This post by Jose Michaca was originally published on the CPA4IT Blog on January 17, 2019
Imagine what your life would be like if you knew that all of your living expenses were covered. That you could roll out of bed, do nothing, and still have all of your basic needs met. That instead of living paycheck to paycheck, you could do the work you want to do rather than the work you have to do. This is financial freedom, and it can be achieved through passive income.
Now, the common misconception is that financial freedom is synonymous with retirement. It’s not. Regardless of age, when you generate enough passive income from your investments to cover all of your living expenses, you have financial freedom. Once your living costs are covered, employment becomes optional, and you’re free to focus on the things you’re truly passionate about.
It sounds pretty ideal; however, building enough passive income to realize this goal requires careful planning. As a small business accounting and tax accounting firm, CPA4IT regularly helps clients to determine their “financial freedom number” and then set a clear path forward. Here’s how we do this.
Identify how much passive income you require
Financial freedom means having your base monthly expenses covered, which means you need to know what those expenses are. So, the first step is to make a list of all of your necessary financial commitments—rent/mortgages, utility payments, internet and phone expenses, insurance premiums, car payments, health expenses, school expenses, childcare expenses, basic food, clothing, entertainment, travel expenses, and so forth.
The amount of passive income a person needs will vary. A younger person who may be putting a child through school will have higher monthly expenses than an older individual whose children have left home. For the purposes of this article, let’s say you break down those costs and determine that you can live off $6,000 a month.
Determine your financial freedom number
Now that we know what your expenses are, it’s time to figure out how much money you need to save and invest in order to make $6,000 per month in dividends. To start, we look at your personal balance sheet to determine where you are now, financially. Do you have a house? RRSPs? A TFSA? Unregistered investments? Assets?
Once we determine what your current equity is, the next thing to figure out is how much total equity you need. So, if we take your monthly expenses of $6,000 and assume a 5% dividend, you would need a $1,444,000 principle to generate that amount. We then subtract your current equity from that amount to give you your financial freedom number. Let’s say you’ve currently got $700,000. Your financial freedom number is $744,000. Once you hit that target, you’ll be able to sustain your lifestyle through passive income.
Now that we know how much you need to put away, the next step is to establish a game plan for how exactly you’re going to do that.
Apply the Financial Freedom Pyramid of Power
The Pyramid of Power is most commonly applied to business strategy and goal-setting. However, at CPA4IT we’ve developed another version—the Financial Freedom Pyramid of Power. The Pyramid breaks down into four simple steps that we use to help you achieve financial freedom through passive income. Let’s take a look at these steps and their related strategies in more detail.
Invest it—start earning passive income.
Protect it—insure yourself and your assets.
STEP 1: MAKE IT
Maximize your earnings by …
Evaluating your income.
Obviously, a big part of building equity relates to your income. If you’re an employee, what is your base pay rate and are there additional skills or trainings you could get that would earn you a higher hourly rate or salary? If you’re a business owner, what are your short-term and long-term plans for business growth? How will that impact your income over the next 3-5 years?
Let’s say you’ve built up your net worth but it’s just not enough. Perhaps you had a rough time in the market and worry that you no longer have enough money to retire, or perhaps you started saving late and worry that you won’t be able to hit the amount of equity you need in order to achieve financial freedom.
Then the question becomes, how can you generate more money with what you’ve currently got? Can your current assets generate more income? Are there expenses that could be cut? If not, we usually may get out clients to work on developing a full traditional Pyramid of Power to help us explore options.
STEP 2: SAVE IT
Maximize your savings by …
Evaluating your spending habits.
As stated earlier in this article, it’s important to understand where your money is going. In fact, one of the very first things we do with our small business accounting clients is evaluate spending. Whether you’re working with an accountant or not, it’s a useful exercise. Ask yourself, where is your money going right now? Is there anything that can be cut out? Are there non-essential expenses that are ultimately less important to you than your financial well-being? If yes, cut those costs, and save instead.
Banking every raise you get.
Usually when people make more, they spend more. Unfortunately, this is not the best saving strategy. The best strategy is to stick to your existing budget and divert that raise directly to savings. Of course, there will be times when unavoidable new expenses arise; however, as an overall strategy banking your raises can really help to boost the amount of money you have available for investment. This strategy is particularly useful for millennials who may already be accustomed to living on a budget and could divert raises to paying down student debts more quickly.
Setting aside $0.30 of every dollar you earn.
As a base minimum, you should be diverting $0.10 of every dollar you earn towards savings. But there are other considerations. Namely, taxes. Taxes are deducted automatically for company employees, but if you’re a business owner, entrepreneur, or self-employed individual, you should be setting aside at least $0.30 on every dollar to cover your GST and taxes owing. You’ll likely use $0.20-0.25 of that to pay your taxes. Once you’ve settled up with the CRA, anything left over can be pushed to your savings. If you can manage the other $0.10 on top of that $0.30, even better.
Paying off bad debt.
If you have debt, your first instinct may be to pay that off before you begin saving. Sometimes this is a sound strategy, sometimes not. There’s a difference between good debt and bad debt. Good debts are low interest debts, like lines of credit and mortgages. Bad debts are high interest debts like credit cards. Debts to the CRA, such as amounts owing on your GST and payroll / source deduction taxes or personal income taxes, also fall into the not-so-good category. It’s wise to discuss your current debts with your small business accountant to ensure that debt repayment is adequately accounted for in your saving strategy.
Investing (slightly) less in your business.
Entrepreneurs and small business owners work hard, often putting everything they make back into their business. But that’s putting all of your eggs in one basket. What happens if, in 20 years, the business doesn’t work out? Even entrepreneurs need a bit of a balance. Moreover, as a small business owner, you won’t have access to a large company or government pension. Instead of investing 100% of your profits back into your business, make it 75% and use the rest to build up your nestegg.
Worrying less about the mortgage.
Contrary to common belief, paying off your mortgage isn’t the best path to financial freedom, particularly when you’re self-employed since your mortgage is a deductible expense. By paying it down you’re losing that deduction. Sure, you’re paying off debt, but that debt is only costing you 3.5%. If you invested that money in the market instead, you could make more than that amount in dividends. Strategies like the Smith Maneuver can also be used to simultaneously build up your net worth while paying down your mortgage.
STEP 3: INVEST IT
Maximize your passive income by …
Starting to invest right away.
Now that you’re saving, you want to start earning passive income as soon as possible so that you can continue to increase your savings. Unfortunately, you usually need $200,000 or more before a financial advisor will be interested in working with you, which means that initially you may be reliant on your own knowledge.
There are plenty of resources out there. Start by looking for investments that provide at least a 5% dividend, ideally 7%, and have minimal management fees (if any). Your small business accountant can offer suggestions on how to manage investment accounts and can offer you a few pointers on what sort of investment options will be most accessible and manageable for you based on your current level of equity.
STEP 4: PROTECT IT
Maximize your long-term security by …
Protecting your investments.
What we’re talking about here is insurance, and the strategy is pretty straightforward—get some! The key types of insurance you should invest in include health insurance, life insurance, homeowner’s / rental insurance, disability insurance, and car insurance (if you own a vehicle). In terms of stocks and bonds, there’s no way to directly insure these assets, but you can make sure your portfolio is diversified and consult with a financial advisor to develop strategies for handling your investments in times of market turmoil.
If achieving financial freedom through passive income appeals to you, we’re here to help. Contact CPA4IT for a more information about how to arrange a consultation.