Your 3-step guide to financial independence

Financial independence means having enough passive income to pay your living expenses so you don't need to work for a living. 

Someone who is financially independent is not reliant on others or employment to meet their needs. Instead, they rely on their assets and the income those assets generate to live a comfortable life. 

If you achieve this type of financial freedom, you may decide to retire early.

How to achieve financial independence in 3 steps

There are many strategies for achieving financial independence. What they all have in common is they involve making your money work for you rather than the other way around. Achieving this financial goal is one of the key reasons people choose to invest in financial assets. 

A diverse portfolio of share investments can provide both passive income and the potential for capital growth. Building such a portfolio opens up many possibilities that might otherwise not be available to you, such as a better lifestyle or the ability to retire early. 

Achieving financial independence takes some work but can be boiled down to three steps: 

1. Develop a financial plan – this will give you a roadmap for building your financial future over time
2. Set aside money to grow – your financial plan should include a budget that allows you to set cash aside for investment 
3. Make investments that suit your financial situation – this will depend on how much you earn now, how much passive income you need to live comfortably without working, and your retirement plan. 

1. Develop a financial plan

To achieve financial independence, you need assets that generate enough passive income to meet your living expenses. How much money is enough is different for each individual. It will depend on your personal financial needs. 

Someone with a lavish lifestyle will need a greater amount of passive income to achieve financial independence than someone with a simpler lifestyle. 

For example, if you have living expenses of $2,000 a month and a net passive income (after expenses and tax on earnings) of $2,000 a month, you have financial independence. 

Financial independence is not achieved overnight. It is a journey that requires consistent time and effort. The key is to gradually but consistently increase your income-generating assets. This means putting money aside for the future and investing it appropriately. The cash flow from your investments will increase your net worth over time. 

What makes an appropriate investment will differ between individuals and may change over time. Financial planning can help you understand what an appropriate saving and investing strategy is for you. 

When you are young, you can afford to take more significant risks because you have more time to compensate for any losses. As you near retirement age, however, you may prefer to invest in lower-risk assets to minimise any potential loss of capital. 

2. Set aside money to grow

Once you have a clear financial plan, the next step is making sure you have money available to put that plan into action. This means building a habit of regularly setting aside part of your income for investments.

The most effective way to do this is by creating a realistic budget that covers your essential expenses while leaving room for savings. You might start small (even as little as 5–10% of your income) and increase the amount as your financial situation improves. Consistency matters more than the size of each contribution, as regular saving builds your investment capital over time.

Consider automating your savings so a portion of your income is transferred directly into a separate account earmarked for investing. This reduces the temptation to spend and ensures your money has the chance to grow. Over time, these contributions, combined with the power of compounding, can significantly accelerate your progress toward financial independence.

3. Make investments that suit your financial situation 

Passive income is earnings from sources other than employment or contract work. Examples include dividends from shares, rent from an investment property, and interest on money in the bank. 

The benefit of passive income is that little to no effort is required to generate it. In essence, you make money while you sleep. As the famous investor Warren Buffett said, "If you don't find a way to make money while you sleep, you will work until you die." 

We can generate passive income by investing in assets that provide a financial return. Investing in ASX shares is a popular method of creating passive income, as many ASX shares pay regular dividends to shareholders. 

Shareholders receive a regular income stream without having to actually do any work (aside from making the initial investment). Share prices can also increase over time, adding to the overall wealth of the shareholder. 

What are the benefits of financial independence? 

Achieving financial independence offers a range of personal and financial benefits. Once you no longer rely on a traditional job to cover your living expenses, you gain greater control over your time and choices. Here's what financial independence can offer:

Freedom to choose how you spend your time

• No longer tied to a job for income, you can prioritise activities that bring you the most fulfillment.
• Spend more quality time with family and friends without the constraints of a 9-to-5 schedule.
• Pursue passions, hobbies, or travel without worrying about financial limitations.

Reduced financial stress and increased security

• Having enough passive income to cover your expenses means you are not constantly worrying about making ends meet.
• Economic downturns or job losses become less concerning when you have financial stability.

Opportunities for personal growth and entrepreneurship

• With financial freedom, you can explore new career paths, start a business, or volunteer for causes you believe in.
• Invest in further education or develop new skills without the immediate pressure of earning an income.

The ability to make more informed financial decisions

• Reaching financial independence requires financial literacy, helping you make smarter investment choices.
• By understanding investment options such as real estate, shares, and managed funds, you can create a diversified portfolio that continues to generate passive income.

Legacy and generational wealth

• With the right financial strategies, you can create wealth that supports future generations.
• Financial independence allows you to contribute more to charity or other meaningful causes.

Ultimately, financial independence isn't just about money. It's about gaining the freedom to design the life you want while maintaining financial security.

How much money do you need to be financially independent? 

The amount you need to achieve financial independence depends on your lifestyle and expenses. However, a general rule of thumb is the 4% rule, which suggests that you should be able to withdraw 4% of your investment portfolio in the first year of retirement, adjusting for inflation in subsequent years.

Estimating Your Financial Independence Target

To determine your required investment portfolio, multiply your annual living expenses by 25 (since 4% is 1/25th of your total assets).

Example:

• If your yearly expenses are $50,000, you would need approximately $1,250,000 in income-generating assets to sustain financial independence.
• While this may seem like a large sum, the power of compounding can help you reach this goal faster than you might expect.

The Role of Compounding in Wealth Creation

• Historically, the Australian share market has delivered annual returns of around 7%-10%, combining dividends and capital growth.
• Reinvesting returns allows you to earn returns on previous returns, whether by purchasing more shares yourself or through dividend reinvestment plans (DRPs).
• This compounding effect accelerates portfolio growth, helping you build wealth over time and achieve financial independence sooner.

Accounting for Inflation

Inflation erodes the purchasing power of money, so your passive income must grow over time to maintain financial independence.

Example: If your current monthly expenses are $2,000, and inflation is 5%, next year's expenses would rise to $2,100 per month.

• To remain financially independent, your passive income must also grow to match or exceed this increase.

• This is where the 4% rule helps, as it includes adjustments for inflation, ensuring long-term sustainability.

By considering these factors—investment growth, compounding, and inflation—you can set a realistic financial independence target and take strategic steps to reach it.

What are the challenges of early retirement? 

While early retirement is an exciting prospect, there are potential pitfalls.

Funding shortfalls

Chief among these is the risk of incorrectly forecasting future income and expenses, resulting in a shortfall of funds. This means careful consideration must be given to expected living expenses and income from investments. 

We cannot predict the future, so you must be careful not to overlook unexpected and one-off expenses that can crop up. These can potentially eat into your income or capital, so they should be considered when calculating how much money you need to retire. You don't want to retire early only to find your resources are stretched in old age. 

Therefore, it is wise to have a stash of cash in an emergency fund to provide a buffer to protect your investments.

Unexpected expenses

Unexpected expenses will inevitably arise, requiring funds to meet them. By keeping some cash on hand, you will not be forced to incur expensive credit card debt or exit any of your investments early. 

Your emergency fund can also be used if your investment income is disrupted. This can occur if one of the companies you invest in encounters a hurdle that requires them to retain more earnings than usual. 

Global events

Major global economic events can also disrupt your passive income. For example, the COVID-19 pandemic in 2020 prompted many ASX companies to reduce their dividends — or pay none at all — depending on how badly their businesses were impacted by the pandemic and associated lockdowns.

Boredom

Another potential pitfall of early retirement is boredom. When you have no obligation to work, there is a risk that you may have too much time on your hands! Although this is not necessarily a bad problem to have, it does mean that you will need to find ways to fill your extra time. 

Some people choose to continue working, perhaps part-time, to add interest and structure to their lives. The benefit of financial independence is that you don't need to work. However, you can choose to do work that is meaningful to you. 

For some people, this involves volunteering and charity work. For others, it is a chance to explore a new industry or calling. What was previously a hobby may become a whole new career opportunity! Continuing some form of work in early retirement can also provide some supplementary income. 

Whatever you choose to do, the important thing is that the choice is yours. Being financially independent gives you the ability to pick and choose how you spend your time. You are not beholden to anyone. 

Why should you make financial independence a goal? 

Financial independence is a fantastic goal. Not only does it offer the prospect of early retirement, but it can also help you organise your financial affairs right now. 

For many people, the decision to aim for financial independence involves a shift in mindset. This can be a powerful and positive change. Striving for financial independence and early retirement requires taking control of your financial affairs and gives you a clear goal to work toward. 

You will need to educate yourself about financial products and markets, make and adhere to a budget, and monitor your investments. All of these things can make you smarter, richer, and happier — which is our whole philosophy here at The Fool. Check out our free Education Hub to guide you through your investment journey.

Foolish takeaway

Even if you don't quite reach the goal of financial independence, you should gain added financial stability. Whether you are planning a traditional retirement or an early retirement, aiming for financial independence can result in more money in your bank account, which gives you greater freedom. 

At the same time, it is important not to totally sacrifice the present in favour of the future. Life is to be lived, and the goal of financial independence should not get in the way of this. You must balance your current and future needs. 

Aiming for financial independence does not mean completely giving up your current comforts. While investing for the future is hugely important, so is enjoying the journey. Be realistic about what is required to achieve financial independence and what you can afford to contribute toward this goal today. 

FAQs

What is passive vs. active investing?

• Passive investing: A hands-off approach that involves investing in index funds, ETFs, or diversified portfolios designed to grow steadily over time. This is ideal for those who prefer long-term, low-maintenance investing.
• Active investing: A more involved approach that requires buying and selling assets strategically to try and outperform the market. This method requires research, time, and a deep understanding of market trends.

At what age should I be financially independent?

In Australia, most people aim to be financially independent by their early 30s, meaning they can support themselves without relying on family or government assistance. This typically involves earning a stable income, managing expenses, saving regularly, and contributing to superannuation. Full financial independence—where you no longer need to work for income—is often reached closer to age 60–67, aligning with access to superannuation and the Age Pension. However, those pursuing early retirement or the FIRE movement may achieve this in their 30s or 40s through disciplined saving, investing, and a frugal lifestyle.

What is the 4% rule of financial freedom?

The 4% rule is a guideline for financial independence that suggests you can safely withdraw 4% of your investment portfolio in the first year of retirement, adjusting for inflation in subsequent years, without running out of money. This rule is based on historical market returns and assumes a balanced portfolio of stocks and bonds. For example, if you have $1 million saved**, you could withdraw $40,000 per year to cover living expenses. While not a guarantee, the 4% rule helps estimate how much savings you need to sustain long-term financial freedom.