Financial independence means different things to different people.
To some, it means being able to pay the bills. For others, it means being able to eat out on a whim. Yet for some, it means being able to have three vacation homes and a yacht. I define financial independence as being able to support the lifestyle you desire without having to work.
There are two important pieces to this definition:
- First, you need to differentiate the lifestyle you desire from your current lifestyle. This is a significant distinction. Too often, we reduce our lifestyle to fit within our means. Financial independence is not about limiting or reducing your lifestyle, but about living the life you want and having the means to support it.
- Second, financial independence means you don’t need to work to support your lifestyle. This just means that the income generated by your assets can fully support your expenses.
“Financial independence does not mean that you can’t work; it simply gives you the option of working or not. Most of us want to continue working—our contribution to the world provides a sense of accomplishment and esteem.”
Earned Income vs. Passive Income
Income from labor is earned income. It requires your participation, effort, and energy. If you decide to take a year off, your earned income ceases. Earned income is how most of us receive money. Our alarm wakes us in the morning, we have our cup of coffee, we take a shower and get dressed, and we drive to work. We put in our day and we drive home. Every couple of weeks, we get a paycheck. This is the earned income cycle.
Earned income is an exchange of time for money. Through education and experience, we can increase the value of our time and will be compensated accordingly. Even high-powered attorneys or surgeons who make hundreds or thousands of dollars an hour, still exchange their time for a paycheck. The minute they stop this exchange, they stop earning income.
Financial independence breaks this cycle. It replaces earned income with passive income. Passive income includes the following sources of income:
- Investment income (e.g., dividends, interest)
- Rental real estate income
- Partnership and business income (if you don’t have to work or manage anything to receive it)
Passive income is the Holy Grail of personal finance. Why? You don’t have to trade your time for it. Passive income gives you the freedom to do what you want. Earned income is a chain that restricts what you can do and when you can do it. Passive income liberates us from 9-5 jobs and two-week vacation limitations.
Contrary to its name, accumulating passive income is not a passive endeavor.
Accumulating the assets to generate passive income requires skill, education, and diligence. You can’t expect to sit back and have massive amounts of passive income deposited into your bank account every month. Generating passive income from dividends and interest requires you to select, and monitor the appropriate investments. Rental income requires purchasing and maintaining commercial or residential real estate. Royalties and licenses require the development and sale of a product. Partnership and business passive income, like investments, requires the careful selection of investments and monitoring them diligently.
There are two important advantages to passive income:
- First, passive income doesn’t take as much effort to generate. To earn a salary, you have to put in 40 or 50 hours of work a week. Generating the same amount of passive income takes a fraction of the time.
- Second, you can outsource what little time it takes to generate passive income to somebody else. You can hire a financial advisor to select and monitor your investments, an accountant to monitor your royalty and license fees, and a property management company to collect rent and fill vacancies. This is an advantage that just doesn’t exist with earned income. Can you imagine hiring a temp to take your place at work?
Financial independence does not mean that you can’t work.
It simply gives you the option of working or not. Most of us want to continue working—our contribution to the world provides a sense of accomplishment and esteem.
The proceeding blog post is an excerpt from The Six-Day Financial Makeover: Transform Your Financial Life in Less Than a Week!, available now on Amazon.
About the Independent Financial Advisor
Robert Pagliarini, PhD, CFP®, EA has helped clients across the United States manage, grow, and preserve their wealth for the past 25 years. His goal is to provide comprehensive financial, investment, and tax advice in a way that was honest and ethical. In addition, he is a CFP® Board Ambassador, one of only 50 in the country, and a real fiduciary. In his spare time, he writes personal finance books, finance articles for Forbes and develops email and video financial courses to help educate others. With decades of experience as a financial advisor, the media often calls on him for his expertise. Contact Robert today to learn more about his financial planning services.