Savings Rate is the most important factor to determine how long it’ll take you to reach financial independence. The higher your savings rate, the faster your path to Financial Independence. Find out everything you need to know about savings rates and how to calculate your personal savings rate.
What Is Your Savings Rate?
Your savings rate tells you what percentage of your income you’re saving.
Let’s start with your actual savings: Take your total income and subtract your expenses. What you have left is your savings.
Now very simply take that savings figure and divide it by your income, which gives you a percentage and that percentage is your savings rate.
At a high level, it really is that easy!
Sure there’s always nuance, which we’ll discuss later, but if you just want a back of the napkin answer to your savings rate, now you have it.
Savings Rate in the U.S.
Savings rates in the U.S. vary over time. During 2020, savings rates shot up to 16% – the highest on record over the last 50 years. In December 2022, the personal saving rate in the United States amounted to 3.4 percent, down from 7.5 percent in December 2021.
Why is Calculating Your Savings Rate Important?
In the Financial Independence community, we emphasize the importance of your personal savings rate because your savings rate is the determining factor for how quickly you’ll reach Financial Independence.
The basic idea is that the more of your income that you can save, the sooner you’ll be able to retire.
How Does Savings Rate Affect Financial Independence Timeline?
Let’s see a few examples.
If you are living paycheck to paycheck (0% savings rate) you can never retire. You need your paycheck just to make it to the next paycheck. As depressing as that sounds, it’s amazing how easy it is to ignore that mathematical reality. If you have no savings, you can’t retire.
A 1% savings rate would mean that every 99 years we work we could afford to take a year off. That’s a marginal improvement over a paycheck-to-paycheck lifestyle, but most of us won’t be able to live long enough to see that turn into financial independence
A more traditional 10% savings rate means that every 9 years you are able to replace a year of expenses. But while this is a societal norm and might be good enough if your goal is to retire in your late 60s or seventies, the magic happens as you start to dramatically increase your savings rate to 30%-50%.
A 50% savings rate means that, even without investing the money, every year you work you could afford to replace another year of expenses.
Most importantly, the magic happens when you start investing that money. If you invest those savings in low cost index funds, something powerful happens.
The power of compounding.
The mathematical result is that there’s a high likelihood you are at the point where working is optional in 15-20 years (depending on market conditions of course).
Your invested money has become another income earner in your home and it works harder than you do 24/7, 365 days a year.
Your Savings Rate is the single best predictor of your financial trajectory and your timeline to reaching financial independence
How Your Savings Rate Can Predict Financial Independence
If we were to take all the fancy math and map it out on napkins we could quickly chart out the impact of savings rate on how many years we would need to work to be able to replace our income.
Napkin Math Assumptions
Assuming you’re starting out with a net worth of zero, you make 5% in inflation-adjusted returns and are planning on living off a 4% safe withdrawal rate in retirement.
Our napkin math was inspired by a post that Mr Money Mustache wrote way back in 2012 (still worth reading)
Based on these assumptions, a savings rate of 5% will result in 66 years until you have enough money to reach FI. On the other hand, a 25% savings rate shrinks that time to 32 years. A 50% savings rate shortens the time to 17 years. And a 75% savings rate slashes your time until FI to just seven years.
We focus on the 30%-50% savings rate because this is very practical for those seeking Financial Independence after some intentionality has been applied to both lowering your expenses and increasing your income.
This results in a 17-28 year working career, which will enable you to ‘retire’ decades earlier than your friends & colleagues.
How Much Should I Save Each Month
It’s easy to fall into the trap of asking how much should I save each month and looking for a number like $500 a month, but this is misleading and inaccurate because any answer is dependent on your goals and how much your life costs.
If you bring home $100,000 a year and you are able to save $2,000 a year we can infer that you spend the remaining $98,000. In this case, the $2,000 isn’t really making a dent in your goals over a short to intermediate timeline and you most likely will not be able to retire comfortably with a meager 2% savings rate.
If we plan on working till we die (which is an actual retirement strategy- not advised) then those numbers may work out since you are technically saving. But this isn’t a strategy to really win.
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Most traditional personal finance ‘experts’ recommend saving between 10 % to 20%. These conservative savings rates will work if you are planning on working for 40-50 years. The problem is that most people never question that assumption. What if you want to unlock Financial Independence in 10-20 years?
Is that even possible?
Of course, it is – refer to the napkin 🙂
Our Financial Independence Timeline is directly tied to our savings rate.
With 20% Savings, you will reach FI in an impressive (by societal standards) 37 years but you don’t have to stop there. If you can reach a 50% savings rate you’ll knock 20 years off that timeline and reach Financial Independence in just 17 years.
Imagine the possibility of being at the point where working is completely optional in a mere 17 years!
The beautiful part of this math is it doesn’t matter when you start. This isn’t just for perfect people finding this concept in their early 20s. Even if you’re starting from $0 of savings now, if you can get to a 50% savings rate, you are 17 years from Financial Independence.
That should bring great joy and liberation to everyone. It doesn’t matter when or where you’re starting from — it only matters what you’re going to do from here!
But how do we define Income and Savings? Keep reading…
How to Calculate Your Savings Rate
As we mentioned above, calculating your savings rate is at its essence really a simple exercise:
Savings/Income = Savings Rate
Easy, right? Well, how do you define income? Is it gross income? Take Home Pay, Net income after taxes? If it’s net income, how do you calculate your net income? What counts as “savings”? Does your employer match your 401k count? What if it’s pre or post-tax savings? Do you include your mortgage principal payment in your savings rate?
The 3 Most Common Savings Rate Calculations and Which One Is Best
Let’s explore different ways you can calculate your income and ways you can calculate your savings. Pick the methodology you’re most comfortable with or create your own to measure your personal savings rate.
Case Study to Show How These Calculations Will Give You Different Results
Method 1: Total Savings divided by Gross Income
Method 1 is based on Gross Income and will consistently return the lowest or most conservative savings rate. But since you are likely in your highest tax rate while you are working you could make the case that it is resulting in an artificially low savings rate.
Method 2: Total Savings divided by Take Home Pay
Method 2 will always produce the highest possible savings rate but it is a flawed calculation and is easy to break especially for those individuals with creative income situations that are putting a large percentage of their income into pretax accounts. When someone reports a 70-90% savings rate this is probably the flawed logic that was used. any savings used in the numerator should be included in the denominator which brings us to method 3.
Method 3: Total Savings Divided by Income Net of Taxes
This is still an easy calculation and is the 95% sweet spot for the vast majority of people. When building Your own personal savings rate the best practice would be to start with this method and then build in additional complexity as needed or desired.
Method 4: Weighting Pretax Savings vs After-Tax Savings
After-tax investments are more valuable on a dollar-to-dollar basis because the taxes due have already been paid. To calibrate the difference you could take the calculation from method 3 and give your pretax savings a tax haircut based on what your expected tax rate will be in retirement (15% ?). This would make the relative value of your pretax savings more in line with your after-tax savings. But there is a point of diminishing returns and this adjustment probably isn’t worth it in most scenarios
Selecting a Method for Calculating Savings Rate
Now that we have had a chance to discuss different ways to calculate savings rate you have seen how dramatically it can change your results.
In the scenario above it produced a variance of nearly 20% (wow!).
Savings Rate Calculator
Most of you are going to want to use method 3 and here is a Savings Rate Calculator that will give you your Simplified Savings Rate using Method 3 (Income – Net of Taxes)
Savings Rate Calculator
now we will explore the income and savings variables to consider on the way to calculating your personal savings rate.
How To Define Income
How you define your income is important when calculating your savings rate.
How do you calculate income? If you have no side income, real estate investments, business income, etc. then this gross income is likely just your W-2 salary. You can adjust to net income by deducting the taxes you pay from your gross income.
Let’s say hypothetically you make a $100,000 salary and you pay $15,000 in taxes of all types. Your net income in this case would be $85,000 and would be the denominator you use in the Savings/Income = Saving Rate calculation.
You could make it easy on yourself and say your net income is the amount you’re paid each pay period. Then just multiply by the number of pay periods in the year and you arrive at your annual net income.
If you take this easy approach then don’t forget to factor in any retirement contributions that came out of your paycheck as well as employer contributions. Adjustments to your net income should be made if you get a large tax refund or if you owe a meaningful amount
If you do have other sources of income outside of your W-2 income, you want to add them to this total figure. Some examples include:
- Real Estate Income
- Business or side hustle income
- Investment Income from various sources
Once you have this figure calculated, you’re halfway there to figuring out your Personal savings rate!
How to Define Savings
Defining savings isn’t an exact science either.
The absolute simplest method is to add up all the money you invest each year and then call it a day and say that’s your annual “savings.”
But of course, there are more complex alternatives that give you a better sense of your true savings if you want to go to that level of detail.
First, add up all the money you contributed to an investment account this year. This includes savings accounts, taxable investment accounts, tax-advantaged accounts, health savings accounts, and retirement accounts like 401(k)s, IRAs, and their Roth counterparts.
So basically anything you specifically saved and invested this year.
Next, you may decide to add in any employer match or employer contributions you receive for retirement accounts or health savings accounts since these amounts clearly are “savings” by any definition. If you do this, be sure to add the same amount to your income figure to level out the effect it could have.
A simple example: let’s say you are a couple and have a household income of $100,000. As a couple, you save $20500 into your 401(k)s. and $9500 into your after-tax investments You’d be saving 30% of your income. If your employer is contributing $5,000 per year to your 401(k) and you count that in your savings rate, you are now saving 35% of your income.
If you also add the $5,000 of your employer contribution to your income (denominator), now your savings rate is 34%, which is the most accurate.
There is some nuance in calculating your savings rate when you consider whether some retirement contributions are pre-tax (traditional IRA, 401k, HSA, etc.) or post-tax (Roth IRA and Roth 401k) as this would technically be a different answer. But at that point, you get into complexity that most likely causes more problems than it is worth in the nuance.
How Does Mortgage Principle Payments Affect Savings Rate?
You may even want to consider adding in the portion of your mortgage payment that goes toward the principal each month. You are growing your net worth when you make your mortgage payment each month in the amount of the mortgage principal you paid and this could technically be considered savings since it is increasing your net worth.
Similarly, if you are making debt repayments of any type, you may want to consider adding your principal repayments into your savings amount like you did for your mortgage principal payments.
How Does Checking & Savings Account Balance Affect Savings Rate?
Finally, even though we are talking about overt “investments” you should also consider an increase in your checking account from the beginning of the year to the end of the year if it’s significant.
For instance, if you had $3,000 in your main checking account on January 1st and somehow had $12,000 in the account on December 31st, even though you haven’t formally moved that extra $9,000 into an investment vehicle yet, it clearly is savings.
If this difference is small, it probably isn’t worth getting into that level of detail, but hopefully, this thought process helps you think through ways to more accurately reflect your savings amount.
Take Action: Calculate Your Savings Rate
How you precisely decide to calculate your savings rate is ultimately up to you.
There is no exact right answer as everyone calculates it slightly differently, but the important point is that you take action.
As long as you’re consistent year after year with your savings rate calculation then you can get a sense of your personal trend, which is really what’s critical.
Personal Savings Rate Worksheet
Once you have your savings rate you can refer back to the Napkin Math above to get a sense of roughly how many years it’ll take you to reach Financial Independence.
Of course, if you want to more accurately predict how soon you’ll reach FI, you’ll have to add some nuance based on your situation.
For instance, very few people start their FI journey with a net worth of $0 and very few people go from a 0% savings rate to a 50% savings rate overnight.
Your situation undoubtedly is more nuanced as you might be starting out with some debt or negative net worth, or you may already have built up a nest egg of some level.
You’ve taken an important step here to calculate your savings rate and with it to have a sense of how many years it’ll take you, based on your current trajectory, to reach FI.
Congrats on taking action!
Savings Rate Podcast Episode
Brad and Jonathan continue along their, “Financial Independence A to Z,” journey by examining savings rates and the many different ways it can be calculated! One of the pillars that set the FI community apart is the emphasis on saving money in order to unlock more in your life. So, by having the right tools needed to calculate your savings rate, you can begin to make adjustments and hopefully start the process of taking back your time!
0:59 – Introductions
4:30 – Ben’s Question
7:41 – How Do You Calculate Your Savings Rate?
12:00 – Why Savings Rate Is Important
18:25 – Nuances In Saving
21:55 – Calculation Example
28:15 – Scenario Three
37:57 – Looking At The Nuances
46:56 – Conclusion