Financial independence means having control over your time without worrying about the ability to pay your bills or forgo experiences you'd like to share with your friends and family. This guide was designed to help you achieve financial independence.
Most of what you learned growing up about money, income, and wealth are not true. This is understandable - think about whom you first learned them from (odds are good, it was from those who were not rich themselves). From confusing high incomes with wealth to not knowing the importance of tax asset placement when choosing your investments, after reading this special, it might make more sense to you why some professional athletes making $20 million a year quickly go bankrupt, while a bus driver can retire a multi-millionaire and have no financial worries.
In fact, this step-by-step guide to achieving financial independence was designed so you can discover some of the most remarkable secrets to freeing yourself from that special brand of anxiety that money troubles can elicit.
This step-by-step guide to financial independence is part of our How to Get Rich guide for new investors.
#1: Income Is Not Wealth
If you make $1 million a year from a job, you could lose your job any day. If you make the same $1 million from owning hotels, or businesses, no one can take that from you. Having a high income alone does not mean financial independence.
Most people believe the key to wealth is a high-paying job. Yes, it's easier to amass assets if you have more money coming in each month, but the true secret to increasing your net worth is to spend less than you make. It is a cliche; but it is the fundamental, absolute, non-negotiable reality of money. To escape this trap, you need to understand that income is not wealth.
What is wealth? My personal definition: Wealth is the part of your net worth (assets minus liabilities) that generates capital gains, income, and dividends without your labor. If you are a Doctor or Lawyer, you need to put in long hours after years of specialty training and higher education to get a paycheck. On the other hand, if you have a portfolio of private businesses, car washes, parking garages, stocks, bonds, mutual funds, real estate, patents, trademarks, and other cash generators, you could sit by the pool. The real value, of course, is that you could maintain your lifestyle even if you were disabled or unable to continue working at your primary occupation. Better yet, unlike a salaried employee, wealth can't fire you - you have to squander it. It's far easier to lose a job that wipe out a well-constructed portfolio.
The level of your wealth should be measured by the length of time you could maintain your standard of living without an additional paycheck. In other words, if you had to stop working right now, how long could you keep up your purchasing pattern for cars, clothing, music lessons, college tuition, video games, etc.? The average person isn't educated in this truth, which is why the more and more they earn, they are left wondering why financial independence and security continue to allude them, always seemingly just out of grasp.
#2: You Must Have Surplus Funds to Invest
As Napoleon Hill said in, "Think and Grow Rich", all financial success starts with the savings habit. When opportunity presents itself, those with the capital set aside to take advantage can profit big, perhaps even enough to be set for life.
The only way to take advantage of investment opportunities is to have the money to invest. The reality of successful investing is that there is a certain point where you reach critical mass and the returns generated on your assets can change your life; e.g., earning a 10% return on $10,000 is only going to net you $1,000 before taxes - hardly earth shattering, but the same return on a $1,000,000 portfolio is $100,000, which has far utility despite requiring the same effort and research.
Amassing wealth and becoming financially independent is a slow process that takes time. You do small things every day such as cut your expenses, generate extra income, and put the money into brokerage and tax-deferred retirement accounts. With time, it begins to amount to something. As each new opportunity appears, you can react on a larger scale than your previous investments. That's called compounding. It's when the interest, dividends, and capital gains your money has earned begin to generate their own interest, dividends, and capital gains, and on and on in a virtuous cycle. It's how $10,000 can grow to $2,890,000 over 50 years at 12%.
Commentator Larry Kudlow pointed out one of the great truths years ago when he said that profits are nothing more than margins times revenue. The profoundness of that statement is sometimes lost by its simplicity. The only way you can have more money left over at the end of the month is to either increase revenue (your paycheck, business sales, billable hours, or whatever it is that provides funds to cover your bills) or decrease costs. That's it. Write it down. Frame it. It's that remarkable. Your choices are to increase revenue, cut costs, or both.
#3: Taxes Matter - A Lot
Taxes matter. By actively working to lower your taxes through IRAs, 401(k)s, real estate appreciation, or other legitimate means, you can add a few percentage points to your return each year. Over 50 years, an extra 3% per year is 3x the wealth.
All income is not equal. The idea that where and how you hold your assets can mean the difference between being somewhat well off and obscenely rich was so important that I covered it in depth in an article entitled Tax Strategy: Asset Placement - Lowering Your Tax Liability Through Intelligent Allocation. The basic premise is that those with little or no wealth generate a lot of taxable income, while those who end up financially independent generate large unrealized gains in the form of real estate appreciation, unrealized capital gains, and profits made through tax-advantaged or tax-free accounts such as a Roth IRA or 401(k).
An illustration is in order. A physician earning $250,000 per year is going to get taxed heavily, probably paying $95,000 in taxes for a net income of $155,000. Yet, if he had earned the same amount from within a pension plan or IRA, he wouldn't pay a single penny in taxes. That's an extra $95,000 per year compounding for him. At 12%, over 30 years, that's an extra $23 million in wealth. That's right - $23,000,000 simply because the money is earned within a tax-advantaged account instead of regular labor. This is why you should do everything you can, within reason, to fully fund your retirement plans, as well as to focus on how your seemingly small decisions help or hurt tax planning. No decision is too small - you've already seen how a simple decision to title US savings bonds can have huge tax implications for your estate.
#4: True Wealth Is Control Over Your Time
True wealth means having control over your time. Unless you get to do what you love every morning when you get out of bed, you are not successful. You are merely a highly paid wage slave.
How do you know when you are truly wealthy? When you have complete control over how you spend your day. I know that I've said that before and it's not news to long-time readers of the site, but so few people understand that basic truth. No matter how much money you make, unless your days are spent doing the things the really make you happy - the things that you enjoy so much that you would pay to do them - and you have control over your time, you aren't wealthy.
Each morning, when you show up to the office, or the job site, or the practice field, or studio, it should feel like you are unwrapping a Christmas gift when you turn the key. That's not some standard boilerplate advice. If you find the profession that gives you that feeling, and you are disciplined in your management of the business side of it by controlling costs, you have a huge advantage over your competition because you will continue to work ten, fifteen, eighteen hours a day not because you need to or because you want another car in the driveway, but because you love the process and product itself. You cannot compete with passion.
#5: Grades Have No Correlation with Wealth & Financial Independence
Everyone knows that more education means higher income over the course of life. But what people fail to realize is that there is no correlation between grades and wealth. An "A" college graduate will be just as successful as a "C-" college graduate.
According to decades of extensive research by Thomas J. Stanley, Ph.D., author of The Millionaire Next Door, the grades one earns in school have no correlation with the economic wealth and success other than in the medical and legal professions. That's not to say education isn't important - it is! More than 90% of American millionaires did, in fact, graduate with an undergraduate degree.
Why, then, do parents, teachers, and councilors continue to tell children that they won't be successful if they have a C- grade point average? Statistically speaking, according to Stanley, it's because these people are themselves not financially successful. Therefore, they have no idea what it takes to achieve financial independence and buy into the great myth that good students go further in life. They pitifully measure analytical intelligence only and not the creative intelligence that is responsible for sparking innovations, societal advancements, and the opportunity to craft solutions in niche markets that everyone else misses. They also fail to realize that most millionaires wear blue jeans, overalls, or work shirts, not a suit and tie. They eat McDonald's and Burger King. They live in ordinary, well-established neighborhoods. Most own their own business.
Statistically, if you want to guess who is going to be wealthy and financial independent, you'd be more likely finding a self-sufficient student in wood shop class who paid for his own car, gets decent (but not spectacular) grades, has a job, and enjoys what he does than selecting someone from the honor roll. It's counterintuitive, but it's true.
#6: Niche Markets Aren't Glamorous - But They Are Lucrative
Successful, financially independent people know how to turn seemingly ordinary products, problems, or ideas into business machines that produce money. By solving society's problems, they reap huge rewards that allow them to live comfortably.
Billionaire investor Charlie Munger has remarked that entrepreneurs can thrive if they specialize in an overlooked economic niche, much like animals in nature. Often, these niches are extremely lucrative but not likely to win you friends at cocktail parties. Don't believe me? Quick! Conjure up images of a multi-millionaire. What do you see? High-tech 20-somethings on a yacht? Molecular biologists? Although there are a few, most of the big money is in industries such as waste management (garbage), pizza, clothing stores, trailer parks, candles, and shipping.
Consider the case of Sam Walton. He built a tiny dime store from the corner of Arkansas into the biggest retailer in the world, amassing a family fortune of more than $125 billion. There's nothing sexy about selling fifty-cent flip-flops and bottles of cheap cologne in small towns but Walton was on a mission to bring affordable goods to everyday Americans. He was a man possessed with vision. He built his company one store at a time - one might even say one checkout at a time - with no fanfare or red carpet walks.
Business owners represent a disproportionately large segment of the millionaire population. It's hard to believe, but there's a good chance that the biggest hardware store owner or plumber in your town has a net worth many times that of you highest paid doctor. Part of the reason is a concept we've discussed called capitalized earnings. Another is something Dr. Stanley mentioned in his book. Doctors are pressured to buy status symbols to convince their patients they are successful. Not the plumber. He can put more money into his retirement accounts. Over decades, the result is millions in additional wealth for the guy who unclogged toilets instead of arteries. That's not something you learn about in school.
#7: Financial Independence Takes a Complimentary Spouse
Regardless of how good you are at saving and investing, you can't achieve financial independence if your spouse is a spendthrift that rings up credit card debt. It's like trying to get out of quicksand but having someone pull you back in every day.
No matter how successful you are, unless your spouse is equally disciplined, frugal, and investment-oriented, your efforts toward a better, financially independent life are going to be like struggling in quicksand. Marry the wrong person and the emotional, financial, and social toll it can take on your life will overwhelm almost any progress you can make in your career or pocketbook. As you try to build a life, he or she will be out spending your money on status symbols, making it nearly impossible for you to achieve financial independence.
To truly build a life, you need to have the kind of support that allows you to take risks because you know, no matter what happens, there will always be someone waiting for you at home that loves you unconditionally. It may sound surprising, but a tremendous amount of success is based upon proper temperament and psychology. How can you focus on your work and creating the life about which you always dreamed if you are worrying about the situation at home? For more information, after you've finished this step-by-step to financial independence, read Love and Money.
#8: Support Your Productive Children - Not the Losers
Money has nothing to do with love. If you have children that are successful, moral, ethical, and disciplined with their finances, they deserve a larger share of your support and estate than those who are not. It's as old as the Parable of the Talents.
It is almost always a mistake to provide gifts of cash and support to those relatives who are unable to generate high incomes on their own or who are constantly in financial trouble. Think of the incentive system you setup! One son becomes a physician and one daughter an attorney and you say they don't "need" your money, while at the same time you provide free rent, board, and bailouts for their sibling, who sits at home in credit card debt and unable to find work.
Regardless of whether they are religious, those who are financially independent – and who want their children to become financially independent – follow the lesson found in the parable of the talents. The "parent" figure in the parable comes back and gives more to those who successfully invested and grew their wealth, telling the one that failed to achieve these that he was "wicked" and "lazy".
Now, you might not use such harsh words, but let me put it bluntly to you as you read this article in the privacy of your office or home: You're an idiot if you give "equal shares" of money to your children when some are clearly more productive than others. You’re a damn fool if you give more to the unsuccessful ones.
You have managed to effectively turn them into a financial and credit junkie; it’s unlikely they'll ever get over their addiction. You become, in effect, a crack dealer providing one more hit. The customer tells you it’s the last one they’ll ever need but the fundamental, underlying problem is their inability to manage money. They postpone the action needed to fix their life because they know that the cavalry is always coming (if they beg and whine long enough).
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