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?
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
(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?