Hi Pocket Changers! I’ve mentioned this thing called a “Savings Rate” several times in the past few posts, but have added a caveat that it’s worth a post on its own. That time has come! In the Budgeting Outside the Box post, I summarized the savings rate as the total amount you’re saving divided by your total income. Doesn’t sound too complicated right? Well, that ultimately depends on you, your FI journey, and how detailed you’d like to be. From gathering information and cherry-picking what works best for us, this is how we’re going to move forward with the savings rate definition, and what we’ll base our calculations on.
The Purpose of the Savings Rate
Before we embark on the math used in figuring out the savings rate, it’s a good idea to understand what it is and why it’s important, right? I vote yes, so let’s go!
What is a Savings Rate? A rate that reflects the savings over a period of time (usually annually but can be monthly) divided by the amount of income in the same term.
Why calculate the savings rate? Calculating the savings rate provides a baseline reading or a litmus test of placement on the financial independence scale of 1-100. For example, if someone can sustain a 100% savings rate (i.e. they are saving everything they earn) they don’t need to work. The closer to 100% someone is, the sooner they will reach financial independence. For most, it’s a marathon, not a sprint. It’s going to take time.
How much time will it take? Great last and final question! Most folks in the FI world have seen the “When Can I Retire Calculator” and I find it works great, so head over there and plug in your information to get your savings rate. Based on our calculation of 33% savings rate, we’re going to retire in a little over 25 years! Seems like a long time, but that puts us around age 55 instead of the conventional age of 65!
Calculating the Savings Rate
For those that want to see a breakdown of the equation, simplified it reads as follows:
Yes, back to Algebra for a moment! For starters, let’s look at our annual income, and savings, and put meat on those bones.
Income (Y): Combined income for wife and I sits roughly around $45,000 annually after taxes (taxes are a whole new world of FI — we’ll get to that later!).
Savings (X): Currently calculated out to a year, we’re theoretically saving $15,000 annually, including 401k contributions, Roth IRA contributions, and savings account deposits. This number is based on what we’ve been saving so far this year, and plan to save or increase going forward. This number is one of the main contributors to how long it will take us to reach financial independence. It’s also the number that comes under most scrutiny… should you calculate using gross or net income with gross or net savings? For our example, we’re calculating net income (income after taxes) and gross savings (savings including pre-tax contributions).
Savings Rate (Z): To determine the Savings Rate, take the savings account amount ($15,000 above) and divide it by the income ($45,000 above).
15000 / 45000 = 0.33 or 33% (repeating of course)
Our Savings Rate
|Current Savings Rate||33.33%|
|Current Annual Income||$45,000|
|Current Annual Savings||$15,000|
|Current Annual Expenses||$30,000|
NOTE: Regarding expenses, in theory, the difference between income and savings should be expenses. If you used the calculator linked above, this is automatically calculated so I’ve left it out of our equation.
What’s the Next Step?
Now that you have your Savings Rate, it’s time to take the next steps in your financial independence journey. Let’s review where we’ve come from so we know where we’re headed:
- Decided to pursue the journey of financial independence
- Taken a financial inventory to understand what’s currently at our disposal, and how we can leverage it
- Reviewed budgeting for this journey, and understand that it’ll look different than conventional wisdom says it should because our goals are different
The next step is to take action, and this looks slightly different for each and every person. We have listened (and continue to) to many podcasts on these topics and read a lot of blog posts. But, it’s not going to get you very far if you only have the knowledge but no action!
Your income, expenses, savings, and life goals are different than ours but the end goal (if you are following along) remains the same — figure out ways to leverage your income and reduce expenses to boost your savings rate to reach financial independence. More on how to leverage later.
Let’s face it, you and I both know that having things doesn’t give us infinite happiness or fulfillment. Money isn’t the root of happiness or joy, nor are possessions. However, unlike possessions, money will give us some level of freedom to participate in various activities like spending more time with our loved ones or serving others – and that does bring happiness and joy to ourselves and to others.
Put in the hard work up front to save and invest money and instead of waiting until 65 to retire, and it’s possible to become financially independent at a much earlier stage in life. This then will give us the freedom to enjoy traveling, family and friends, service and community outreach opportunities, and more. In the next post, we’ll discuss some action items we’ve put into place, and ways we can continue moving towards Financial Independence.