For the vast majority of us, income is something for which we trade about half of our day to generate. We rise early on Monday morning to prepare, then travel to our jobs, spend nine hours there with a couple breaks, and return home, exhausted, only to repeat the process the next four days.

At the end of the week, or month, we’ll receive an income – earnings we receive in exchange for that time spent working. We pay all our bills using this income, and with the little left over, try to put away some savings for retirement and spend a little on things to distract us from the realization we have to go back to work on Monday.

When you think about it, working for an income is no way to spend your life. Consider the amount of time parents are away from their kids. Think of all the good one could be doing for their community if they did not have to work full-time for money.

Now back to reality.

Unless you are born into a family of millionaires, or inherit a large sum of money during your life, you are going to have to work to accumulate wealth. There are no shortcuts.

But at some point, most of us should aim to “retire” from the career that helped us generate that wealth, and move on to something more soul-satisfying. Now, if your soul is satisfied writing computer code, or answering telephones, or assembling parts, then by all means, keep doing what you love. The other 99% of us would probably like to do something different, but are not able to because of the need to generate an income from a regular job.

How Do You Replace Your Income?

Replacing your full-time income with investment income is no small feat, particularly if we continue to be in an environment of low interest rates, and similarly low yields on income-producing investments. With lower yields, it means we have to have a bigger pile of capital working for us. What exactly is capital?

My favorite personal finance book, Your Money or Your Life (that’s a link to my review) goes to great lengths to help readers understand the difference between savings and capital. To summarize, savings are dollars earmarked for near-term goals and expenses. This would include things like a down payment fund, or a car replacement fund, college savings, etc.

Capital is money that you specifically set aside to begin working for you. For example, if you have $10,000 in savings above your basic emergency fund and short-term savings needs, you might decide to invest that $10,000 in an income-producing investment, such as a bond, a dividend-paying stock, or even a CD or high-yield savings account.

At a 4% rate of return, that $10,000 would generate about $33.33 in monthly income. That’s not a lot of money, but you didn’t have to work for it either.

Now imagine you had $100k in “working capital” earning a 4% rate of return. That amount of capital would spin off about $333 a month – maybe enough to cover half your grocery budget, or your monthly utilities, or some other day-to-day expense. And the best part? You earned that money without having to work any extra hours, or miss any sleep.

Given these two examples, you can begin to see the secret to replacing your income. Eventually, the investment income each month would cover your basic life expenses. Maybe your lifestyle would require a $650,00 nest egg, where others could easily live on the $1,333 a month that a $400,000 nest egg yields.

Whatever your personal comfort level is, it is at that point that you are officially financially independent. You no longer have to work for an income. You may decide to work a few more years doing something you love to supplement that capital for a cushion, or as I mentioned earlier, maybe because you simply love what you do.

The Accumulation Phase

Here’s the tricky part. For most of our working lives we are in an “accumulating” phase with respect to capital. We may only be able to scrape together $300 a month to contribute towards capital, and if we only reinvested those 4% earnings, it would take a long time to replace our income.

During the accumulation phase, it probably makes sense to look outside these income-producing investments for higher opportunities to increase our capital. That’s not to say we could not augment our overall portfolio with investments more known for producing income, because those types of investments are generally regarded as safer than high-flying stocks and mutual funds.

However, at some point we are going to have to take some risks-calculated risks-for the hope of higher returns. Assuming we have a long investment horizon, we can afford to weather market ups and downs, and use the downs as opportunities to acquire more assets for less dollars.

Essentially, the goal here is to accumulate enough capital in various investments to cover your basic expenses, assuming this total amount was invested in income-producing investments. When your capital has reached this number, you can move it to more conservative investments and begin to live off the income they produce.

For example, you may have $100,000 in a rental property, $85,000 in stocks, $25,000 in bonds, and $30,000 in cash, all earning different rates of return. You’ll know you have “enough” when the sum of all your investments could be liquidated from their current investment vehicle and invested in a safe, income-producing investment such as those previously mentioned (CD ladders, bonds, dividend, etc.).

Total up your savings and investments and multiply by something like the current yield on the 30-year Treasury Bond (currently hovering around 4%). Divide that yearly earnings figure by 12 to determine your potential monthly investment income. You should now have an idea how close, or how far away, you are to financial independence.

Where to Save “Capital”

I can’t tell you exactly where to hold that capital until you’re ready to retire. You are going to have to do some homework here, and decide based on your risk tolerance and time to remain invested, which types of investments work best for your situation.

I will say this – your capital should be well-diversified across a variety of investments. At any given time, it might make sense to hold stocks, bonds, gold, silver, real estate, and during periods of extreme uncertainty, maybe even just cash. This way a real estate bubble, a stock market meltdown, or a period of currency devaluation, don’t completely wipe you out.

And at no time should you consider exposing your near-term savings, such as your tri-level emergency fund, to the same level of risk as your working capital. You might begin to feel that the pile of emergency savings could be better “invested,” similar to your other investments.

Moving that emergency money into capital and investing it all but guarantees you will experience a major emergency, at which point you’ll have to sell investments at the worse possible time, take penalties, etc. to finance your emergency. It’s just not worth the risk.

How to Get Started

Once you are debt free, and have established a year of emergency savings, begin thinking about the next steps of your savings plan. It is at this point that planning for financial independence really starts to become a motivator.

Begin asking yourself questions like…

• How quickly could I pay off my mortgage early?
• How much income would I need each month to live off without any debt payments?
• What would I do with my time if I no longer had to work for money?
• How can I continue to save money every month to further reduce my expenses?
• What types of investments should I look at outside of my retirement accounts?
• What are the tax implications of investing in taxable investments?

For me, the very idea that I may only have to work for some finite period of time, even if that is another 15 years, is motivating. Before I began to plan this way, I just assumed I would work until I dropped. But that’s not a great plan.

There are things I’d like to accomplish outside of my chosen profession, and things I’d like to see and do that I cannot while working full-time for an income. But as I am beginning to understand, it doesn’t have to be that way forever.