What is financial freedom?
Ask a room of people to define financial freedom, and you’re likely to get a dozen different answers. “Money means a million different things to a million different people,” says Matt Higa, a financial representative with Northwestern Mutual who lives in the San Francisco area but serves clients nationwide.
For some, financial freedom means being able to pay the bills with money left over each month or having a fully funded emergency account. Others may want to retire early and travel extensively. Regardless of how you define financial freedom, the following 10 steps will help you achieve your vision for the future.
Commit to living within your means
The path to financial freedom begins with a step many people overlook. “First, it starts with mindset,” says Nev Harris, a financial expert who works with agency owners, small business owners and freelancers. “Now that’s normally not something people want to hear, but it’s an absolutely critical foundational piece to achieving financial freedom.”
People need to analyze their beliefs about money and examine their relationship with it. Rather than assuming wealth is something attainable only by those with high incomes, recognize that even middle class families can move from living paycheck to paycheck to a financially comfortable lifestyle so long as they spend less than they earn.
Consider using a financial advisor
Not everyone needs a financial advisor. For instance, if you’re just starting out in life and don’t have any savings or investments, an advisor may be limited in the type of assistance they can provide. However, for everyone else, an advisor can help you make smart money decisions that will advance your financial goals.
“There’s a reason professionals exist,” says Andrew Rosen, partner and lifelong advisor at Diversified Lifelong Advisors in Wilmington, Delaware. They have both experience and expertise that other individuals may not. What’s more, they aren’t emotionally invested in your money, which means their advice should be neutral and objective.
Open the right accounts
There is no one single account that is right for all your money. Cash for retirement should be placed in a tax-favored 401(k) or IRA account while college savings are usually best kept in a 529 plan. Meanwhile, you’ll want your emergency fund separate from your other savings to avoid dipping into it unnecessarily.
When selecting accounts, keep risk mitigation in mind. “That’s usually where people get tripped up the most,” Higa says. They place all their retirement money in a 401(k) account without considering whether a portion should go into other savings vehicles such as a Roth IRA or permanent life insurance policy. Another mistake is putting emergency savings in a bank account that earns minimal interest rather than using another option such as a high-yield savings account. Higa also recommends people consider buying disability insurance to supplement workplace benefits which may not begin paying for months and, even then, only replace a portion of a worker’s income.
Set up a deposit schedule
Once you have your accounts set up, you need to create a system for ensuring they are fully funded. “A dollar can only be split so many ways,” Rosen says, but that doesn’t mean families should neglect one type of savings – such as retirement or emergency – over another.
Many employers will direct deposit paychecks into multiple accounts, so you can divert a portion of your income to checking, regular savings and your emergency fund. You can also contribute directly to your 401(k) through a payroll deduction. For other savings goals, you may be able to set up automatic, regular transfers from your bank account to other financial accounts. Finance experts often recommend saving 10% of your income for emergencies or other goals and another 10% for retirement.
Track your spending
If you’re currently living paycheck to paycheck, setting aside 20% of your money for emergency and retirement savings can seem daunting. However, “the name of the game in wealth management is how much are you able to keep and hold onto,” Higa says.
While putting 20% of your income in savings is ideal, you may have to start with a smaller amount. To find out exactly how much you can save, you first need to understand how much you spend. Take a month to track where your money goes, from major bills to the couple bucks spent on coffee in the morning. Using a free app like Mint or a paid budget service like YNAB can make it easy to collect and categorize spending data.
Trim your budget
Now that you know how you’re spending your money, it’s time to trim wherever possible. That doesn’t necessarily just mean cutting your morning latte or gym membership. Instead, people should think beyond the small expenses and consider making major changes in their lifestyle to make a major change in their financial situation.
Selling your house or buying a cheap, used car may seem like a significant sacrifice. However, it can be worthwhile if it helps achieve your ultimate goal of lifelong financial independence.
Create a debt payoff plan
For most people, financial freedom means eliminating debt. While it can be difficult to own a house without a mortgage, getting rid of credit card debt or even car loans can be more achievable. “Bad debt is the killer of the financial freedom dream because it locks us into a cycle of never being able to get ahead,” Harris says.
It’s easier if you start by focusing all your extra money on one debt while making minimum payments on the rest. From a mathematical standpoint, it may make the most sense to start with the debt charging the highest interest rate. However, some finance experts suggest paying off the debt with the smallest balance first to build momentum and motivation. When you pay off that debt, don’t let the money you had been paying toward it get absorbed by your budget. Instead take that payment amount and apply it to the next debt on your payoff plan.
Build an adequate emergency fund
It can be tempting to deplete savings in order to pay off debt more quickly, but that approach can backfire. “You want to be sure you have the emergency fund established,” says Kara Duckworth, managing director of client experience for Mercer Advisors in Newport Beach, California.
Without an emergency fund, you risk going into high-interest credit card debt should an unexpected expense occur. Instead of prioritizing debt over savings, or vice versa, direct a portion of your available cash to each priority every month. While you want to be able to access your emergency fund easily, consider a separate high-yield savings account where you won’t be tempted to dip into it for nonemergency purchases.
Invest for the future
Many people assume they need a large income to achieve financial freedom but that isn’t necessarily true. “There is a big distinction between high-income people and wealthy people,” Harris says. Some households with high incomes may carry substantial debt, ensuring they will never be wealthy. Meanwhile, other wealthy families may have modest incomes.
Rather than amassing wealth through their income or an inheritance, many people become wealthy because they save and invest money consistently throughout their lives. There are a number of investing options including bonds, stocks, mutual funds and annuity products. A financial advisor can help you determine which options are right for your financial needs and goals.
Prepare your legacy
This final step isn’t so much about creating your own financial freedom as much as ensuring that of your heirs. After a lifetime of managing money correctly, you don’t want your money to end up in the pockets of relatives you didn’t intend or, worse, Uncle Sam.
Create a will, update the beneficiaries on financial accounts and, if your assets are considerable, talk to an attorney or CPA to discuss strategies to minimize estate taxes. Beyond that, regardless of your income, you’ll want to maintain adequate life insurance to support your loved ones in the event you die unexpectedly. It’s important that you continually update your financial and estate plans, Duckworth says. Throughout the years, your life will change, and tax laws will change. Your financial plans need to change along with them.
Steps to reach financial independence:
- Commit to living within your means.
- Consider using a financial advisor.
- Open the right accounts.
- Set up a deposit schedule.
- Track your spending.
- Trim your budget.
- Create a debt payoff plan.
- Build an adequate emergency fund.
- Invest for the future.
- Prepare your legacy.
