The Best Way to Calculate Savings Rate

If you’ve spent any time in the Personal Finance blogosphere, you’ve no doubt seen many posts littered with discussions of savings rate. In it’s simplest form, savings rate is a way to measure what percentage of your earned income is staying in your pocket (or bank account, or brokerage).

Ever since I set out on my path to financial independence, I’ve tracked my savings rate as a method of measuring my progress. For those of us seeking FI, our savings rate can be a sacred number. It’s a clean, elegant percentage that says a lot about our goals, values, and grit.

The beauty of a percentage is that it fits people in different walks of life and stages of FI pursuit. High earners, extreme frugalists, and regular middle-class folks can use the same gauge of progress.

But what specifically about our savings rate is so important to our goals and quest for FI?

Why is My Savings Rate so Important?

The ultimate milestone for us FIRE seekers is to accumulate enough assets that will pay us in the form of passive income in perpetuity. The higher percentage we redirect to accumulation of assets to our chosen investment vehicles, the faster those assets take over and tell us, “we don’t need you any more.” At this point, traditional work becomes optional.

The reason savings rate equals time to FIRE is summed up in this immortal MMM post.

Here’s an example. Assume you start with zero net worth, and all of your invested assets return 6% annually. The following chart shows how much time it would take your assets to replace your income (your spending, actually).

Now there are various ways to calculate your savings rate. The variation revolves around gross vs. net pay, pre-tax vs. after-tax investments, company contributions, pensions, healthcare and debt. I will tackle the other variations and why I don’t prefer them in the Appendix.

How to Calculate Savings Rate

There are really only two things we want to capture in the savings rate:

1. How much money is being diverted to net worth improvement
2. How much money is being spent

It’s that simple. However, we want to make sure we are capturing everything when we calculate this number. Some people fail to include retirement savings in this calculation, which obviously is contributing toward reaching FI. Others include taxes and miscellaneous elements that just make this task more difficult.

Here’s the savings rate calculation that I’m recommending:

Let’s break down the components of this equation. The general rule of thumb is: if it is adding (or subtracting) from my net worth, I should include it.

Net Income (take-home pay): The only income that matters is the money that hits your pocket. This includes W2 income, side hustle money, or any other cash flows to your bank accounts. I would also include investment income, if it’s paid out to your account and not immediately reinvested.

Pre-tax Savings: deferrals to your 401k, 403b, 457 and HSA should always be included. Don’t forget employer contributions, as they are also increasing your net worth.

Spending: spending is every transaction that detracts from net worth. This would include the obvious- housing, transportation, food, and discretionary spending. When it comes to debt payments like student loans and the mortgage, it should include the interest payments, but it should not include the principal portion of the payment, since this is increasing your net worth (by decreasing debt).

Calculate Savings Rate with Personal Capital

If you use Personal Capital, you should be able to get a reasonably accurate savings rate calculation with minimal manipulation. If you don’t use Personal Capital, what planet are you from?

To Calculate savings rate using Personal Capital, follow these steps:

1. Log In. Under Banking, click on Cash Flow, and the appropriate time period you want to use. Write down this value.
2. Click on the Expense tab next to Cash Flow. Write down this value.
3. Calculate your pre-tax savings (or look at your W2).
4. Savings Rate = (Cash Flow + Savings – Expense) / (Cash Flow + Savings)

Make sure to back out any principal payments or other hidden savings from your expense category, to get a more accurate representation.

Appendix: Alternative Methods and Considerations

Gross vs. Net Pay: some prefer to use their gross pay, rather than net pay, as the income portion of their calculation. I don’t really see the logic in this, except that some people have their gross pay memorized (salary). Using gross pay would give a significantly lower savings rate, and a savings rate ceiling corresponding to your net pay (ie., you can never save more than your tax rate allows).

Pre-tax Investments and Employer Contributions: I don’t think people disagree that pre-tax investments should count toward savings rate. However, some ask whether employer match and contributions should be included. Why not? As long as it vests, it is additional money that adds to your net worth. Count it!

FICA (Payroll) Taxes: this one’s a little trickier. Technically, Social Security and Medicare contributions are deductions made with the expectation that you will receive a future benefit in retirement. However, you’re not filling a tangible bucket that you will draw directly from in the future. It’s more like a reverse Wimpy agreement. I wouldn’t count this in savings rate.

Healthcare: Most folks are paying for healthcare in one form or another during their working years. This includes premiums, copays, deductibles, and coinsurance. My preference is to ignore the pre-tax portion in your calculations, and count the post-tax portion in your spending. Why? Because life costs money, and there’s no way to avoid it. Since your healthcare deduction is not a voluntary contribution, and does not add to your net worth, it shouldn’t be subtracted from spending.

Deductions: Besides healthcare, other deductions may include transportation benefits, Flex Spending Accounts (FSA), and dependent care deferrals. I look at these as a ‘discount’ on your costs. However, they do not increase your net worth, just like that new BMW in your driveway.

Summary

Ultimately, your savings rate is personal. If we use savings rates primarily as a comparison tool, then we are just “keeping up with the Joneses” in another form. Albeit a better version, because it might push us to save more than we normally would.

The real reason to calculate savings rate is to get an understanding of how our money is being spent or saved. Then we can ask ourselves if this aligns with our values, and decide to make a change if it doesn’t.

Personally, tracking my savings rate pushes me to keep optimizing our finances in an effort to boost our numbers in any way possible. Improving our savings rate is one of my primary goals of 2019.

What about you? Do you find calculating savings rate useful? Do you agree with my method?