One of the financial numbers I’ve come to value a lot lately is ** savings rate**; in fact, savings rate was at the center of my recent post on the “spectrum” of personal finance.

Let’s step back a bit and look at what exactly a savings rate is, and why it’s so important. Let’s start with a good definition, like this one from Investopedia:

A savings rate is the amount of money, expressed as a percentage or ratio, that a person deducts from his disposable personal income to set aside as a nest egg or for retirement.

In other words, your savings rate is the amount of money you’re saving each year for very long term goals for yourself (usually retirement) divided by your total *disposable* income for the year.

The first thing to notice is that **savings rate really only cares about long term savings.** It doesn’t care about short term savings that you’re likely going to spend in the next several years, like your emergency fund or your cash savings for a car or a down payment on a house. Instead, it’s concerned with retirement savings and other long-term savings that you may be doing. Money that goes into your 401(k) counts, as does money that goes into your Roth IRA. Taxable investments count if the purpose is very long term.

The other part is a bit tricky. This definition points to **a person’s disposable personal income as the baseline**, but what defines disposable income? Many people think of disposable income as being the money left over after you pay your bills, but what bills are fundamentally essential? For this calculation, the best answer is

*none of them, except for taxes.*Take your annual salary, subtract the amount of taxes you paid, and you’re left with your disposable income, at lest for the purposes of this calculation. I don’t include sales tax in this, only income and property taxes.

**That’s why I usually use our net income on our income taxes as a good number to use for savings rate.**

So, let’s say you make $60,000 a year and pay a total of $10,000 a year in state and federal income taxes and property taxes. Your baseline income for figuring your savings rate is $60,000 minus $10,000, or $50,000.

Now, let’s say, for example, that you socked away $5,000 in a Roth IRA and $5,000 into your 401(k). Your total long term savings is $5,000 plus $5,000, or $10,000.

To figure out your savings rate, you take your total long term savings, divide it by your total disposable income, and multiply it by 100 to convert it to a percentage. So, in this case, it’s $10,000 divided by $50,000, giving 0.2, and multiplying that by 100 gives a 20% savings rate. Easy enough, right?

*What value does this rate really have, though?*

First of all, **it provides a nice financial benchmark to measure your financial progress with.** If you calculate your savings rate for last year and calculate your rate for this year, you can assess pretty easily whether you’re improving your financial decision making or, at the very least, keeping pace. It boils down your efforts toward retirement (or other very long term goals) to a single easy-to-understand number.

Second, **improving your savings rate becomes a nice goal that directly links to personal action.** A higher savings rate means a more comfortable retirement or a shorter road to retirement, so simply raising your savings rate can be a worthwhile financial goal. Let’s say your savings rate was only 5% last year. Striving to raise it to 15% or 10% or even just 6% will have a profound impact on your savings for retirement. Nothing more clearly indicates a stronger commitment to planning for your future than raising your savings rate.

Third, **a higher savings rate means a lower cost-of-living rate when you approach retirement.** Let’s back up to that previous example. In that example, the person in question had a disposable income of $50,000, but managed to save $10,000 of it, which is a 20% savings rate. That person is living happily on $40,000 a year.

What happens, though, if that person’s savings rate bumps up to 25% due to their effort? 25% of $50,000 is $12,500. $50,000 minus $12,500 equals $37,500.

What does that mean? It means that the person in question here is now living happily on only $37,500 a year instead of $40,000, while actually saving more. That means that the total amount needed to retire has gone *down* at the same time as that person’s annual savings rate has gone *up*.

If you need $40,000 to live on and you’re saving $10,000 a year in a typical 7% annual return retirement investment and you’re planning on a fairly safe 4% withdrawal rate, you’d need $1 million in the bank and have to save for 31 years to make it there. (This isn’t accounting for Social Security nor inflation, just a simple illustration.)

If you need $40,00 to live on and you’re saving $12,500 a year in that same account at that same withdrawal rate, you need only 28 years to make it. This is the benefit of saving more.

If you only need $37,500 to live on and you’re saving $12,500 a year in that same situation, you need only 26 years to make it. That’s the benefit of spending less.

**Bumping up your savings rate benefits in both ways – it’s about saving more, but it’s also about spending less.** If you bump up your savings rate, you absolutely *will* be in better shape for retirement.

**Calculating your own savings rate is easy.** Just pull out your taxes that you likely just filed and see what your adjusted gross income is. Then, take a look at any and all retirement and investment accounts you have and total up all of your contributions to those accounts that you made last year. Divide your total contributions by your income and multiply that result by 100 and you have your savings rate, expressed as a percentage. It’s just that simple!

Now, what can you do to raise that savings rate this year?

The easiest step is to just **nudge up your contributions to your retirement accounts.** If you have a 401(k) or a similar account (403(b) or TSP, for example) at work, bump up your contribution a little. If you don’t contribute, start doing so. Try to aim to contribute enough to get every single dime of matching funds from your employer (I count those as “contributions” for this calculation). If you don’t have a retirement plan at work, open a Roth IRA somewhere (I use Vanguard, for a number of reasons, but there are reasons to go elsewhere) and start automatically contributing a little each week or each month, straight out of your checking account.

If that seems like a financial impossibility, **consider making a few little lifestyle tweaks so that it’s not impossible.** After all, on a $50,000 salary, just contributing $40 a month is a 1% bump in your savings rate. Can you find a way to spend $40 less per month? I bet you can, using any of the tons of ways to save money I’ve shared over the years. One great one that will easily save $40 a month for most families is simply switching to store brands for most household supplies and staple foods (try switching for everything, then only switch back to the name brand if there’s a specific problem with that product).

So, the core of what you need to know is that savings rate refers to how much money you’re saving compared to how much after-tax money you’re making and that improving your savings rate makes retirement come faster and more robust. The actual steps for making that happen aren’t hard, either.

What about me? As alluded to in the earlier spectrum post, our family’s savings rate (everything we save for the long term future) usually clocks in at around 30%. If we were childless, that rate would quickly shoot above 50% and possibly even higher than that – it turns out that children are quite expensive!

Good luck to you on your financial journey, and may your savings rates be high!

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