Many purveyors of FIRE (Financial Independence, Retire Early) have large incomes. These are people such as doctors or lawyers who make large salaries but live a modest, middle class lifestyle. This allows them to pile up money and reach financial independence in their thirties or forties.

Others reach FIRE through extreme frugality. Reducing their expenses to nothing so that they can save and invest despite a relatively modest income. Even once they retire, they maintain a modest lifestyle so that they don’t need a big income. Therefore they don’t need to save up so much to reach their early retirement goal.

Create Free Cash Flow

But what if you don’t have a big income and also don’t want to live an extreme, spartan lifestyle? Most people in this situation assume they’ll be dependent on a job until Social Insecurity and Medicare kick in. They therefore go on living their debt-laden, suburban, home-equity loan lifestyle. Maybe they’ll put enough in their 401k to get most of the company match.

Many assume they need a big income or must live on the edge of frugality to reach financial independence. That is a false choice. Just as it’s false to assume you need the natural physique of Sylvestor Stalone to become healthy.

While their incomes are radically different, what the large income and extreme saving families are doing is controlling cash flow. This enables them to reach financial independence.

Specifically they are creating a big enough free cash flow to save or invest. Either save up enough directly to reach FI. Or, invest and increase their income enough to no longer need to work to pay for things.

The Cash Flow Diagram

To understand free cash flow, study the Cash Flow Diagram (CFD) provided in Figure 1. A CFD shows how wealth comes into your life through income. It rests briefly in your bank account as cash-on-hand. Then cash flows out to expenses, investments, and savings.

For most people, cash flows in as income (Box A). Flows into Cash-On-Hand (Box B). Then is paid out in expenses, Boxes C-E. Wise people will also put some money away into 401k accounts and college funds, which are Required Investments (Box F). This is wise since you really need to save for these things if you are financially responsible.

Free cash flow is what remains in your hands after you’ve paid all of the bills and put money away into required investments. Free cash flow is a result of reducing your spending (or increasing your income) enough to have money left over after you’ve taken care of important things like health care and retirement accounts.

People with big incomes and small incomes can both have the same free cash flow. It is the size of your free cash flow, not the size of your income, that determines how long it will take for you to become financially independent.

Why It’s Important to Create Cash Flow

The reason free cash flow is important is because it is what is available to flow into Box G: Income Investments.

Income investing is the purchase of assets that are not in tax-sheltered accounts like IRAs and Educational Savings Accounts. (Note, an asset is something you own that produces a return for you. A bank account, share of stock, and rental property are all assets. A personal car, personal residence, or a living room suite is not.) Income investing generates monthly cash flow that you are free to use as you wish, regardless of age, without paying a penalty. This means you can replace your income from work by building up enough assets.

Income assets can include things that might be in a 401k account, such as mutual funds, or they can be things like individual stocks and bonds, rental properties, collectibles, farmland, a hit song, or even businesses franchises. Income investments are separate from your standard occupation so that the income that they generate does not go away when you quit your job. Ideally they also do not require your active management, so things like mutual funds are better than things like owning a side business, unless you simply like running the business.

Income Investing Increases Income

Note that there is an arrow in the CFD pointing from Box G to Box A. This is because income investing increases your income, meaning that your cash on hand will be bigger each month each time that you add an income investment. This can mean that you can increase your spending if you wish when you add assets, but this is not the best way to reach financial independence.

Instead, most of the money generated by your income assets should be used to purchase more income assets. Doing so creates a feedback loop which, like when a microphone is held too close to the speaker, will feedback through the system, build upon itself, and cause your income to grow exponentially.

Create Free Cash Flow to Reach Financial Independence

How quickly can you reach financial independence using free cash flow to create a feedback loop? That depends on the amount of your free cash flow that you use to buy income assets and the rate of return you receive from your investments.

Figure 2 shows the age at which a 20-year old can reach financial independence, assumed to be a $1 M portfolio. The rates-of-return given are in the range that you can receive during a given ten or twenty-year period in an all stock portfolio. 10% is a fairly common return, where 15% would be an exceptional return, seen during periods like the 1980’s and 1990’s. It is also possible that you might only make 5% or 8% during a given period, but it is extremely unlikely that you will not generate a positive return if a portfolio of stocks is held at least ten years.

Your free cash flow is also a factor in how quickly you can reach financial independence. You might reach financial independence before age 60 if you put $200 away each month and have good returns on your investments during a period of about 30 years, but it is likely you’ll be there in your forties if you can create a free cash flow of $1,000 per month. While this may seem like a lot, realize that it is only a couple of car payments and a few meals out each week. If you can make small sacrifices and have patience, you can receive big rewards.

Focus on Investing ROI

Investing better to increase your rate-of-return also lessens the time required to reach financial independence. The time period over which your net worth will double with a 7% return is 10 years, while it is about 6 years if you receive a 12% return. Good investing is not difficult, but it does require a bit of knowledge.

The Small Investor website is a good resource to learn how to invest and find other articles on personal finance. Even during periods of bad returns and even if you do not invest optimally, you can still reach financial independence before retirement by creating a sufficiently large free cash flow.

Create Free Cash Flow To Catch FIRE!

Creating enough free cash flow to reach FIRE does not need to mean a big sacrifice. As discussed in the previous section, if you purchase used cars for cash and avoid car payments, you can create a substantial free cash flow.

This is because you are eliminating a common obligated expense – defined as an expense that you cannot easily reduce or eliminate once you’ve signed on the dotted line. You can also make small changes to your necessary expenses. Those categories of things like food and shelter that you must purchase, but where you can choose cheaper options.

This also applies to optional expenses – defined as luxuries like golf and lattes. This just involves creating a budget where you purposely limit your expenses to create a desired amount of free cash flow.

Unexpected Expenses

One issue that arises, however, is that you may budget well month-to-month and be building up assets, but then the car quits working. Or the air conditioner breaks and you end up selling off assets to replace the item. Your income investment account can be used to solve this issue if you include saving and investing for big expenses in your budget. To do this, when preparing your yearly budget, develop a list of high-dollar, long-term items like home upgrades, appliance replacements, and roof replacements.

Assign a dollar value to each and an expected period of years before that purchase will be made, dividing the former by the latter to determine how much you need to save yearly for each expense. Then, when you allocate money in your budget, go down your list and fund as many long-term items as you can. Continue to fund items as your income builds and as you find ways to cut expenses until you have covered the whole list. Invest the money you put away for these items, selling investments to raise cash as needed as the time draws near to when you’ll need to make the purchase.

What will happen is that the assets you buy with the money you’re putting away for these long-term expenses will generate extra income as all assets do. At first this will mainly help you save up for those large expenses, but eventually this extra income will also allow you to buy enough assets to generate income that is free and clear. You’ll build up a $100,000 investment account from which you may pull $10,000 to buy a car once in a while, but you’ll have the remaining $90,000 generating income. Let this income buy more assets, and you’re off to the races to FIRE.

Reduce Tax Advantaged Participation?

Finally, you can also think about reducing your investments in traditional tax-sheltered retirement accounts to create more free cash flow to build up your income investing portfolio. Money put into an IRA or 401k is locked away until you are 65 years-old or older, well beyond your planned retirement date. So investing less in retirement accounts and more in income investing accounts will reduce the time needed to build up a sufficient income portfolio to quit working.

Still, the employer match you can receive in a 401k should not be turned down. Doing so would be leaving money on-the-table and the tax advantages of those accounts will allow your assets to grow faster. While you might cut your traditional retirement savings somewhat, it would be wise to still put some money into these accounts. This will also help protect you from the effects of inflation if you retire at 45 and have fifty years to spend in retirement since you’ll get an extra shot of income after you have been retired for twenty years and can tap these accounts.

Realize that most people that retire early end up living longer than those who retire on time or late. Putting in a little extra protection to avoid running short of cash in your later years only makes sense.

Joe Sheeley, aka SmallIvy, is a rocket scientist who reached FI at age 42. He has been investing since age 12 and is the author of The SmallIvy Book of Investing and his latest book, FIREd by Fifty. He is the founder of the Small Investor Blog.