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How Much is Enough?

raining_money_on_woman.jpgWhat is prosperity? Is it a measure of the personal freedom your finances have won you? Freedom to work when you want, where you want—or to not work at all? And if so, how much money is enough?

Many books on personal finance say you’ve “made it”—achieved financial independence—when income from your assets is sufficient to support you without working. In other words, if interest, stock dividends, rental property income, and other so-called passive income covers all your expenditures each month (plus taxes, remember), you’ve made it.

That’s a reasonable definition, and one that allows each of us to define “financial independence” according to our unique income needs. A family with a big mortgage, two cars, and children approaching college age needs far more than a childless couple with modest housing requirements.

So the first step is to get a good grasp on how much you need to survive—and thrive—each month. Let’s call this your “Prosperity Point.”

Here’s an example. By tracking actual expenditures—Step One on the Prosperity Path—let’s say you determine that the Prosperity Point for your family is $5,000 per month. In other words, you’ll need assets that throw off $5,000 in cash each month, or $60,000 per year, in order to be financially independent.

Now let’s figure out the assets needed to produce $60,000 per year in income. It’s an easy calculation, but let’s assume you dislike risk as much as I do, and agree to keep the money in essentially risk-free financial instruments: money market funds and CDs.

Such risk-free assets pay about 5% yearly at the moment. Therefore you need $60,000 divided by 0.05 (60,000/.05), or $1.2 million in order to achieve a passive monthly income of $5,000. Let’s call the $1.2 million figure your “Prosperity Pillow”:

Prosperity Point

$5,000/month or $60,000/year

Return on Assets

5%

Prosperity Pillow (pp) calculation

pp x .05 = $60,000

Prosperity Pillow

$1.2 million

In other words, you’ll need to accumulate 20 times your Prosperity Point to reach financial independence. If you achieved a 10% rate of return, you’d need only ten times your Prosperity Point, or $600,000:

Prosperity Point

$5,000/month or $60,000/year

Return on Assets

10%

Prosperity Pillow (pp) calculation

pp x .10 = $60,000

Prosperity Pillow

$600,000

But peace of mind is a big part of prosperity, so let’s stick with risk-free assets.

Note I don’t use the term “net worth” when describing the Prosperity Pillow because net worth includes your primary residence (less any outstanding loans). But you must exclude the value of your primary residence when calculating assets needed to achieve your Prosperity Pillow, because your home costs you money, it doesn’t produce cash (see Why Your Home is a Liability). And it goes without saying you won’t count cars, boats, tools, jet skis, musical instruments, and other such stuff. Remember: Assets pay you money.

Imagine now that you’ve achieved your Prosperity Pillow of $1.2 million, excluding your primary residence, and every month $5,000 comes flying into your bank account, without a minute of effort on your part. A good feeling, to be sure! But wait a second. Last time I checked, the IRS taxed interest and other short-term passive income just like ordinary (active) income, at an adjusted rate of somewhere around 14% for someone earning $60,000. If you pay state income taxes as well, you might see 20% or more of your monthly $5,000 eaten up in taxes. So your actual take-home earnings would be $4,000 rather than $5,000. Ulp.

Taxes. It’s a nasty word, but I said it. Can your family live on $4,000 a month? Hmm. Maybe $1.2 million isn’t quite soft enough a Pillow.

Now consider this. You might get by on $4,000 monthly now, but how about five years from now? Or ten? Prices are going up. If your Pillow just throws off cash without increasing, how will it keep up with inflation?

Many families living not-particularly-extravagant lifestyles have monthly cash needs of $6,000, $7,000, or more. Imagine the kind of Pillows they need to become “financially independent.”

Here’s my point: Focusing on the Pillow alone is daunting. Rather than defining “enough” in terms of pure financial independence, we’ll do better to create a more holistic definition—one that considers not only income, but spending, work, retirement, and other lifestyle choices.

In short, as we go forward, we’ll seek to define true prosperity, rather than simply asking, “how much is enough?”

See also: “Why Your Home is a Liability” and “A Gift From My Father

1 Comment to How Much is Enough?

On Dec 16, 2007, Minimum Wage commented:

I don’t have a Pillow, just a Pill.

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