The more time you spend in the financial independence community the more you’ll see the term savings rate thrown around. It is almost viewed like a sort of trophy that we can use to prove to ourselves and others how dedicated we are to achieving FIRE. It can also be used as a tool that allows us to forecast the time required to reach FIRE.
The problem that often arises when comparing savings rates with others is the fact that each person may choose to calculate their savings rate differently. On the surface, it’s a very simple calculation. You just divide your savings by your income to arrive at a percentage of income saved.
Savings / Income = % Savings Rate
It is largely personal preference as to which factors are included in your savings rate calculation. On the income side of the equation, the debate is largely between using net or gross income. On the savings side of the equation, you have savings accounts, retirement accounts, employer match on those retirement accounts and even the portion of your mortgage payment (or other loan payments) that goes toward the principal of the loan.
Why Do We Calculate Our Savings Rate?
Why are all of us in the financial independence community borderline obsessed with our savings rate? Is it really that important?
The reason that we all love talking about our savings rate is that it allows us to create a timeline of when we will be able to retire. What it boils down to is the more money you are able to save, the sooner you will be able to retire.
The chart below illustrates just how impactful increasing your savings rate can be.
The math behind this chart assumes a few things. First, this assumes a starting net worth of zero and using net income for savings rate calculations (we’ll dive into this further). Second, you will earn a 5% inflation adjusted return. Third, you will use the 4% rule after retiring.
This is just a baseline to work off of, these assumptions will not work for everyone.
Abiding by our assumptions and looking at the chart, you can see that if you save 5% it will take you 66 years until you will be ready to retire. Up that 5% to 30% and you will cut your years to retirement down to 28 years. Up that 30% even further to 65% and you will cut your years to retirement down to 10.5 years.
Knowing how soon we can achieve financial independence is the driving factor behind the coveted savings rate calculations.
Calculating Savings
The first step needed to calculate savings rate is to determine your savings. To do this we need to decide which pieces should be considered in these calculations.
The easiest piece is, well, plain old savings. This could be money that goes into a savings account, checking account, cash, etc.
The next piece is money that goes into retirement accounts. This includes pre-tax retirement accounts as well as post-tax.
This is where things begin to become personal preference. Retirement account contributions made by an employer could be included as savings. If you decide to count employer contributions as savings you should also count them on the income side as well. This will give you a more accurate savings rate. Here’s a few example scenarios in which Mary’s savings rate is calculated based only on her 401k. This means she is saving zero dollars anywhere else. This is probably not very likely, but it demonstrates the difference in savings rate percentages quite well.
Scenario 1: No Employer Contribution
Mary’s net income is $75,000 and she contributes $19,500 to her 401k. Her savings rate would be $19,500 / $75,000 = 26%.
Scenario 2: $5,000 Employer Contribution Added Only to Savings
If she counted her employer’s contributions to her 401k on the savings side and not the income side her savings rate would be $24,500 / $75,000 = 32.67%.
Scenario 3: $5,000 Employer Contribution Added to Both Savings and Income
If she counted her employer’s contributions to her 401k on both the savings and the income side her savings rate would be $24,500 / $80,000 = 30.63%. This is the most accurate calculation of the three.
The last potential savings to consider are any portion of loan payments that are going to the principal of the loan. This is often debated among the FI community.
The argument for including this in your savings is that it is directly increasing your net worth by lowering your outstanding debt. The argument against this is that you will likely not see a 5% inflation adjusted return on this money, required by the assumptions in the savings rate chart. Though, if you had a loan at 7% and inflation remained at 2% or lower you would see a 5% inflation adjusted return.This could also include principal only payments that you may make towards a loan, not just the principal portion of a regular payment. Again, there is no right or wrong answer here it is just personal preference as to what you would like to include.
Full Calculation of Mary’s Savings
Let’s calculate Mary’s savings in entirety.
She is able to save $500 per month in her savings account.
She contributes $19,500 ($1,925 per month) into her 401(k) and receives $5,000 (~$417) employer match.
She contributes $100 per month into a Roth IRA.
She also pays $100 per month onto her mortgage principal. She has decided to exclude the principal portion of her mortgage payment and she has no other outstanding debts.
$500 savings account + $1,925 401(k) contribution + $417 employer 401(k) contribution + $100 Roth contribution +$100 extra principal payment = $3,042 Total Monthly Savings.
Calculating Income
Calculating our income does two main things for us. First, it allows us to figure out our total spending. Second, it gives us the last piece we need to finish calculating our savings rate.
Our spending, in the simplest terms, is the difference between our income and our savings, right?
Income – Savings = Spending
We don’t need to know how much we are spending to calculate our savings rate. But, how much we spend is important because with this we can calculate how much we will need in investments to retire. The generally accepted formula is 25 times annual spending equals the amount needed to retire (assuming a 4% withdrawal rate, refer to the Trinity Study for specifics).
For example, annual expenses of $40,000 x 25 = $1,000,000 needed in investments to retire.
Now, when we talk about income we generally think pre-tax (gross) or post-tax (net). Depending which of these you choose will have a large impact on your perceived savings rate.
This again will be personal preference, but I generally advocate for using net income. Your savings rate will be higher using this method because you take taxes out of the equation. Taxes are a sort of forced spending and you can’t control this, or save what you are paying in taxes. To me, this makes more sense because it allows you to achieve a savings rate of 100%. If you were to use gross income the highest possible savings rate you could achieve would be 100% minus taxes.
Remember, you may have to make some adjustments for your 401(k), if applicable. You will need to add your contributions back to your income as well as your employer match, if you are going to include that on the savings side.
After you decide between gross and net income you will need to take into consideration all other forms of you income you might have. This could be interest, dividends, side-hustles, etc.
We’ll refer back to Mary for another example.
We know that she nets $75,000 per year from her job ($6,250 per month),
Contributes $19,500 ($1,625 per month) to her 401(k) and receives a $5,000 ($417 per month) employer match.
She also earns $10 per month in interest
$100 per month from dividends.
$200 per month from side-hustles.
$6,250 monthly job income + $1,625 401(k) contribution + $417 employer 401(k) contribution + $10 interest + $100 dividends + $200 side hustles = $8,602 total monthly income.
Putting It All Together
We now have all the pieces needed to calculate Amy’s savings rate.
Mary’s Monthly Savings = $3,042
Mary’s Monthly Income = $8,602
Amy’s Savings Rate = $3,042 / $8,602 = 35.36%. A savings rate of 35% puts Amy at 25 years until retirement, assuming she has a zero dollar net worth.
I recommend calculating savings rate on a monthly basis. And at most, quarterly. Calculating your savings rate is one of those eye-opening things that can directly affect your actions going forward. If you are only calculating this annually and you then realize that you are way behind where you want to be, it is too late to make any changes for the year. If you calculate your savings rate monthly, you don’t risk wasting too much time not knowing where you stand. I find checking on this more frequently motivates me to not only maintain my current rate but also to try to find ways that I can improve as well.
What is your average savings rate?
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