What is the difference between Financial Freedom and Financial Independence? Most people will tell you that they mean the same thing. They’ll say that it’s just a difference in terminology that can be used interchangeably. I won’t say that those people are wrong, but I have a slight difference in opinion.
What Is Financial Freedom?
Financial Freedom is the financial state of an individual or a family. It is usually defined by the following criteria:
- Debt free – Absolutely zero debt. The money a financially free person makes goes to no one but them (and unfortunately through taxes, the government).
- Emergency Savings – Have a level of liquid (immediately available) savings that will sustain you during any period of income loss or cover unexpected expenses. The general rule of thumb is 6 months worth of expenses, but your goal should depend on your comfort level, stability of income, and strength of earnings.
- Retirement Savings – Saved (invested) enough to supplement social security or a pension at retirement so that you can live comfortably without downgrading your typical lifestyle. Again, a general rule of thumb for retirement savings is to sock away 15% of your gross income while you are working, preferably in tax sheltered or deferred accounts like a 401(k) or an IRA.
- Insurance – It may not apply to everyone, but there are a myriad of insurance choices out there. Home, auto, life, health, umbrella, and so on. The point is, you should have enough insurance to shield you from catastrophic loss.
- Long Term Care – Everyone grows old. It’s an unavoidable fact of life that I wish weren’t true. That said, be prepared for the most expensive part of your life. Health care, while being a worthwhile expense, will suck you dry. If you’re not ready to face the challenges of the future, you will have limited choices. Think about your preferences for home care, nursing homes, and rehabilitation centers. Most importantly, think about proximity to family and what role they can play. If you’re depending on your kids to take care of you financially, just be aware that you will be severely impacting their chances of financial freedom.
- Estate Plan – Everyone should have a plan in case they die or become disabled. Don’t let your loved ones deal with unnecessary red tape and bureaucracy trying to handle your affairs without legal documents. Trust me, it’s enough of a pain dealing with customer service. It’s a whole different realm dealing with them when they won’t talk to you because you’re not the account owner and they “can’t” talk to you. Plan for the worst even if you don’t think you’ll need it. You will need it someday. Basics include a Power of Attorney, Will, and Advance Health Care Directive.
What Is Financial Independence?
Financial Independence is the financial state of an individual or a family that meets the qualifications of Financial Freedom with a couple variations. The ultimate goal for a person or family striving to be financially independent is to have the option of retiring early, or continue to work/volunteer at will (under their own terms).
- Covered Debt – If used carefully, covered debt can be used to fund investments that can help create wealth. This means that you are using debt as leverage to fund an investment that is secured by an asset. A common example of covered debt is a mortgage on a rental property. The mortgage is the debt. The property is the asset that “covers” the debt. In other words, if the property was sold, it would pay off the mortgage in full. Covered debt is not necessary to meet the conditions of financial independence, but is frequently used to obtain it.
- Retirement Savings – Strive to save enough for the traditional retirement period so you do not have to count on supplemental income from social security or a pension. Income from social security or a pension is just the cherry on top. Maxing out tax-advantaged accounts may or may not be the best strategy for everyone, but it usually is. Savers who max out their tax-advantaged accounts usually do so to defer/avoid taxes or for estate/inheritance purposes.
- Investment Income – Those seeking to be financially independent usually have a significant part of their investments in taxable accounts. One technique is to have enough savings in taxable accounts to accommodate a withdrawal rate that will last until the period where one can start withdrawing from retirement savings. Then, withdrawals would start from the retirement accounts until the end of life. Another strategy is to have enough in taxable accounts where the income from investments would cover all expenses for life (travel and fun stuff included), thereby allowing for minimal withdrawals from tax-advantaged accounts later in life. Basically, the cash flow from investments replace working income, freeing you from relying on others to make a living.
What’s The Difference?
There isn’t much. Financial Freedom means you are debt free and are financially stable. You’re prepared to deal with what life throws at you without the worry of living paycheck to paycheck. You’re working, enjoying life, and getting ready for a comfortable retirement.
On the other hand, Financial Independence takes you to another level. You’re the epitome of living below your means and you want to build wealth. You’re saving as much as you possibly can and are investing, or running your own business. You’re going to retire early, do what you want, and answer to no one but yourself.