally (35-50% tax brackets).
A huge advantage in the Canadian taxation system relates to dividend income. Dividend only income can be received personally with very little taxation. If you can keep your expenses reasonable, a significant amount of your savings can end up in your pocket.
Dividends from a private controlled Canadian corporation are called ineligible dividends. These would include most privately controlled small business corporations which include most professional corporations like medical, dental, legal or accounting corporations. In the province of BC, you can receive $50,000 of only ineligible dividends and pay about $3000 in tax. This is similar in many provinces and I will update the post with a chart once back home.
So a couple can receive $100,000 in ineligible dividends and pay about $6000 in tax. This leaves $94,000 to spend after tax. As you take more ineligible dividend, the tax percentage does increase gradually.
This compares to eligible dividends which are received by investors from publicly traded Canadian corporations. Examples would include Bell, Royal Bank or other large companies that pay a portion of their yearly earnings out as dividends to their shareholders. The dividend yield is the percent of the total dividend payments/year received divided by the total purchase price/share that an investor spent for the stock. If you received $3 on a stock that cost $100/share, the dividend yield is 3/100 or 3%.
If you receive only eligible dividends as your personal income from an investment portfolio, you can receive about $50,000 TAX FREE. The only problem here is you need around $1.66 million in eligible Canadian stocks that yield 3% to receive $50,000 in dividend income yearly or $3.32 million to get $100,000 tax free as a couple.
See this Financial Post article by Jonathan Chevreau for more details on the exact tax reasons why this is possible.
My Family’s Case For Financial Independence
Our family currently needs over $200,000 pre tax income to maintain personal living expenses of around $150,000/year after tax. In FIRE, we will be able to reduce personal spending by about $50,000 mainly from reduced child care costs and no need for ongoing personal savings. Luckily, our current spending already has a generous travel allotment of around $25,000/ year which we don’t think would change much while the kids are still in school.
So with around $100,000/ year via ineligible dividend payments from our large corporate portfolio savings, we would be set for financial independence based on the 25-33x yearly SWR. As mentioned before, we both currently work an amount that allows us to enjoy a balance between our young family and our professional life. Recently it has felt great to give up a few shifts to facilitate travel and experiences without feeling any concern for the missed income. It is nice to feel the flexibility to adjust our work to whatever the future holds. This trip with my wife and kids has been a blast and we look forward to many more over the years to come!