Two of the most misunderstood terms in the personal finance universe are Financial independence and Early retirement. I get asked by people many times as to how I achieved the first and whether and why I have opted for the second. I thought it would be a good idea to write a post explaining what these are and how they need to be understood. Since I have already written posts on these earlier I will be borrowing heavily from them.
Financial independence is simply a state where you can carry out all the things you need to do in life without the need of an Active income. A simple definition of Active income, will be the income you generate by spending time in order to benefit someone else in a job or profession or business. Passive income, on the other hand, is the income you earn out of your earlier acquired assets, financial and otherwise. Active and Passive income is explained in this post.
Now, you are financially independent when you have generated a passive income stream to take care of all your financial needs. In general, this will happen when you have completed the investments for all your financial goals in life, as investing out of your passive income for future goals will mean you must have a very large asset base – possible but unlikely. Read about my perspective on financial independence and my strategies to achieve the same. You may also be interested in how I created a passive income stream.
Does financial independence mean that you retire early? Not at all, it just means you now do not have any constraints of having to earn an active income in order to support your financial responsibilities. You can be financially independent and continue on your job, if that is what you love doing. You may also go ahead and try to do something else which excites you, but you were never able to take the risk of it earlier. I recently read about entrepreneurs who have started at the age of 50 plus on things that they have been passionate about for a long time.
Of course, one of the things you can do in your financially independent state is to actually retire early. However, this is simply an option, most people including me will not be following that. The other thing to understand is that you may well have Active income in your state of Financial independence. For example, I have some income from my Consultancy practice. This income can be used for investing , for your indulgences or for some cause dear to you. Note that, you are not needing or depending on this income any more which is a great situation to be in.
If you want to know more about how you can reach this state of financial nirvana, follow these steps:-
- Check how you can do it by reading this post.
- Create an investment plan to reach Financial independence by following the methods here.
- Understand how you can create a passive income stream from these guidelines.
- Read this useful summary on financial independence to motivate yourself.
I think it is important that for all of us to strive for Financial independence and that it must be one of the critical goals that we have. However, I do not believe in early retirement as one should really keep working till he can, irrespective of the earning associated with it. So finally, look at your life in these stages to get a complete handle on it:-
- Preparing for a career or profession till about the age of 24.
- Active earning through job or profession from 24 to the age of FI. This can be 50 or even 45 if you have planned well.
- Financially independent state between 45/50 to the age you actually desire to retire at.
- Actual retirement when there is no active income from whatever you are engaged in.
Apply this template to your life, based on your individual context and I think you will be genuinely in control and happy.
Interested readers may pls follow my blog on email by clicking on the relevant button on the right hand panel. I will shortly be stopping the practice of posting the links in different Facebook groups. Following the blog will ensure you get intimated whenever there is a new post.