Financial Independence: Order of Operations

Financial independence is a goal that many of us share. Although it is a common desire, many are unaware of the most efficient way to achieve this goal. We all remember the saying “Please Excuse My Dear Aunt Sally” and the accompanying acronym PEMDAS while taking algebra in high school. Parenthesis, Exponents, Multiplication, Division, Addition and Subtraction. While solving an algebraic equation one must follow this order of operations to arrive at the correct answer. If one step is done incorrectly, it can throw the whole equation into a tailspin. For example, 2 x 4 + 2 = 10, but it would be very easy to arrive at an incorrect answer of 12 by adding before multiplying.

Financial independence can be viewed in a similar way. There is a certain “order of operations” that should be followed, to protect yourself and use your money most efficiently. We do not want to throw our finances into a tailspin. I’m going to call the financial independence order of operations TEFHIDI, Track Expenses/Emergency Fund, High Interest Debt, Invest. This is the advice that I would give to anyone who wants to start their journey to FI, has already started and isn’t sure where to go next or anyone who wants to achieve FI in the most efficient way.

Understanding FI

Financial independence (FI) is often used synonymously with early retirement. Though they aren’t the same thing, one does allow the other to occur. In its most basic form, retirement is a state that is achieved when you do not work and your passive income exceeds your expenses. Financial independence, on the other hand, has nothing to do with whether you are working or not. It is solely the state in which your passive income exceeds your expenses.

This distinction is important because becoming financially independent will allow you to retire early. It gives you the ability to dictate your future. Don’t like your job? Quit. Want to work somewhere fulfilling, for little pay? Do it. Never want to work another day of your life? Your choice. These are the steps to make it a reality.

Track Expenses and Save An Emergency Fund “TEF”

The first step to financial independence is to have an emergency fund saved. This is typically 3-6 months of expenses saved in liquid assets. This can be a high yield savings account, checking account, cash, etc. Having an emergency fund saved will allow life to happen, which it inevitably will, without throwing you off track too dramatically. If and when life does happen and you need to dip into your emergency fund to pay for the situation at hand (lost job, car broke down, hospital bills or any other unexpected expense) you should immediately focus on building your emergency fund back up to previous levels.

Before you are able to save 3-6 months of expenses for your emergency fund, you’ll need to know what your monthly expenses are. This is not a one time calculation and will need to be updated periodically as your situation changes. I use the notes feature on my smartphone to quickly write down the date, amount and a quick one or two word description of each of my expenses (and any income). At the end of each month I use these notes to fill in a spreadsheet that categorizes my expenses (and income). This method works for me, but it isn’t the only method. The key is to find a method that you are able to stick to long term. Once you know your monthly expenses multiply that number by 3-6 to determine the size of your emergency fund. However you choose to track your expenses, do it consistently and make it a habit so you are aware of changes that may need to be applied to your emergency fund.

The 3-6 month recommendation is simply that, a recommendation. You may feel comfortable with three months of expenses saved, or you may not feel comfortable until you have nine months of expenses saved. This is entirely a personal preference. The only scenario to be weary of is if you have a massive emergency fund. This is inefficient because your emergency fund will typically earn less money than if it were invested.

The last emergency fund point I want to bring up is the difference between a slim and a fat emergency fund. Both of these distinctions, slim and fat, are still going to fall within the basic recommendation of 3-6 months of expenses. The difference between the two is which categorization of expenses is used. A slim emergency fund consists of 3-6 months of necessary expenses. A fat emergency fund consists of 3-6 months of total expenses. The premise behind the slim emergency fund is that if you encountered a life changing situation like losing your job, you would cut back on all unnecessary expenses for the next 3-6 months or until you found a new job or remedied the pressing issue. This allows for more money invested in the hopes for larger potential growth. The approach that I prefer, is the more conservative fat emergency fund. If I were to lose my job while utilizing this approach I would be able to maintain my current lifestyle for those 3-6 months while looking for a new job. Meaning my total expenses, not just my necessary expenses are covered by my emergency fund. To take that even further, I could extend the life of my emergency fund past those 3-6 months by cutting unnecessary expenses during this time.

Tracking your net worth is not necessary but it is a good gauge on your progress and allows you to visualize changes that you are making, whether negative or positive. I use Personal Capital to track my net worth. It’s phenomenal, honestly. I login almost daily to keep an eye on things. If you want to check it out, use my link to sign-up here. (It’s free)

Pay High Interest Debt “HID”

Once you have established a suitable emergency fund for your preference and needs, it’s time to tackle debt. There are an infinite number of different opinions on this one. Some people despise debt in any form. Others will only tolerate debt if it is a mortgage or a home equity loan. I tend to disagree with both of these opinions.

I think debt is a valuable tool that when used appropriately can help you build wealth and achieve your goal of financial independence. That being said, debt can also be detrimental to your success. As a general rule of thumb, I consider “high interest debt” to be any debt that is 7% or higher.

I generally tend to be conservative in my investment growth calculations. Given this fact, I like to use 7% as an expected rate of return for investments. If a debt is matching my low end investment growth expectations of 7% then there is no gain or loss by investing or paying the debt. If a debt is above my low end growth expectations, above 7% that is, then I theoretically would be losing money by investing and not paying that debt. The difference between debt and growth expectations, is that by paying debt (assuming fixed rate) it is a guaranteed rate of return. Your investments may return 12%, 3% or they may even lose money. So when given the choice between a guaranteed 7%+ return by paying debt or a possible negative return by investing, I choose to take the guaranteed return. Change the 7% debt to 6% and I would rather invest that money.

I like to think of debt from a tiered approach. Anything from 1-4% should be ignored and minimum payments made. Anything 5-7% can be paid or not, based on personal preference and risk tolerance. Anything above 7% should be paid off immediately.

So for the next step in the order of operations, abiding by the 7% rule, is to pay any debt that has an interest rate of 7% or higher. There are plenty of debt reduction strategies out there to choose from. Two of the most common are the debt snowball method and the debt avalanche method. The snowball method is more of an emotional strategy while the avalanche is a math driven approach. The more efficient method between the two is the debt avalanche.

When possible, it may make sense to refinance high interest debt rather than paying it off. This depends on a few different factors, which we won’t get into here.

The last point I want to talk about regarding debt is the fear to reintroduce debt. Once debt is paid, many are afraid to utilize debt going forward. Opportunities to increase wealth often present themselves in ways that simply cannot be cash flowed. By utilizing debt, you can take advantage of these wealth building opportunities. If you do find yourself in a position where you have reintroduced debt, use the 7% rule to determine what to do with this newly acquired debt. If 7%+, get rid of it, if below 7%, leave it.

Invest “I”

The final piece to the financial independence order of operations is to invest. This can be done in tons of different ways and with different objectives in mind. The two major objectives for financial independence will be wealth accumulation and wealth preservation. The goal of this article is to create a path to achieving FI, with that in mind we are going to focus on wealth accumulation. Wealth preservation is something that becomes relevant after achieving FI. The general goal of wealth accumulation is to increase capital to the point where it is viable to live off 4% of the portfolio per year (also known as the 4% rule, which will be discussed further down).

The “VTSAX and chill” methodology has been accepted by many, myself included. VTSAX is a total stock market index fund offered by Vanguard, there are other similar options offered by other brokers as well, such as Fidelity’s FSKAX. These index funds track the entire stock market giving you exposure to the entire U.S. equity market at an extremely low cost. The “chill” aspect of this methodology is where the strategy comes into play. Essentially, all you need to do to follow this method is to dollar cost average VTSAX (or something similar). You don’t try to buy low and sell high, you don’t implement some crazy day trading strategy. You simply buy VTSAX at consistent intervals. It is extremely simple and stress free, you need not panic if the market is down or worry that the market is too high, you buy and then “chill.” This allows you to continuously buy the market as a whole, with the idea that the market always maintains an upward trajectory over time. Over the course of the last 100 years, from 1919 to 2019, the average annual return of the stock market was about 9.4%.

It is extremely important to stay the course while following the VTSAX and chill approach. If you panic and sell when the market drops instead of purchasing more shares, you are missing an opportunity to buy in at a discount. JL Collins wrote a fantastic book called The Simple Path to Wealth that I highly recommend reading to gain a better understanding on this approach.

VTSAX is just one piece of the puzzle, though. There is another mini order of operations when it comes to investing. We have tax advantaged accounts such as 401k, 457b, 403b, HSAs and Roth IRAs. We also have non tax advantaged accounts such as a taxable brokerage account. The order in which you fund these accounts can have a dramatic effect on your long term wealth.

For simplicity sake, I’m going to lump 401k, 457b, and 403b together and refer to the three of them as 401k. They are all employer sponsored retirement accounts and similar enough for our purposes. The advantage of a 401k is that it is tax deferred. This type of account is funded directly from your paycheck, pre tax. This allows the maximum amount of your money to grow over time since you didn’t have to take a tax hit up front. Another large advantage to a 401k is there is often an employer match offered. This is essentially free money. The downside to a 401k is that you’ll pay tax on the money you withdraw in retirement. Because of these reasons, this is the first account you should utilize and max out. The 401k annual contribution limit for 2021 is $19,500.

** If you have a high deductible health plan you may be eligible for a Health Savings Account (HSA). If you do have the ability to fund one of these accounts, you should do so AFTER receiving the full employer match from your 401k (if available) and BEFORE maxing the rest of your 401k. The HSA contribution limit for 2021 is $3,600. It is extremely important to understand why and how an HSA can help fund your retirement.**

The next account to utilize is a Roth IRA. A Roth provides the opposite tax benefits that a 401k does. You contribute post tax money into your Roth and then at age 59 1/2 when you withdraw your money it is tax free. Another benefit of a Roth is that any contribution that you make can be withdrawn at any time tax and penalty free. The Roth IRA annual contribution limit for 2021 is $6,000.

The final investment vehicle to utilize is a taxable brokerage account. This account provides no tax benefits. Money is taxed going in and coming out. This account provides the most flexibility in that it has the least amount of restrictions. There are also no annual contribution limits. You are also able to utilize tax saving strategies within this account, such as tax loss harvesting.

To recap, contribute enough into a 401k to receive the full employer match, max out your HSA (if applicable), max out 401k, max out Roth IRA and then everything past that will go into a taxable brokerage account. For 2021 this would look something like, $19,500 into your 401k, $6,000 into your Roth IRA and then $10,000 into your taxable brokerage account, assuming no HSA option.

Now What?

You may be wondering how long you need to stay in this loop of tracking your expenses, updating and managing your emergency fund, managing your debt and investing? Fortunately, I have a very simple answer. You can even start to get an idea of the answer after you’ve completed the very first step in our FI order of operations. The answer is the 4% rule.

The 4% rule is nothing more than a simple drawdown strategy. This rule says that you can withdraw 4% of your investments each year, indefinitely. Some people adjust this rule based on risk tolerance. For example, 3.5% for someone who is more conservative, 4.5% for someone who is willing to take on a bit more risk. I’m comfortable with 4%, personally. The reason this helps us is because it allows us to project how much we will need to retire early.

**The 4% rule was created by financial planner William Bengen in a study that is know as the Trinity Study. The goal was to find a safe withdrawal rate so that retirees wouldn’t outlive their savings. During this study, specific asset allocations were used in determining the chances of success of different portfolios of 30 year time periods. For example, it was shown that a portfolio consisting of 75% stocks and 25% bonds had a 98% chance of survival over a 30 year period. A portfolio consisting of 25% stocks and 75% bonds had an 87% chance of survival over a 30 year period. The reasons I’m telling you this are one, the 4% rule will vary based on asset allocation and two, the 4% rule only measures past performance and does not guarantee success in the future. Having said that, the 4% rule is a great guide and starting point to determining a “safe” withdrawal strategy.**

There are a few different ways to utilize the 4% rule. The first way to use this rule is by taking your annual expenses and multiplying by 25. For example, $30,000 per year in annual expenses multiplied by 25 = $750,000. According to the 4% rule you would need $750,000 in investments to pay your expenses.The second way you can use this rule is by taking your total investments and multiplying by .04 (4%). For example, you have $750,000 in investments, multiplied by .04 = $30,000. According to the 4% rule you have enough invested to pay $30,000 worth of expenses each year. These two methods work great for current scenarios. But often with FI, we are never satisfied with our current scenarios.

Luckily, the 4% rule allows for these calculations in the same way. Rather than using current expenses, project an expense number that you think you will need in early retirement. You may have $30,000 per year in expenses now but by the time you are ready to retire early your mortgage may be paid off and drop your expenses to $24,000. Conversely, you may want to up that $30,000 per year to $40,000 to allow for a $10,000 travel budget. Alternatively, you can use the investment numbers in the same manner. How much would $1,500,000 invested earn me? $60,000, great, what about $2,000,000? $80,000, fantastic. As with many things FI, the numbers that you land on will be entirely personal preference.

Overview

Financial independence can seem like an impossible feat, but by using these simple steps in an effective way it can become much less daunting. Remember, start by tracking your expenses and saving an emergency fund, 3-6 months of expenses. Then pay off your high interest debt, 7%+, and finally start investing in the most efficient accounts. Finally, use the 4% rule to plan your eventual escape and early retirement. Combined these steps form my silly order of operations acronym that I’ve deemed TEFHIDI (Teff-he-dee).

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I use Personal Capital to track my net worth. It’s phenomenal, honestly. I login almost daily to keep an eye on things. If you want to check it out, use my link to sign-up here. (It’s free)

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