Ben Nash breaks down the five per cent rule and how it can give you the freedom to quit work. ·Getty/Ben Nash
There are a lot of different labels given to money success; financial independence, financial freedom, FI/RE, financial security, and the list goes on. Everyone’s version of this looks a little different.
Most people I chat with about money, don’t necessarily want to retire early. Instead, they want the option not to work, or to work on their terms.
Having helped a number of people get there, I can tell you from experience this is a total game-changer.
True financial independence is a big goal, but the good news is that it is all entirely possible in less time than you’d think - when you take the right approach.
The five per cent rule states that you can draw an income from savings or investments at a rate of 5 per cent essentially for the rest of your life.
So for example, if you have $100,000 saved up, using the five percent rule as a guide you should be able to use this money to generate an income of $5,000 ($100,000 x 5 per cent) each year.
If you have $1 million, the five per cent rule would deliver you an income of around $50,000 each year.
This is based on the long-term sharemarket return of 9.8 per cent, then making an allowance for inflation and investment fees, leaving you with 5 per cent to spend.
It's worth noting that this is a rough guide, but based on historical data it would have held true for most of the last hundred years or so.
You can use the five per cent rule to set targets around your investing and wealth building, by first setting your income goal, i.e. how much money you’d need to replace your salary (or ideal salary).
From there, you divide the number by 5 per cent to get your target saving and investment balance to replace your salary.
Start investing ASAP
Next step is to invest.
If you hold your money in cash savings the long term return is lower at around 4 per cent, and after you factor in inflation and taxes any money you have in savings isn’t really growing in ‘real’ terms.
You need to be investing to target a higher return, and to get compound interest working in your favour.
If you haven’t invested before, this can be a little confusing and seem scary, but know that it is a critical part of replacing your salary with investment income.
There are lots of different ways to be right when it comes to investing, but the statistics show that index funds perform better than other investments more than 80 per cent of the time.
Given index funds do better more than eight out of ten times, they’re worth seriously considering as a starting point.
If you haven’t invested before, getting started can seem complicated.
But the good news is that these days there are a heap of investment apps that can be a great place to get started, and with most of them you can do it all on your phone in under 15 minutes.
Be smart with tax
If your aim is to replace your salary with investment income, by definition over time you’re going to be building tens of thousands, maybe even hundreds of thousands of dollars of investment income each year.
When you invest and own all your investment accounts in your own name, all of your investment income will add to your employment income when it comes time to calculate your tax payable at the end of the year.
But you don’t need to own your investments, these can be owned with a partner, through a trust, investment bond, company, or even your super fund.
Each of these different investment structures have different tax rates, many of them much lower than personal marginal tax rates, which means there are some serious tax savings up for grabs.
If you wait until after you’ve built up your investments, it can be difficult and expensive to change things - instead plan smartly in the early stages of your investing so you reap the rewards later on.
The wrap
When you replace your salary with investment income, you change the game.
You’re then in a position where you can choose to work if you want to, or if you don’t, you can direct your time to the things you really want to do.
It’s a big goal, and it doesn’t come easily.
But when you have the right approach, it can become simple.
Set clear targets on how much income you want from your investments, and use the five per cent rule to get clear on your ultimate wealth goal.
Then start investing and leverage the power of compound interest to grow your money faster. From there it becomes a momentum game.
It’s important you’re smart with your planning, with both tax and your overall strategy, so you can maximise the money you have today and get to your goal sooner.
Ben Nash is a finance expert commentator, podcaster, financial adviser and founder of Pivot Wealth. Ben's third book is out soon, Virgin Millionaire; the step-by-step guide to your first million and beyond.
Disclaimer: The information contained in this article is general in nature and does not take into account your personal objectives, financial situation or needs. Therefore, you should consider whether the information is appropriate to your circumstances before acting on it, and where appropriate, seek professional advice from a finance professional.
