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
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.
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
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
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 ma 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, alsofall 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 adequatelyaccounted 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 yourbusiness, make it 75% and use the rest to build up your nest egg.
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, youcould 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 thatinitially 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 carinsurance (if you own a vehicle). In terms of stocks and bonds, there’s no wayto 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.