5.5 MIN READ
Financial independence isn’t created overnight. Have patience and take these steps 1 at a time. If you stay focused on improving your financial situation one step at a time, you will eventually achieve life’s greatest financial goal – financial freedom. To find out how you’re doing, take the short quiz below and get customized tips to help you improve (Then continue reading below).
Below I will share with you the 5 stages everyone must work through to become financially independent. If you are still dealing with getting out of debt, or haven’t yet created a written financial plan, first read How to Save Money and Pay Off Debt in 5 Steps and complete those steps before moving on to this guide. Once you are debt free (or only have low interest debt with a plan to pay it back), you can move on to working towards your financial freedom.
1. Establish an Emergency Fund
You can also think of this as your “financial freedom fund”. This prevents an unexpected expense, layoff, or other unforeseen event from turning into a financial disaster. Or, perhaps an opportunity arises that you wouldn’t have been able to take advantage of otherwise without having to go back into debt.
Emergency fund balances can vary person-to person, but should generally be about 3-6 months of expenses. If you work in an industry with potentially unstable future income – consider increasing your emergency fund to up to 6-12 months of expenses. If you’re not sure how much you should keep in your emergency fund, check out my free emergency fund calculator.
Once this savings goal has been met, you can go out and make other investments and know you won’t need to sell them in a down market or go into debt to meet your immediate living expenses.
2. Contribute to Retirement Accounts
Once you’ve got your near term goals met and a financial safety net, you can begin adding more to your retirement accounts. Consider maxing out your employer sponsored plan (such as a 401k or 403b) before moving on to other savings vehicles.
A great additional retirement savings tool is the Roth IRA. You pay tax on the money you put into your Roth IRA now, but it can be taken out completely tax free after age 59 ½. This can equate to huge tax savings and you also typically have more investment options available in a Roth IRA than in your employer sponsored retirement plan.
One of the best parts about the Roth IRA is that the amount you contribute can always be taken back out with no penalty. This can be used as a pseudo emergency fund or to fund other goals such as college if necessary. Just remember if you take any of the earnings in the account prior to withdrawals being qualified (typically, over age 59 ½ but a few other exceptions apply), you will owe tax plus a penalty on the amount taken.
If your AGI is above $124,000 if filing single or above $196,000 if filing jointly in 2020 you are not eligible to make the full regular Roth IRA contribution. However, you may still be able to fund a Roth IRA through a “back door contribution”. Make sure you understand the rules around this and qualify before doing it. Consult a tax professional for help identifying the best retirement savings vehicle for you because depending on your situation, you may have other options available to you.
3. Save For College
If you’ve identified paying for a child’s education as a priority, you’re now able to begin putting dollars towards that goal. Consider a state sponsored 529 plan as a good place to start. This is not the only way to save for college, and the type of account should be considered in light of your overall financial goals.
Check if your state allows 529 contributions to qualify you for additional tax savings. For Minnesota, you can deduct up to $1,500 (or $3,000 if married filing jointly) from your state taxes for your 529 contribution in 2020. Depending on your tax bracket, you may be able to take a state tax credit instead of the deduction up to a maximum credit of $500. 529 plan contributions are not deductible for federal income tax, but gains on the investments are tax free if used for a qualifying education expense.
Other common college savings techniques are to utilize Roth IRAs, Coverdell ESAs, custodial (UGMA/UTMA) accounts, taxable savings accounts, trust accounts, prepaid tuition, and treasury bonds. Review the advantages and disadvantages of different plan options or consult with a financial planner to make an informed decision on the right account type for you.
4. Make Other Investments and Stay the Course
Once you’ve maxed out your retirement benefits additional money can be saved in “regular” or “taxable” accounts. Usually these are simply individual or joint accounts (like your bank account) that you set up with an investment firm. Any gains and interest in these accounts are taxed, but withdrawals and deposits can be made at your discretion without other tax consequences.
Real estate is also available as an alternative investment option. Remember that if you’re managing the real estate yourself, this can be like a part time job so make sure you’re willing to put in the extra hours (and account for your time when you’re calculating your return). You can also hire a property manager to do that part – but account for that when you’re projecting just how profitable the investment might be.
However you decide to invest at this stage, consider your investment strategy in light of how long you plan to keep the money invested, and how comfortable you are with the risk. Be realistic with yourself about your ability to pick investments. Most of the time a simple strategy of a diversified, low cost index fund portfolio is both the easiest to manage and better performing.
Remember to stay the course and not panic when we see market volatility (which we saw recently, and will see again). Seeing your account values fluctuate is a normal piece of a healthy long-term investing strategy.
While not necessarily a “worst case scenario”, you should plan to handle similar levels of volatility as we saw during the financial crash in 2008. The downturn lasted about 4 years, and you should plan for an extended bear market like this in your portfolio in the future. If you need the money you have invested within the next 5 years, you shouldn’t be investing it heavily in the stock market in the first place. If you don’t need it within 5 years, you shouldn’t be worrying about the short term moves in the stock market, so stay the course!
5. Have Some Fun
One of the most rewarding parts of my job is being able to tell someone – “you know that back porch you’ve been thinking about building for the grandkids to play in? Build it!” Financial Planning isn’t always about telling people they shouldn’t spend their money. Sometimes, it’s also about reminding a family that has worked hard, that they have worked hard for a reason – to enjoy it.
This only comes after you’ve achieved all of the steps above and identified what financial goals you are want to achieve. When you have this clarity, you can feel good about spending your money on the goals you have planned for. Remember to still regularly review and update your financial plan to make sure you stay on track.
Once you’ve achieved financial freedom, the conversation changes from “Do I have enough to be OK?” to “What would I like to do next to get the most fulfillment out of life?”. It’s a powerful place to be, remember to enjoy it. Ultimately money is nothing but a tool to help us live the lives we would like to live, and once you’ve done the hard work, you deserve to live that life guilt free.
About the Author
Matt Elliott is a CERTIFIED FINANCIAL PLANNER™ and founder of Pulse Financial Planning. I provide financial planning and investment management to help healthcare professionals organize, invest, and protect their assets. Pulse Financial Planning is a fee-only fiduciary advisor and never earns a commission of any kind.
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