Ever since college I’ve been obsessed with tracking my finances; investment returns, expenses, and sources of income. Before I started working, I thought that if I could create an income stream of $5,000 per month I could live like a king! Of course, as a 23 year old that was single, drove a used Honda Accord, and house-hacked his way to living rent-free, this made sense to me at the time. My girlfriend and I would go out to eat once or twice a week and I had the freedom to do what I wanted, when I wanted. Life was good! But, of course, I wanted more.

At the time, I developed my plan for financial independence: buy enough properties to have $10,000 per month coming in after expenses (and before debt service) and pay these properties off over 10-15 years. For me, this was a simple, achievable plan. My first property brought in about $1,000 per month or about $700 after expenses. My most expensive property brought in about $3,000 per month before paying the mortgage. For most people this plan would mean owning 5-15 properties.

If you start at 25 and buy 1 property per year for 10 years and pay them off in 15 years as Dan Butler suggests in his podcast with me you will end up with 10 paid-off properties by age 40. Combine this strategy with a disciplined insurance strategy and 401k match and you should have a nice retirement account along with a 5-figure passive income stream by the time most people are experiencing some level of mid-life crisis!

So what is a step-by-step plan for determining how much you need to be financially independent (at any age) and putting together an actual plan to get there?

Step 1: Determine Your Average Monthly Expenses

The first step in determining how to achieve financial independence is determining how much you and your family need to cover your regular expenses. I’ve been using Quicken for many years to track this, but now prefer Personal Capital. It’s free to sign up and they have a host of Financial Tools to assist in this process. Take the time to link your accounts to one of these sites and the work is done for you. You can then review your expenses on a monthly basis to keep a pulse on everything.

I like the expression, “What’s measured, matters.” Measure your expenses every month, because it matters! At the end of each month I update my accounts and review our expenses vs. our budget with my wife. I actually put this number into a spreadsheet and compare it to our passive income. What should you include in your monthly expenses? Everything!

• Mortgage/Rent

• Property Taxes

• Car payment(s)

• Insurance (health, life, disability, property, etc.)

• Groceries/food

• Dining/Entertainment

• Tuition

• Clothing/shopping

What’s nice is that Personal Capital categorizes everything for you.

Step 2: Determine How Much You Need To Save/Invest To Cover Your Monthly Expenses

This is the step that is going to take some time as you develop a strategy to produce enough passive income to cover your expenses. A lot of investors depend on “Accumulation Theory” and the ability to withdraw 4% annually to cover expenses. In my opinion there are two major flaws with assumptions in these formulas. In engineering school we were taught to start with the assumptions. If the assumptions are incorrect, the answer is probably incorrect.

Assumption 1: Rate of Return

I see and hear the “Long term average return of the stock market is 10%” thrown around a lot. The issue with this assumption is that an investor doesn’t actually get the “average return.” An investor gets the Compounded Annual Growth Rate (CAGR) which is called the geometric mean. Here’s an example:

Starting account balance: $100

Year 1 Return: 100%, Account Balance = $200

Year 2 Return: -50%, Account Balance = $100

What’s your average return? (100 – 50)/2 = 25%

What’s your actual return (geometric mean)? 0%

As you can see, no one in their right mind would look at the above scenario and tell you that they averaged a 25% annualized return. But this is how most people view market returns. What this doesn’t take into account is volatility. That’s why I’m a fan of stable assets, like income-producing real estate to help balance portfolio returns. You can see how the actual returns of the stock market this century have been closer to 6% with this tool from MoneyChimp.

Assumption 2: You Can Have a “Safe Withdrawal Rate” of 4%

Again, what this assumption doesn’t take into account is volatility. In this case we are talking about sequence of returns. What I mean is that if you start with a $1 million dollar portfolio and assume that you can withdraw $40,000 a year to supplement your retirement income sources, you will potentially run out of money very quickly if you enter a period like 2009 right after you retire.

If you retired at the end of 2007 feeling pretty good, you would have been quite concerned a year later. In this example your portfolio could drop in value by over 30% and take as much as 5 years to recover. In this scenario you would be eating away at principal and at the end of your first year of retirement you would have less than $600,000 in your account! At that point you could either decrease your withdrawals to $24,000 per year or perhaps go back to work.

Needless to say, you want to set yourself up to avoid these scenarios.

The Stunning Problem With The 4% Retirement Income Rule In One Chart

In my book (get your free copy here) I talk about how the wealthiest families combine insurance and income-producing real estate along with other investments to develop a strategy for success. Personally, I developed a plan to increase my passive income to a level that exceeded my monthly expenses. It’s no secret that I’m a fan of real estate, but you can combine passive investments in real estate, annuities and even small business income to achieve your number.

When you determine this figure I would be conservative with your stock market return assumptions and add in other sources of income that are less volatile. I like to have at least 4 sources of income from different buckets:

• Cash-value life insurance/annuities

• Income-producing real estate

• Stock/bond portfolio

• Small business income

• Social Security?

If you need $10,000 per month your income streams could look like this:

• Insurance/annuity income: $3,000

• Income-producing real estate (6% cash return on $1M portfolio): $5,000

• Stock/bond portfolio (at 3% SWR & $1M value): $2,500

• Small business/part-time work income: $1,500

• Social Security?: (I choose not to include Social Security and would consider this icing on the cake if I actually get it.)

As you can see, a $10,000+ monthly income from the above sources is very achievable with a multi-bucket approach. In my book I also show how a similar strategy decreases your volatility while INCREASING returns! How nice!

3: Save & Invest!

Now that you have an end-goal in mind you need to put your strategy to work. Over a 30-year period from age 30 to 60 the above numbers are very achievable. You can even double the numbers if you’d like. To achieve the above numbers over 30 years you can:

• Pay off your home mortgage

• Invest $1,000 per month in a balanced stock and bond portfolio

• Invest in 5 income-producing real estate properties (passive or active)

• Purchase a properly structured cash value life insurance policy where your monthly premium is $1,000

The above strategy would require you save about $3,000 per month. If you are more ambitious or aggressive like me, you could increase these numbers so that you can achieve the same numbers in 15 years. The strategy that I teach is to accelerate the process so you can be financially independent in only 7 years. However, this may take additional discipline and creativity!

If you’d like to learn more about how to work directly with me to achieve your goals, send an email to coach@nextlevelincome.com and let me know what your goals are and what you need this year to achieve them.