Ah, savings rates. The pissing contest of the frugal.
People in the financial independence / early retirement community love to compare their numbers and accusations are flung about once people post ridiculously high numbers.
Here’s the issue: I’m not sure people are comparing apples to oranges. Some people use net income, some use gross. In the net income camp, some use “after-tax” income, while others use “take-home”. In some cases people confuse the two, using take home pay but then add their pre-tax savings (like a 401k) to only the savings side of the equation. This can lead to some pretty drastically different numbers. And the latter can lead to rates that are effectively unattainable by a normal human being.
Let’s step through some examples to see what savings rates we end up with using the same income / savings as our base.
Bob makes $50,000 a year pre-tax. He has a 401k, saves some after taxes in an online savings account, has a mortgage, and has some health/dental pre-tax costs.
This gives us:
- $50,000 gross income
- $40,000 income “after-tax”
- $15,000 401k contributions
- $ 1,000 savings
- $ 3,000 health/dental care, pre-tax
- $ 1,000/month mortgage, with $100/month going towards principal, $500/mo towards interest
Savings Rate based on Gross Income
We add up the 401k contributions and savings to get a total of $16,000 savings. Then we just divide by our gross income of $50,000 and we get a savings rate of 32%.
Savings Rate based on “After Tax” Income
We take our $16,000 savings and divide by the income after taxes, which is $40,000 in this hypothetical. This gives us 40%.
Savings Rate based on “Take Home” Income, Take 1
Now we’re excluding healthcare and other pre-tax costs and savings from the income side of the equation. So the figure we’ll use as the income portion of our math will be $40,000 – $3,0000 – $15,000 = $22,000. So $16,000 / $22,000 = 73% savings rate!
The problem here is that we’re subtracting the 401k from our income, but keeping it in the savings total.
Savings Rate based on “Take Home” Income, Take 2
Let’s fix this discrepancy and take our after tax income, subtract pre-tax costs, but add the pre-tax 401k contribution to both the savings and the income. That means we’ll do $16,000 / $37,000 = 43%
In general, the argument for using take home pay for the equation is that taxes after an expense you can’t really control or pare down; and one that will go down very low once you retire. I’d say “after tax” is a better indicator (than “take home”) to reflect that since you’ll still be having healthcare costs in retirement.
I’d also argue that there are more wrinkles here. Remember, Bob has a mortgage. A good case can be made that any amount of his mortgage that goes to principal should be counted as “savings”, since he is gaining equity in the home equivalent to that.
Savings Rate based on “After Tax” Income, Taking Mortgage Principal Into Account
We take our $16,000 savings from before, add $1,200 in principal payments/equity and divide by the income after taxes, which is $40,000 in this hypothetical. This gives us $17,200 / $40,000 = 43%.
Of course, this is just a simple comparison of some of the various ways I’ve seen people compute their savings rates. It would help if people not only gave their numbers but would tell us which of the above calculations they used (or explained their own system). After all, for this same individual we’ve gotten values of 32%, 40%, 73%, and 43%. That’s one heck of a spread!
There are plenty more wrinkles out there (what about interest payments on mortgages? Once the house is paid off and you’re retired, that’ll go away too…). I’d be interested to hear what calculations people use when they figure out their own savings rate, and any other adjustments that could be made.