If you have begun to do your research about Financial Independence, one of the most common phrases talked about is savings rate. Your savings rate is essentially the amount of money you save as a percentage of your total take home pay. It is a benchmark that gives you a quick overview of how much you are saving and a directionally accurate picture of how much of your total take income you are living off of. We will dive into the concepts in this post, tell you why your savings rate matters, and how to calculate your savings rate.
We should preface that even though this concept is super common, there is some debate around what exactly should or should not be included when calculating your savings rate. For example, some people choose to include employer contributions while others don't. We try to take a simple approach that gives what we feel is the best picture for having a clear idea of how much you are saving. The reality is that everyone's
Before we get started, we defined a few key phrases that are required to know when doing this type of calculation. If you are a seasoned in the ways in Financial Independence, you can probably skip this section.
Savings Rate: The percentage of your total income that you save toward retirement every month.
Total Income: Total income is a somewhat fungible term, but is essentially the sum of all items that bring you income every month. This normally includes wages from a job, side hustles, or even income from real estate or other money-producing assets.
Pre Tax Contributions: Pre tax contributions are contributions to investment account off of your gross pay before any taxes have taken out. Normally, these type of contributions are limited because they are tax advantaged, meaning they save you money on taxes down the road.
Post Tax Contribution: Contributions to investment accounts after taxes have been taken out.
Employer Contribution: The money your employer contributes to any sort of retirement account, like a 401K.
Taxes: The amount of money that is taken out of your paycheck by the government.
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You might be wondering why a savings rate matters in your journey to financial freedom. The reason why there is so much focus on your savings rate is because a higher savings rate means you can become financially independent faster. Let's look at quick example:
To give you an idea of why increasing your savings rate can shave years off of your time to financial independence, lets take a look at a quick example. Our example person started off in a typical situation where they are saving around 22% per year of their savings (8% pre tax, 5% employer contribution, 10% after tax). At this rate, our fictional person has 35 years until they are financial independent, not to shabby.
If our fictional person doubles their pre-tax contributions, they will have a 28% savings rate and save 5 years of working.
Now, if our fictional person can get up to 40%, which we know is a huge jump they can save 13 years of working and be financially independent before the age of 50.
This is a very simple example of why your savings rate matters. It allows you to see how you are performing and align your savings rate with your goals for financial independence. Some people are able to save large amounts of their income while other may only be able to save less. No amount is wrong, just a guide for your timeline towards financial freedom.
Alright, after all that explanation you are probably ready just to calculate this thing. If you have all of the information ready to go, it is super easy to do. Here is the equation:
Savings / (Total Income - Taxes)
Let's step through this. The numerator is savings. Savings is how much you save towards retirement every month as a total dollar amount. This includes both types (pre-tax and post-tax) of investment contributions and any employer contributions. Total this number up and keep it for later. If we say a fictional person saves $500 pre tax, my employer matches $500, and they contribute another $500 after taxes my total savings would be $2,000.
Total income should be the sum of what you take in as income without accounting for taxes or anything. For example, if you make $50,000 a year and have a side business that makes $10,000 a year your total income is $60,000 a year or around $5,000 per month.
Taxes are something that everybody loves to hate. This number can be found on your pay stub. If you are self-employed or have side income, you should be able to use your average tax rate from the previous year or do an estimate of what you think you will pay in taxes per month this year. To continue with our example let's keep the numbers simple and say that on the $50,000 salary a year our person pays $12,500 in taxes and on the side income they pay another $3,000 in taxes for a total of $15,500 per year or $1,292 per month.
Now for the math
Using our numbers from above our example now looks like this:
$1,500 / ($5,000 - $1,292) = 40.45%
When you have the numbers, the math becomes pretty simple. You can change up some of the numbers to see how saving more or less affects your savings rate as well. If you would like a more detailed view, please be sure to check out our financial independence and early retirement calculator.