You’ve all seen the headlines.
“SHOCKING Frugal Weirdo Saves 99% of His Income!!!”
I think I’ve even been featured in a few of those articles.
But as I’ve responded to various reader emails, browsed a few of the internet’s personal finance forums, and scariest of all, combed through the comments section of those mainstream media articles, I’ve noticed there’s just one huge problem to those types of headlines…
Nobody’s really sure how you’re supposed to calculate your savings rate.
Obviously, this creates all sorts of problems for comparison’s sake. (How are we ever supposed to humble brag in some internet stranger’s face, if the gloating-baseline isn’t clear?)
So let’s settle this score, once and for all.
How about we finally agree on the best, easiest, and most accurate way to calculate our savings rate?
- Why does your savings rate even matter, anyway?
- The Wrong Way to Calculate Your Savings Rate
- Finally, the best way to calculate your savings rate
- An example savings rate calculation, using The Money Wizard’s real numbers
- So, how do we calculate my savings rate?
- What’s a good savings rate?
- My Personal Savings Rate Goal: At least a 50% Savings Rate
Why does your savings rate even matter, anyway?
Math sucks. Blog posts about math are even worse. Which is why my motto is that before we ever resort to crunching numbers, it’s always worth reminding ourselves just why we’re doing the work in the first place.
Especially because, in recent months, the almighty savings rate has come under some serious fire in the FIRE community. (How about that pun!?)
And we all know there’s nothing more juicy than a little early retirement drama…
In any case, critics of the metric will argue that savings rate isn’t everything.
Their biggest point is that different incomes can skew the overall usefulness of the metric. A mega-billionaire is going to have a slight advantage in building wealth, no matter what their savings rate is. Mark Cuban saving 5% of his annual income will always blow away The Money Wizard’s 60% efforts. Duh.
But from where I’m standing, those side arguments don’t take away from just how useful the stat can be for the average investor.
Because plain and simple, if you’re trying to measure your own success, then there’s no faster and easier way to do it then with a quick savings rate calculation.
Not to mention my personal favorite aspect of the savings rate – it serves to game-ify your frugality. It might be hard to believe, but over time, tracking your savings rate actually makes saving more and more money kinda fun!
Oh, and last but not least, no savings rate discussion would be complete without mention of the graph that might as well be the early retirement community’s Holy Bible:
That graph is a topic worthy of an entire post in itself, but the key point is this.
All else being equal, increasing your savings rate directly reduces the length of your mandatory working career.
Through this lens, increasing your savings rate from 30% to 50% is far more than meaningless numbers on a screen. With typical investment returns, it’s actually the difference between a 20 year working career and a 12 year one.
8 years of your life back!
Pretty amazing right?
We just have to make sure we calculate it the right way. So, let’s get to it.
The Wrong Way to Calculate Your Savings Rate
Plot twist! First we’ve gonna start with some of the most common mistakes people make.
1) Punishing yourself for paying taxes
This happens when you calculate your savings rate relative to your gross pay.
It’s the simplest calculation, but also the least accurate.
The obvious problem here is that even if you’re saving 100% of your take home pay, your personal savings rate still won’t ever be higher than around 70-80%. (Because your tax rate is counted against you.)
I find this horribly demotivating. Taxes are bad enough. We don’t need to add to that pain by penalizing ourselves for something that’s entirely out of our control!
2) Ignoring retirement contributions
Another common way people shortchange themselves usually goes like this:
They’ll use their take home pay, subtract their spending, and then use those two numbers to divide into a savings rate.
Did you catch the problem there?
They forgot all about retirement contributions!
If you’re building up your 401k, for example, you should give yourself credit. And yet, most savings rate calculations completely ignore this very important factor.
3) Over inflating the impact of your retirement contributions
On the other extreme is this formula:
(Annual Savings + Retirement Contributions w/ employer matching) / Take Home Pay
If you look closely, you’ll see the mistake. They counted retirement contributions as savings, but never considered that those contributions originally came from their gross income, and therefor should be added to the income side as well.
Using this strategy, it’s actually possible for a really frugal saver to have over a 100% savings rate. Which obviously makes no sense at all.
4) Stretching the truth about what should count as savings.
If you blow tons of cash leasing a Lamborghini every month, should that count as savings? I think we know the answer…
A more realistic example is counting your mortgage interest as savings. While it might be an associated cost of building an asset, mortgage interest is surprisingly similar to rent. It’s money out the door, never to come back. It’s not savings.
Finally, the best way to calculate your savings rate
After lots of personal trial and tribulation, I’ve found that far and away, the best way to calculate your savings rate is using this formula:
Savings Rate = Your True Savings / Your True Income
Savings Rate = (Annual Savings + Retirement Contributions + Employer Matching) / (Annual Take Home Pay + Retirement Contributions + Employer Matching)
Is this formula absolutely, forensic accounting perfect? Not entirely, but it’s also simple enough that it’s definitely the best way to calculate the savings rate of any normal human.
That said, there are a few terms in there we should clarify.
Annual Savings: I calculate this simply enough.
Savings = Take Home Pay – Spending
Retirement Contributions: For most people, this is their pre-tax 401k contributions. (Money that ultimately ends up in Roth IRAs is after tax, so it will be captured in the annual savings calculation earlier)
Employer Matching: Your employer’s contributions to your retirement plans, but this can also include things like employer matched HSA contributions for certain people.
What should count as spending?
The one area that seems to trip people up the most is deciding what should and should not count as spending.
I consider spending to be anything that leaves the door, never to come back.
Here’s a few of the more confusing items which you should definitely consider spending:
- Interest on debt
- Car payments
- Insurance premiums
- Property taxes
- Anything else that’s personal consumption, including but not limited to… rent, groceries, entertainment, travel, massages, Lamborghini leases, stamp collections, and drug addictions.
What should not count as spending?
Basically, anything that improves your net worth, including:
Investment contributions – investments into index funds, stock and bond purchases, or even cash built up in your checking or savings account should not count as spending.
Roth IRA contributions – any after tax retirement account contributions are saving, not spending.
Principal portion of debt reduction – for most people, this is the equity building portion of their mortgage payments.
But this can also include any type of debt reduction, such as the principal of student loan payments and even the non-interest portion of long-term* credit card debt.
Because from a net worth perspective, reducing debt levels is the exact same as buying assets. As I mentioned in my Correct Order of Investing article, paying down credit card debt with a 20% interest rate has the exact same effect as earning 20% through a brilliant investment.
(*Note, this should only apply to those recovering from long-term credit card debt – the type of stuff that’s leftover from when you couldn’t pass on that $19.99 snuggie ten years ago, and now you’re still paying interest on it. For example, I pay off my credit card statement balance in full each month. Therefore, I never actually have true credit card debt. Instead, these payments are just settling up my personal consumption, rather than chipping away at debt reduction.)
An example savings rate calculation, using The Money Wizard’s real numbers
Time for a real example!
Last year, my actual numbers looked like this…
Take Home Pay: $56,693
I had two options for finding this number:
- Log into my bank account and add up the tons of paychecks I received throughout the year
- Log into my company’s HR page and reference the handy printout they give me, which includes a net pay number
Not surprisingly, I opted for option 2. (And then, like a true OCD-weirdo, double checked over the next two hours with option 1. But that’s probably overkill…)
Yearly Spending: $33,893
Shout out to Personal Capital and my cell phone’s spreadsheet for making this number shockingly easy to tally.
(This is also a nice benefit of running a blog where you post your exact monthly spending every single month.)
Note: You could also back into this number. To do so:
- Find the movement in your checking/savings account by simply comparing the starting and ending balances.
- Add on all post-tax investment contributions during the period. You now have your total annual savings.
- Subtract this total from your take home pay over the same period.
Annual Savings: $22,800
I found this by subtracting my take home pay from my yearly spending.
Then, I double checked it by adding up all my after-tax investment contributions during the year, plus any changes to my checking/savings account during the year.
401(k) Contributions (Personal): $6,700
How much of my personal paycheck I contributed to my 401k. This gets taken out before I receive my take home pay.
401(k) Contributions (Employer Matching): $6,700
My company has an awesome 401k matching policy, which is a big reason I still work there.
So, how do we calculate my savings rate?
Remember, the formula is:
Savings Rate = (Annual Savings + My Retirement Contributions + Employer Matching) / (Annual Take Home Pay + My Retirement Contributions + Employer Matching)
or, using my actual numbers…
Savings Rate = ($22,800 + $6,700 + 6,700) / ($56,693 + $6,700 + $6,700) = 51.6%
What’s a good savings rate?
Good question! That number by itself doesn’t tell us a whole lot.
Which leads to my annoying answer. A good savings rate is as high as comfortably possible!
Rice and beans every night might be taking it too far. But as the folks on Netflix’s Queer Eye like to say… Make. An. Effort.
For reference, the average American has a savings rate around 5-6%. That’s a disaster.
With that as a baseline, the “common wisdom” says to double that amount to 10%, and then blow the rest of your paycheck carefree. (Even the almighty Dave Ramsey only recommends saving 10-15%)
In my opinion, that’s short sighted too, since a 10% savings rate means you’re still looking at a 30-40 year lifetime of cubicle servitude. Minimum.
Instead, I think it’s more realistic that somebody seriously trying with their finances should shoot for 33% as a good savings rate. This alone will cut your working career to around 20 years – about half of the average employee.
From there, you can ramp up your savings depending on your desired lifestyle and how enthusiastic you feel about building wealth.
Fresh out of college, I saved a little over 40% on a $30,000-ish take home pay. I’ve since increased my income through raises and promotions, which has pushed my savings rate over 60% in good years.
My Personal Savings Rate Goal: At least a 50% Savings Rate
If you’re serious about reaching financial freedom as quickly as possible, you should challenge yourself to reach at least a 50% savings rate.
I find something especially comforting about this number – half of your income goes towards living to the fullest today, while half of your income goes to paying your future self.
What’s your savings rate?
10 Year Target says
I have done calculations to find my savings rate. But I did it far more complicated than you. Not saying one is better than the other. But I did it differently. Please have a look https://10yeartarget.com/how-am-i-going-to-reach-my-money-target/
The Money Wizard says
Yep, like I said, this strategy isn’t forensic accounting level accurate, but then again… your savings rate doesn’t need to be.
The biggest advantage of a savings rate is to track your progress, so all that really matters is finding a way that works for you. IMO, this version is the most realistic and accurate way for most people. The 80/20 of savings rates.
A Journey to Fi says
Thanks for sharing your thoughts about savings rate. I agree with most of your points; however, your best way it’s not my way and that’s totally fine. I keep retirement contributions a a separate bucket and only consider take home pay. In short, I keep the “paying myself first” strategy out of scope when estimating savings rate. Yeah, I could give myself credit for maximizing all tax deferred accounts but it is not an area of optimization (I’ve maximized since I started working) for me at this point. I also wrote about this topic so feel free to check it out https://www.ajourneytofi.com/a-model-to-estimate-your-savings-rate-the-qdikw-pyramid/
The Crusher says
Thank you for taking the time to tackle a topic that is, at its best, messy. I have a few wrinkles to add based on what I do. I 1st do calculate my Gross Savings Rate. I realize this is not completely ideal but this method does have two advantages that are difficult to deny:
It is very easy to calculate consistently year over year. It is a very clean calculation.
It also reminds me that one of my financial goals is to actually reduce my effective tax rate. It keeps this goal on my radar.
I do also take a stab at calculating my Net Savings Rate which is similar to what you are describing. In doing so the only difference is that I do not count my repayment of mortgage principal as a savings. Maybe I should and I would love feedback from other members of the community about whether they count this or not. I do count any additional money added to the mortgage each month as a savings. Maybe that makes my calculation inconsistent??
The Money Wizard says
I included the part about mortgage principal in the post, just because that’s the most agreed upon consensus in the community.
Personally, I don’t adjust for mortgage principal in my own calculation. For me, that’s because 1) the house is still technically under Lady Money Wizard’s name until we’re married and 2) I just don’t see the point, especially when a primary residence is such a lousy investment.
The extra time to figure out what (relatively small) percentage of the monthly payment goes to principal versus interest just doesn’t seem worth the hassle, especially when savings rate is intended to measure cash inflow vs. outflow. The rent payments (aka mortgage payments) will be there until the mortgage is paid off, at which point if I really wanted to give myself credit for all those principal payments, I could just add the paid-off house to my net worth.
Which again gets back to the whole purpose of tracking net worth, savings rate, etc. It’s all about getting it mostly right in a way that makes sense to you, and then tracking the progress consistently.
The Crusher says
I agree completely how important it is to focus on continuous improvement. Our Net Savings Rate has progressed the past 5 years from:
25% to 25% to 29% to 34% to 45%
This year I project we will be close to 50%. Not great but not bad. 🙂
The Money Wizard says
Not bad at all! 50% is definitely something to be proud of.
Johanna Peterson says
This is a very simple way to calculate this. I am very competitive in my saving and could see this as a tool to continue to increase savings! There is one thing that always trips me up when figuring out my savings strategy. I have required pension contributions of 10% that come out of my paycheck for a pension that only vests in 10 years (currently just 1 year in). My contributions will be refunded if I don’t reach vesting before I leave. I am still in my 20’s and thinking about staying at a job just to reach that vesting period doesn’t really sounds great to me even though I like my job.
I am not factoring in any sort of pension income in retirement at this point and try to contribute the maximum amount to my work 457(b) plan (no employer matching) as well as after tax investments.
How do I figure the maybe/maybe not pension in to my savings rate or overall retirement planning strategy?
The Money Wizard says
I view pensions similar to social security. A great bonus if they’re still around when we retire, but considering how many of the programs are flat broke, I’m not giving it much weight in my retirement strategy.
Very informative article Flapjack. I’m sitting at 53%. Feels high to me. Maybe I should knock it down to 50%? Will be interesting how much it goes up by when my raise processes, or when we buy a house. We’re saving for a down payment and an over sized McMansion should nuke my finances like a megaton. Wish me luck.
Why do you add your retirement contribution and employer match to your true income?
Why wouldn’t he? It’s money he’s making by working for the company. It is paid to him in his retirement account as it’s earmarked for savings. The employer match is literally free money paid to him.
I’m sitting at 33.35%. My wife works part-time, so our income is a little bit higher. I thought our savings rate would be higher, but being married, a lot more money gets spent lol
Anyway I thought I’d add: I counted my HSA contributions (+ employer contribution) in my numerator and denominator because those can eventually act as retirement distributions later on
Menard Solve says
You have it wrong when you say Ramsey only recommends a 10-15% savings rate. You’re disregarding the part when he states that you should pay off your home (whether that’s optimal is another discussion) and contribute to a college fund for kids, both of which should be included in the calculation because they can prevent people from retiring. Regardless, this post is really helpful. Thanks for writing it.