“What’s your savings rate?” This seemingly simple question is actually more difficult to calculate than you might think. It’s also one of the most important determinants in you achieving your financial goals.
This article is for you if you are trying to:
- Calculate your current savings rate
- Set a target savings rate for yourself to strive towards
- Compete with your friends in an amazing reverse “keeping up with the Joneses” contest
We’ll cover 5 different methods of calculating your savings rate and walk through examples for each. You’ll be shocked at just how different the results are from each method. Then I’ll explain which method we use for our personal finances, and what our personal savings rate is.
Let’s get started!
To help bring this article to life, I’d like to introduce you to Sam, my hypothetical friend. Sam wants some help calculating his savings rate.
Sam earns $100,000/year and pays $20,000/year in taxes. So his gross income is $100,000, and his after-tax income is $80,000. He also saves the following:
- Saves $5,000/year into his Traditional 401(k)
- Saves $3,000/year into his Roth IRA
- Saves $2,000/year towards a vacation (which takes every year)
Initially, Sam tells me “I think my savings rate is 10%. I add up my savings into my 401(k), my Roth IRA and my vacation savings, which gives me $10,000. Then I divide that by my salary of $100,000. So $10,000/$100,000. That gives me 10%. Is that right?”
Sam’s math is, indeed correct. Using that calculation results in a savings rate of 10%. So let’s call method #1 the “Gross Income Method.” Now let’s look at 4 other methods.
Do you use gross or after-tax income?
In method #1, Sam used his gross income in his calculation. But that ignores the income taxes he pays, which is something Sam has little control over.
For that reason, many investors choose to use their after-tax income instead of their gross income when calculating their savings rate. This is a perfectly valid calculation. We’ll call method #2 the “After-Tax Income Method.”
Using Sam again as an example, his savings amount stays the same at $10,000/year. But his income is reduced from $100,000 down to $80,000. This boosts his savings rate from 10% up to 12.5%, even though the amount he saves remained unchanged.
Do you count debt payoff?
The first 2 methods we looked at explored how the number you use for income affects your savings rate. Now let’s see if debt can also affect your savings rate.
In addition to the savings we listed above, Sam also has a mortgage on his home. This year, he paid a total of $12,000 to his mortgage.
- $6,000 was considered principal, which reduced Sam’s total debt.
- $6,000 was considered interest, which did not reduce Sam’s total debt.
Interest Sam paid does not reduce his mortgage, so that is definitely not savings. But since the principal portion of Sam’s mortgage does reduce his mortgage balance, and thus increases Sam’s net worth, many investors would consider that part of his overall savings.
If we include his principal paydown, Sam’s annual savings increases from $10,000 up to $16,000. This boosts his savings rate again, all the way up to 20%! We’ll call method #3 the “Include Principal Paydown Method.”
Do you include short-term savings goals?
So both income and debt can affect your savings rate. Can the goals you are savings towards also affect your savings rate?
Yes, they can. Sam saves $2,000 each year to fund his annual vacation. He saves this money in a separate account, earmarked for exactly this purpose. That sounds like savings to me.
The trouble is, that each year, this account gets depleted, so this doesn’t really increase Sam’s net worth over time.
The problem lies in your definition of “savings.” Many investors ignore short-term/recurring goals like vacations from their savings rates, since they don’t actually help you build wealth over time.
If we follow that logic, than Sam’s savings decreases from its previous $16,000 down to $14,000. This reduces his savings rate from 20% down to 17.5%. We’ll call method #4 the “Exclude Short-Term Goals Method.”
Do you account for future taxes?
Income, debt and short-term goals can all affect savings rate. But there’s one thing we haven’t looked at yet. Future taxes.
When you save money into pre-tax retirement accounts like a Traditional IRA, Traditional 401(k), or Traditional TSP, that money will be taxed as income when you withdraw it later, during retirement. That means that not all of your savings is really yours, since some of it will go to the IRS.
This is why some investors reduce their savings to account for estimated future taxes. How exactly you choose to do that is up to you. For our example, I’ll assume that Sam’s future tax rate will be the same as his current tax rate of 20% ($20,000 in taxes from $100,000 of income).
That means that Sam will lose 20% of his Traditional 401(k) savings of $5,000/year. Said another way, his net 401(k) savings is really only $4,000 instead of full $5,000 he is contributing. That drops his savings rate from 17.5% down to 16.25%.
Note that we did not reduce Sam’s Roth IRA savings, since withdrawals from Roth accounts are generally tax-free. We’ll call method #5 the “Adjust for Future Taxes Method.”
Wrapping It All Up
So which method is correct? As you can see, savings rates from these 5 calculations varies from 10% all the way up to 20%. That’s a 2x difference! Clearly, some of these must be wrong.
Technically, they are all correct… mathematically speaking. There are no errors in any of these calculations. It’s really a matter of personal preference, and how detailed you want to be. The big takeaway is that when you are comparing savings rates to someone else, be aware that you may be comparing apples to oranges.
Personally, I use method #5, which is the most detailed. But that is too much work for some people, and that’s okay! Pick a method, stick with it, and try to increase that number over time. In the end, that’s what matters most.
Currently, our savings rate, using method #5, is 54%. But we didn’t’ start out that high. In fact, it’s taken a while to reach that.
So tell me, which method do you use? And what is your savings rate?