Many personal finance (PF) bloggers talk a lot about their savings rate. There’s a lot of debate within the community on how to calculate it, and some bragging about whose is larger. If you’re just starting out saving and investing, it can be intimidating to read about all these people saving 50, 60, or 70% of their income. But does it really matter? I would argue No.
Now, you might have a 50% savings rate and be darn proud of it-and that’s great! Really, it is. But is knowing your savings rate what will actually allow you to achieve your goals?
Why Your Savings Rate Is Meaningless
If you’re saving 50% of your income of $50,000 per year, you might think you’re doing an amazing job. But what if your savings are going mostly into retirement accounts (say, maxing out a 401k and a ROTH) but your goal is to pay for your kids college next year? Or if your savings is going into a college fund, but what you really want to do is retire early?
Your savings only matters in the context of your goals. You need to know what you’re aiming for, the amount you need, and your time horizon-only then will you know if what you’re doing will get you where you want to go.
This is why getting to know your goals and dreams is one of the first steps toward financial freedom. If you’re reaching for an arbitrary savings goal without being clear and focused on your dreams, you may be saving in the wrong kind of account – or even the wrong amount! Perhaps your money is going into a savings account instead of being invested toward retirement. Or you’re aggressively funneling extra money into mortgage payoff when you have credit card debt.
Your savings rate alone, while it can be helpful, won’t get you where you want to go. You don’t want to end up sacrificing to obtain an arbitrary savings rate, if it’s not getting you some steps closer to your dreams.
Fudging the Numbers
How do you calculate savings rate anyway? There are many different methods, which is another reason why this isn’t a meaningful statistic. Let’s say someone you know is “saving 50%” of their income, and you’re saving 50% of your income. You could actually be saving different absolute dollar amounts, because you might be calculating it differently. For example:
- Do you count debt pay-down as part of your savings rate? Principal payments only? Extra principal payments only?
- Do you count your 401k match? Or do you add the 401k match to your after-tax salary?
- What about all those other things taken out of your paycheck pre-tax: medical/dental/vision insurance, HSA contributions, FSA contributions? Do you count those in your income? What if your employer contributes to an HSA on your behalf?
- How about your mortgage payment? Or just the principal portion of the payment?
- What about savings toward short and mid-term goals? Are those part of the savings rate, or not? Does it make a difference if you’re saving for a goal you’ll pay for next month vs. next year vs. 5 years from now vs. 30?
- All money you’re saving will be spent eventually, of course, it’s just a matter of time horizon.
- Even if you end up not spending it yourself, it will be spent by someone that inherits your money.
- Does having a high savings rate really benefit you in the long run if you’re saving 50% of your income for a new car next year?
- If that’s one of your major goals, then yes!
- If your major goal is to retire early, then maybe not.
- Do you count your 401k or IRA contributions towards your savings rate?
- Do you use your net income after taxes, or your gross income before taxes? Or some other formula using a combination of after-tax income and some of the pre-tax contributions?
As you can see, there are a lot of different factors that can be taken into account when calculating a savings rate. Different people answer the above questions differently, which leads to two people saving the same amount having different “savings rates”. More than once, I’ve seen people online talking about their high savings rates without the context of exactly how they came up with that amount.
A Deeper Look
Lets take two people – John and Susan. They’re talking one day in the cafeteria at work and discover they’re both saving for early retirement. They have the same job, and both make the same $75k per year income. John brags that he’s saving 50% of his income, while Susan admits she’s only saving 25%. Susan walks away from the conversation beating herself up for her low savings rate-after all, John makes the same amount she does and can save so much more! And John walks away feeling good about himself, like he’s won a frugal bragging match. But Susan is actually saving more money than John. How could that be?
|Student Loan Principal||0||6000|
|Credit Card Principal||0||3000|
How they’d explain it if someone asked:
- Susan says “25% of my income goes into my 401k, so my savings rate is 25%”
- John says “First I take my net income and add back in my 401k contribution and match – Total $60,375. Then I add together all my principal payments toward debt and my 401k contribution and match – Total $30,750. So my total savings rate is 50.9%!
If Susan used the same formula as John, her savings rate would be 52.2%, because she’s putting aside $33k per year in the 401k, match, and mortgage principal.
You can only compare your savings rate against someone else if you’re using identical formulas. So remember that next time you see someone online talking about how they saved X% of their income – if they don’t show you how they calculated it, ask!
What I Do Instead
Rather than calculate my savings rate, I have specific target goal amounts for various short, mid, and long term objectives. Then every time I calculate my net worth (quarterly, for those that are interested), I bump up the amounts I have saved towards those goals against my targets. Then I can see how much I have left to go, and since I know how long I have until I need or want to reach that goal, I can see if I’m on or off track. If I’m off track, I can calculate what adjustment might be needed in my future savings or investment plan to get back on track to meet the goals.
Although it might sound cool to say that I save 50, 60, or 70 percent of my income, I haven’t found that my savings rate helps me figure out if I’m making the progress that I need toward my goals. So I don’t calculate it, and just track my progress instead.
I wrote a whole article on the in-depth process of getting to know your dreams, to help you figure out exactly where you want to go in your financial life. Some other information that might help:
- Make sure your goals are SMART (Specific, Measurable, Actionable, Relevant, Time-Bound)
- Once you have your financial goal, sit down with some financial calculators (give this one a spin, or check out some of my favorite calculators for different situations) and plug in:
- How much you currently have
- How much you need
- How long until you need it
- If the answer to how much you need to save/invest isn’t doable, you may need to change the timeframe or the goal
- Repeat for each goal until you have a plan
- Execute against that plan
- Periodically check in on your progress and re-evaluate if your strategy is on target.
- You can then accelerate the process by saving more
- Or refresh your goals if life or the target amounts have changed
- For example, while saving for college for my three boys, I re-evaluate the target annually
- Rinse and repeat until you’ve met your goals
How about you? Do you calculate your savings rate? If so, what formula do you use? If not, what do you do instead? Let me know in the comments!
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