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I thought a former boss of mine categorized savings pretty succinctly: maximize those things that gain in value and minimize those things that lose value. I personally use that as a barometer to if it’s saving or spending.
Maybe you read somewhere you should be saving 10%, 15%, 20%, or like some “retire early” dudes, 50% of your savings? How do you calculate that percent? There are million ways to do it, and a million questions. Like:
- Do student loans count to savings?
- Does a car loan count as savings?
- Does a house mortgage count as savings?
- How do Roth (post-tax contributions) vary compared to traditional 401k (pre-tax)?
- What about other post-tax investing?
- What about college savings?
- What about saving for other things like presents, or vacations?
You can see that what sounds easy on the surface can get complicated, and everyone could have their own way of doing it. The government calculates it as percent of “disposable income” that is saved. And in early 2015 that rate hovers just under 5%. Here’s how they figure it:
- You earn $4000 gross in a month
- You pay $1000 in taxes
- That leaves $3000 “disposable income”
- Let’s say you put $500 in “savings”
- And spend $1000 on credit card debt
- Plus spend $750 on rent
- and another $750 on car/food/life
- They consider that savings rate as only $500/$3000 = 16.7%
So let’s agree there are different ways to figure this out, and my way is by NOOOO means bible. If you have a different way, that’s fine. And if you are calculating the age-old question: “What percent do I need to save to have X retirement?” this isn’t the site. But here are my basics:
- If you are paying for something you bought in the past that LOSES or has lost value, you are not savings. Hence, paying a credit card is not “saving,” nor is paying off a car loan.
- Like my rule above, paying off your old student loan is not saving either. Hopefully it was an investment, but it is something spent, and you’re paying off a debt. It doesn’t count as saving in my opinion (or IMO as the kids say).
- “Saving” for a new car, or a vacation, or Christmas Club isn’t really saving either. It may reduce stupid-ass interest, but it I don’t believe it should be considered saving to simply spend it on a depreciating asset.
- Saving for a kid’s college I do consider saving, since you are purchasing a potential investment.
- Saving cash for emergency fund, or to invest is saving.
- While this one is all over the board on how people view it, I do consider the principal payment on a mortgage saving, but for me, I only use the pre-payment or overpayment above the required as “saving.” You are obligated to pay that base mortgage payment, but overpayment is essentially saving interest, or getting a direct positive benefit of the interest rate, so I consider that saving. So if you pre-pay on a 4% mortgage, you are essentially getting a 4% return on your investment. Some people will see this as a sunk illiquid cost, I’m ok with that, but I consider this saving since it does increase your net worth, and you could alternatively blow that money on “stuff.”
So below is how I calculate my savings rate, and is probably ok in determining if you’re on the right track.
Step One: Calculate your personal savings; include the following:
- Personal contributions to retirement accounts – don’t worry too much about pre- or post-tax (regular or traditional 401k/IRA vs Roth) as a percent since either way you end up paying taxes. So if you set your 401k up as 10% just use that number of your gross as the amount saved for the calc. below. Likewise, if you spend $5000 on a Roth IRA, don’t worry about gross or net income. It’s noise for my simple calc.
- Employer contributions to retirement accounts. Personally, I don’t count this in the “income” category since it is sort of a bonus and not something I see except as savings that someone else is throwing into the pot. Technically, this should be added to the income category, but unless you are saving anyways, you never see it. I call it a “saver’s bonus” in this calculation. If you’re lucky enough to have a percent matching in your 401k, it may add an additional 3 or 4 percent (for most, though I’ve heard of very generous employers matching 5 or even 10% – makes a huge difference in your savings rate if you get this. My employer matches 4 and my wife’s 2.5%)
- Other contributions to saving or investment accounts with intention of beneficial purchases that increase or remain net neutral in value (rental income, cash-savings position, CDs, Peer-to-peer lending, etc.)
- Amount of overpayment to mortgage
- Amount paid to college funds
- Call this “A”
Step Two: Calculate your total income less taxes
- Subtract taxes (state, federal, local, social security, medicare, etc.) from your gross pay. I also subtract pre-tax payment of health/dental insurance since to me that shouldn’t be included in “discretionary” spending column, since it is mandatory (and Mr. Obama and the tax code thinks so too, penalizing people who don’t have insurance)
- Add any other income (less taxes as appropriate), from side hustles, passive income, rent, social security, pensions, interest, etc.
- Call this “B”
Step Three: Calculate Savings Rate
- Divide Savings (A) by Income-less taxes (B)and multiply the result by 100 to change the decimal to a percentage.
This is pretty similar to how the they calculate savings in the United States.
So to illustrate:
- A married couple contributes $30,000 per year to a 401k from pre-tax dollars
- They also get a 4% match (say, as a 1:1) on the first 4% of employee contribution, or in this case, let’s call it $7,000 based on hypothetical earnings
- They also have automatic savings set up (with post-tax money) for for the following:
- $2,000 per year for their child for college
- $5,000 per year for a Roth
- $,5000 per year for a taxable brokerage account (invested in Mutual Funds)
- $5,000 in prepayment to mortgage principal above their mandatory payment
- Take home pay on the year is very healthy $100,000 (to make math easier) after the 401k contribution.
Hence A = $30,000 + $7,000 (bonus match) + $2,000 + 5,000 + $5,000 + $5,000 = $54,000
and B = $100,000 + $30,000 (401k pretax contribution) = $130,000
Hence A/B * 100 = 0.415 * 100 = 41.5% savings rate (very solid). If everything was half (say $50,000 take home- roughly equal to the median household income in the U.S.- and with half the savings above) it would be the same percentage. How does this couple do this? They are frugal, drive paid off, used cars until they are unsafe or too expensive to keep up, keep consumption to a minimum, and value long-term freedom more than having depreciating items today.
- this percentage is higher compared to some calc’s due to the employer matching contributions, but if you added that back in on the Income (B) side, it would reduce savings percent to 39.4%, not a huge deal
The thing is, if you use this method to calculate your savings rate, your 10% automatic savings rate in traditional 401k does become a higher savings amount in this analysis since your net income goes down and makes the percentage higher, especially if you get a match. Now this approach doesn’t really account for taxes, since you’ll have to pay those later, so is generally going to look a little better than a 10% post-tax (i.e. Roth or Roth 401k or taxable account) savings.
I’m not going to prescribe a goal for you, but use my old boss’s credo (maximize appreciation, minimize depreciation) and you’ll do well. I think a good goal for the normal folk is to be mostly debt free, save at least 15% towards retirement if you really want to kick ass, and if you can, towards things like college. Solid, if not spectacular when most save less than 5% in the U.S.
I know us, and other iFriends (like the former Captain Power) don’t want to settle, so are looking for more. Unless we fire up the old Flux Capacitor, we can’t go back in time and be FIRE (financially independent, retire early) at 30 like Mr. Money Mustache, but we’ll have the opportunity to have some FU money sooner rather than later.
Using the formula above, this year we’re on track to save 36%, the highest year yet. We came from nothing, and simply grinding savings each year, we’ve accumulated a good nest egg. If the market has an “average” year, we’ll be damn close to breaking a half-mil in just tax-advantaged retirement accounts by Christmas, before my 40th birthday. Pretty amazing to this guy who grew up with handmedown bikes and thriftstore clothes for most of my childhood years. And the thing is, we fucked up early in life, but got on track in our twenties and GRINDED to where we are today.
To do this, here are a few general rules, prioritize as you see fit for your circumstances:
- If you work somewhere with a 401k or matching retirement contributions, contribute at least up to the match – it’s free money. Set it and forget it. Do this before maybe anything else. And don’t take a loan from this account.
- Work to eliminate credit card or other high interest debt; then all debts to the extent you can
- Build an emergency fund. Set up somewhere away from your normal account (I use Capital One, but others pay better interest). Set it and forget it (small automatic savings deposited to this account) until you hit 3 to 6 months of savings. It may take several (or more) years, but this is for EMERGENCY, not for a new TV or some other bullshit you don’t really need. I think of it as a “peace of mind if I ever lost my job Fund” and you should too.
- Bump up your 401k (or equivalent, like 403b, or Roth or even a brokerage account if you don’t have anything else) to 10- to 15%, do it slowly if need be, say a couple percent a year. Some will say an automatic Roth IRA here is better (after you hit your match), and with lower fees it likely is, but I also recognize most of us are lazy and simply bumping up this percentage is easier than setting up and tracking another account unless that’s your only choice.
- Work to create other cash funds for cars or other items. You may or may not have enough to pay cash for everything, but you’ll at least reduce the amount you finance, saving money in the long run.
Do this and you’ll be ok, but coupled with reduction in spending and you’ll hit your goals faster. My book has a nice 60 page chapter that consolidates personal finance strategies for those that are starting out or coming up for air after life happened, and is one of the key components of my life and my message.
Best of luck on finding your own sweet spot in personal savings!