You know what I love about personal finance? That it is actually PERSONAL. While there are core concepts that are universal, you have the ability to fine tune and tweak certain things to fit your particular financial situation. For instance, some people use budgets for managing their finances. While I did use a budget when I started my financial journey, I’ve come to a point where I don’t need one anymore. In much the same way, I don’t monitor my savings rate per se. Instead, I keep track of an investing rate. In order to define what this is, we first need to discuss the difference between investing and saving.
Saving versus Investing
In personal finance, people often use the terms saving and investing interchangeably. But in reality they mean different things. I think of saving as putting aside money for short-term goals. Examples of these include building up an emergency fund or saving for a future expense (i.e. car, vacation). I would consider anything under five years to be a short-term goal.
I think investing, on the other hand, is setting aside money for long-term goals. Examples would be funding your retirement or paying for your child’s college education. I consider long-term goals as having time frames of 10 years or more.
Although the distinction might seem like nitpicking, I think it is an important one to keep in mind. The time-frame of your goal can help determine how much risk you can take with your money. And how much risk you can take will dictate which financial vehicles you would use for your money. For instance, you would want to use low-risk options such as savings accounts, money market accounts, or CD’s for your short term goals. The point isn’t rate of return and growth of capital but rather preservation of it. With long-term goals, however, you can afford to take a little bit more risk. Investment vehicles such as stocks, mutual funds, and index funds offer the potential for higher returns and growth of capital through the power of time and compounding. Also, the longer time horizon gives you a chance to recoup any losses incurred along the way.
In its simplest form, your savings rate is the ratio of the money you did not spend over how much you made. Much like calculating your net worth, there can be a number of ways to figure out savings rate. For this article, I’ll use calculations based on after-tax earnings with pre-tax savings factored in. Let’s consider Mr. John Doe as an example. He has an after-tax take home pay of $3,000 a month. He is able to contribute $500 a month pre-tax to his company’s 401k. His monthly budget, which we’ll assume is consistent every month, looks like this:
As you can see, he is able to save $500 a month after taxes. Here’s how I would calculate his savings rate:
- Add up all savings. $500 (pre-tax) + $500 (after-tax) = $1,000
- Add back the $500 of pre-tax savings to the take home pay. $3,000 + $500 = $3,500 of after-tax earnings
- Savings rate = total savings ÷ after-tax earnings = $1,000 ÷ $3,500 = 0.29 or 29%
A 29% savings rate is pretty good, especially since the average savings rate in the U.S. was 5.5% as of January 2017. But if you look closely at Mr. Doe’s saving’s you’ll see that some of it is earmarked for future purchases. While this money will help him accomplish his short-term goals, they do nothing for his long-term ones.
Calculating the Investing Rate
Another way to look at things would be to calculate how much he is investing. To do this, we could categorize Mr. Doe’s savings as follows:
As you can see, only 40% ($200) of his after-tax savings is going toward long-term goals. To calculate Mr. Doe’s investing rate we would count money that he is “investing” and exclude anything that he is “saving.”
- Add up all investments. $500 in 401k + $200 in Roth IRA = $700
- Keep after-tax earnings the same. $3,500
- Investing rate = total investments ÷ after-tax earnings = $700 ÷ $3,500 = 0.2 or 20%
That’s still pretty good compared with the national savings rate, but it’s almost a third less than his original personal savings rate. Imagine if Mr. Doe diverts his $200 into savings instead of Roth IRA investments. While his savings rate would remain unchanged at 29%, his new investing rate would be a much lower 14% ($500/$3,500).
Tracking My Investing Rate Works for Me
My finances are a bit tricky. Tricky in that I have to set aside money for quarterly estimated taxes as well as annual taxes. If I were to calculate my savings rate in the traditional sense, should I include this money as part of that calculation? Should I count it as taxes withheld and consider the remaining money as after-tax take home pay? Or should I wait until I file my tax return and back-calculate a savings rate based on that information? Too many questions and scenarios for my little brain to process. So I just take whatever I invest and divide that by how much I get paid. Using this method, my investing rate for 2016 was 26%. Not terrible, but there’s definitely some room for improvement. We’ll see how things go in 2017…
Go With What Works Best for You
In the end, you should stick with what works for you. If tracking your savings rate in a more traditional sense (i.e. money unspent versus money earned) fits with your financial situation and goals, then go for it! The point is that you’re spending less than you make. Personally, I keep an eye on my investing rate instead. It gives me a more accurate assessment of how I’m doing when it comes to my long-term goals, specifically investing for retirement.
Readers, do you keep track of your savings rate or investing rate? Are they the same thing? Am I getting too caught up on semantics? Share below!
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