The 7 Levels of Financial Freedom

The Financial Independence, Retire Early (FIRE) movement has underscored the power of financial freedom. It's the central theme in my book, Retire Before Mom and Dad. Indeed, financial freedom is the guiding principle of how I manage money.

While financial freedom sounds good, however, many see it as a destination that's at best 30 or 40 years away. To them, it's just a fancy way of describing retirement.

I couldn't disagree more.

While it's true that we can and should define what ultimate financial freedom looks like (see below), we can begin to reap the benefits in a very short period of time. Financial Freedom is more of a journey than a destination.

It's for this reason that my book walks through what I call the 7 Levels of Financial Freedom. And that's what we'll cover in this article. Be sure to check out the free financial freedom calculator near the end of the article.

4 Key Foundational Principles of Financial Freedom

First, there’s value to money that you never spend. This is counter to what must people think. Even retirement savings will eventually be spent, even if it's decades later. Until the money is spent, and even for money we never spend, however, there is tremendous value.

What's the value? Our freedom.

Second, the benefits of financial freedom are experienced much sooner than retirement. The ability to retire is an empowering feeling, but it’s not the only kind of empowerment that savings can afford. Lesser tiers of financial freedom can change someone’s mindset and options for the better. The seven levels below will explain this more clearly.  

Third, the levels of financial freedom are calculated based on monthly expenses, not income. The focus should be on how many months of living expenses our savings can cover. That's real freedom. As a result, we focus on what percentage of our income we can save.

Finally, we use Bill Bengen’s 4%  withdrawal rule when calculating Level 7 Financial Freedom. In other words, we achieve the ultimate financial freedom when are savings equals 25x our annual expenses. For example, a retiree who spends $54,000 a year in retirement would need $1,350,000 to reach Level 7.

The 4% rule has come under fire lately. Some say that given high stock valuations and low bond yields, it's no longer viable. Morningstar recently released a report claiming 3.3% is the new “safe” withdrawal rate. Time will tell who is right. For our purposes, we'll continue to use 4% for planning purposes only.

The 7 Levels of Financial Freedom

For each level you'll find how many months it will take to reach the level if you save 10%, 15%, 20% or 30% of your income. Keep in mind that the number of months won't change for different income levels. In each case, it's your savings rate that determines your time to each level.

You can run your own numbers with the financial freedom calculator here (described in more detail below).

Level 1: One Month of Expenses Saved

Level 1 might not seem like Financial Freedom, but it’s an important start to your journey. It’s here that you stop living paycheck-to-paycheck. You may only have a one-month cushion, but that’s a big deal. It gives you breathing room for when—not if—the unexpected happens.

Studies show that most people cannot come up with $400 for an emergency. According to a study by the Federal Reserve, 4 in 10 Americans couldn’t cover a $400 emergency with their savings. In other words, most Americans have not achieved Level 1 Financial Freedom.

Time to Level 1:

Savings Rate	Months to Level 1
10%	9
15%	5.5
20%	4
30%	2.3

Note that saving 20% cuts by more than half the time to Level 1 as compared to saving 10%. That's because as we save more we spend less. We thus get the double benefit of saving more money and need less money to meet our goal of one month of expenses. I call this the Boomerang Affect in my book.

Also note that compounding has very little to do with reaching Level 1. We haven't yet saved enough money over enough time to see the benefits of compounding. That comes around Level 4 and after, when the majority of our wealth is from compounding.

Level 2: Three Months of Expenses Saved

At Level 2, we reach what most financial gurus say is the minimum emergency fund you should have. You now have enough money in the bank to handle most emergencies. The money could even help you survive during a short-term job transition.

Reaching this point should taste sweet. If an unexpected expense pops up, there isn’t a need to borrow money to cover it. This is important given avoiding high-interest debt is essential to reaching financial freedom. 

Time to Level 2:

Savings Rate	Years to Level 2
10%	2.1
15%	1.4
20%	1.0
30%	0.6

The effect of compounding interest is still in its nascent stage by Level 2. The example shows that around 5% of the ending balance comes from investment returns. Building wealth takes time.

The numbers do change when the savings rate changes. Changing the savings rate in the example to 20% instead of 10% halves the time it takes to reach Level 2. As an investor lives further and further below their means, their journey toward greater financial freedom becomes exponentially faster.

Level 3: Six Months of Expenses

Level 3 is simply the upper bound of an emergency fund, with 6 months of expenses. The balance should be able to cover the unfortunate possibility of all insurance deductibles coming due simultaneously. An extended unemployment period also would be manageable. Compound interest begins to become noticeable.   

Time to Level 3:

Savings Rate	Years to Level 3
10%	2.1
15%	1.4
20%	1.0
30%	0.6

Level 4: One Year of Expenses

Level 4 is when things start to get interesting. Two things happen.

First, with one year of expenses saved, you can handle a significant bout of unemployment. Today the average person will change jobs 12 times during their lifetime. While we hope these transitions go smoothly, Level 4 Financial Freedom will help you ride out any bumps in the road.

Second, we start to see the benefits of compounding, something I call the Money Multiplier in my book. As we now know, most of our Freedom Fund doesn’t come from putting aside money each month. That’s how it starts, of course, when we are trying to reach Level 1, 2, or even 3.

Eventually, however, the money we save starts to earn a nice return. In fact, if done right, our investments will produce far more income than our jobs. That takes time, and it’s here at Level 4 that we start to get a glimpse of the power of the Money Multiplier.

Time to Level 4:

Savings Rate	Years to Level 4
10%	7.5
15%	5
20%	3.7
30%	2.2

Level 5: Five Years of Expenses

At Level 5, you’ve already exceeded the savings that most will achieve in a lifetime. Assuming $50,000 in annual expenses (the round number makes the math easier), for example, you’ve amassed $250,000 in savings and investments. At a 9.3% return (the average return of an 80/20 portfolio over the last 90 years), your Freedom Fund will generate almost $25,000 in returns over the next 12 months. In other words, your investments are generating income approaching 50% of your annual spending.

Level 5 also represents a danger point. It’s here that some may become complacent. With so much money saved, it’s easy to return to old habits or to lose focus. Knowing that now will help you avoid this danger when you reach Level 5.

At this point you may be wondering what Level 5 Financial Freedom feels like. After all, one could say this is nothing more than traditional retirement savings. Oh, but it’s so much more!

Let me tell you a story.

In the middle of my career, I had a job that at times was very unpleasant. I have a vivid memory of a meeting with the boss. He was yelling at an employee on the phone. He was out of line. It was then I understood the true power of Financial Freedom.

While my wife and I hadn’t reached Level 7 at that time, we were right around Level 5. I knew I could walk out of that job if I needed to and we’d be fine financially. I wasn’t stuck. And it was a great feeling.

Less than a year later, I took a pay cut to pursue a new opportunity. I took that risk because I could; I wasn't chained to my job or to the salary. It turned out to be the best career move of my life. And it was made possible because of Level 5 Financial Freedom.

This is an example of how money saved and never spent can have a profound effect on our lives.

Time to Level 5:

Savings Rate	Years to Level 5
10%	23.6
15%	17.7
20%	13.9
30%	9.2

Level 6: Ten Years of Expenses

Level 6 is an important milestone. It’s here that your investment income will begin to equal and then exceed how much you are spending each year.

Let's again assume you spend $50,000 a year. At Level 6, you will have a Freedom Fund totaling $500,000. A 9.3% return will generate returns of $46,500 over the next 12 months, bringing your Freedom Fund to $546,500. The following year, with a Freedom Fund totaling almost $550,000, you will on average generate just over $50,000 a year.

Talk about a great feeling! You are working hard, earning an income, and spending $50,000 a year. At the same time, your Freedom Fund is generating returns equaling the same amount. Like a snowball rolling downhill, your wealth is multiplying before your very eyes.

Time to Level 7:

Savings Rate	Years to Level 6
10%	34
15%	26.9
20%	22
30%	15.5

Level 7: Twenty-Five Years of Expenses

Level 7 is the Ultimate Financial Freedom. It’s here that you can completely retire from work if you so choose. Or, if you’re like me, you can work on projects you love while still earning an income. The choice is yours.

Level 7 enabled me to retire from the practice of law at 49. Following my retirement, I continued to run my personal finance blog, newsletter, and podcast. Two years later I sold my blog, but I still record a podcast each month, and I became a Deputy Editor at Forbes for a couple of years. These activities generated income. But I did them because I’m passionate about personal finance and investing.

When you reach Level 7, you can pursue your passions. That may mean keeping your job. There’s nothing wrong with that if that’s what you love. It may mean starting a business. Here’s the point—you decide for yourself what you’ll do when you reach Level 7. It’s a beautiful feeling.

Time to Level 7:

Savings Rate	Years to Level 7
10%	50
15%	41.9
20%	35.9
30%	27.4

A Simple Financial Freedom Calculator

I've created a free financial freedom calculator in Google Sheets. The tool is simple to use. You simply input the following four things:

1. Rate of return
2. After-tax income
3. Savings rate
4. Current savings

From there the tool estimates how long it will take you to reach each level of financial freedom.

The tool has an investment rate of return of 5% input by default. This roughly represents the historical post-inflation return of a 60-40 stock/bond portfolio. You can change the assumption to whatever you like.

Debt is conspicuously missing from the spreadsheet. This is because debt payments are accounted for in the after-tax income section. Debt repayment is considered a recurring monthly expense. It’s possible to be financially free while having some debt and the calculations reflect that.

The baseline savings rate is listed at 10%. That number is in line with conventional retirement advice. Over an average 40-45 working life an investor would be on track to retire at 65 given a 10% savings rate. Again, that figure can be changed in the spreadsheet.

Finally, be sure to alter the current savings section. Many will be starting at more than zero. The number should include emergency short-term savings as well as retirement or brokerage account balances.

Final Thoughts

Financial freedom is the best thing money can buy. As I was working toward the goal, I viewed every dollar I saved as buying my financial freedom. At first it starts off slow, but it quickly builds to the point that compounding generates far more money than we could ever make at work. The key is to get started now.

And for those that want to track their progress with a more sophisticated tool, check out Empower. It's free and the best overall net worth, investment and retirement planning tool available today.