Are you are one of the 38% to 76% of Americans living paycheck to paycheck? How long will it be until you are able to stop working? Are you planning on working into your golden years (I wouldn’t count on it)? Even if your plan is to win the lottery or somehow become suddenly rich, 70% of people with sudden wealth are typically broke within a few years.
What people don’t understand is that after a certain level it isn’t important how much you make. What is important is how much you spend of what you make. A savings rate of 0% (or even negative if you are in debt) means you will always have to work for a living. Somehow people don’t get how to implement this simple concept.
This isn’t a groundbreaking idea. It has been covered over and over in a lot of different ways. It is simple, but that is the point. People confuse the simplicity of an idea with the simplicity of the implementation of the idea. It is easy to look down on an idea when it is simple. Most everyone “knows” that you should save more for the future, just like everyone “knows” that you should eat less sugar in your diet. Just because they say they know doesn’t mean that they can actually follow a diet or budget. This is because a simple diet or a simple budget is not simple to follow. Consistent action over time is required.
To most people that means using their willpower; I suggest that you don’t depend on willpower but instead automate as much of your budget as possible. Most financial transactions now are recorded electronically. Unlike a diet where you manually have to track what you eat, with a little upfront effort you can start tracking your savings rate. Use technology to your advantage. Pick an online financial program like Mint.com or PersonalCapital.com. Start tracking your income and your expenses. Do it today! Do it right now! The rest of this article will wait.
Savings rate is is the percentage of the money you make (after taxes) compared to what you save. Since you are now tracking your income and expenses calculating your savings rate is straightforward.
Savings rate = (Net Income – Expenses)/Net Income
This is how much you save of every dollar that you earn after taxes.
If you plan on retiring early or achieving some level of financial independence, increasing your savings rate is one of the most important things that you can do. If you make more money but don’t spend more money you are increasing your savings rate. If you spend less money but you income doesn’t change you are increasing your savings rate.
Suck at investing? A high savings rate can help you. The chart below shows this really well. The higher your savings rate, the less dependence you have on return on investment (ROI). To read this chart, you find your savings rate by percentage along the bottom of the chart and then trace the line up vertically until you hit the your expected return on investment percentage. The spread is based on the different in return on investment from 1% to 20%. If you save 20% of your income, depending on your ROI you could either have to work 70 years at 1% to less than 20 years at 20%; the difference at 50% is somewhere over 20 years down to 10 years.
At 20% savings rate the difference in years until retirement for a lucky investor and an unlucky investor is measured in decades; at 50% the difference is much less, measured in years.
How to record where your money goes
I used to feel like I spent all the money that I made. I would look at my bank account and watch as it would slowly decrease until the next time I got paid. To me this was frustrating. I wanted to save money for the future but when I tried to account for where the money went I was left feeling like I hadn’t made any progress. Also, I tried to capture monthly expenses, but since I got paid every two weeks it always felt like I couldn’t account for the differences.
Here was the way I was looking at it:
Income – Expenses = Savings
I wanted the system that I was using to be as simple as possible, so I was looking at my bank statements to do the calculation above. Every two weeks I was paid and the after tax net was automatically deposited in my checking account. This was the amount that I recorded as Income. For the Expenses, everything that went out of the checking account was counted as an expense. By the end of the second week right before the next paycheck the account would be running low and I wouldn’t have anything left over to save.
In the last few years I have discovered that I was looking at it all wrong. I had the correct formula for keeping track of my savings but I wasn’t including all the different sources of income that I had.
The equation stays the same:
Income – Expenses = Savings
The variables are what changes. Income needs to include everything that is counted as income, not just after tax net income. If you have a 401k or other retirement account at work, it needs to be included in income. The amount that you contribute to both pretax and post-tax retirement are included on your pay stub. If your employer provides a matching contribution that amount will be on the pay stub as well.
So now:
Income = Net after tax income + retirement account contributions + retirement account match
If you get paid every two weeks, then you will have two months of the year with an extra paycheck and these two paychecks will have additional retirement account contributions.
The other mistake that I was making was that each dollar coming in and dollar going out were tracked the same way. Not all debits are created equal.
I had setup several automatic transfers to different accounts, one to an investment account and one to a low expense ratio investment account. Since these were going out of my account, my old system of accounting listed these as expenses not investments. I knew they were investments but I didn’t know of a simple way to track them when I was looking at my account at the end of the month.
Also, I was gaining equity in my home as part of my monthly mortgage payment but I was counting all of the mortgage payment as an expense. To really keep track of the expenses, the amount that is invested is not included in expenses.
Doing it this way may sound really obvious, but often you are rushed for time and you just take a quick look at your checking account to see how well you are doing financially. It can be easy to get frustrated when you see how quickly the money goes out and how slowly it comes in.
So now:
Expenses = Expense – mortgage principal (include interest, tax, insurance on mortgage) – investments that are paid out of the checking account.
How to calculate saving %
Once you know your income and expenses calculating savings percentage is incredibly simple. The equation is:
Savings percentage = (Income – Expenses)/Income x 100
It makes most sense to calculate your savings percentage periodically at fixed intervals. I only calculate savings percentage monthly and yearly.
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