My Savings Rate

The savings rate is a topic of much angst and consternation in the financial independence community. I have intended for some time to share my savings rate and periodically track/update it on this site. So, let’s do that. I also have some thoughts on the most sensible way to handle some of the more controversial aspects of computing the savings rate.

I know many of my readers are more interested in investment related topics, but if you will indulge me, I wanted to get my savings rate up on the site as something I’m tracking for myself and for those who are following my (slow) progress in accumulating savings towards…FI?

My current savings rate is about 55%. This calculation includes 100% of my pretax savings and mortgage principal reduction. These two items are often discussed and debated in the circles of people who are interested in such things. If you are unfamiliar with the savings rate generally, you can check out this Mr. Money Mustache post .

While I intended to post about these subjects for some time, I want to tip the hat to a few bloggers who engaged in a Twitter exchange that helped me crystalize my thoughts and prompted me to get off my duff and write this post. Below, I have included three tweets in a long chain discussing aspects of the savings rate calculation.

For those of you interested in personal finance and financial independence topics, these three are good follows on twitter. They all also have blogs that I recommend you check out. As you can see if you read the entire thread, while they are debating a nuance of the way the savings rate is calculated, they each note that there is no wrong answer because it depends on what you are using the savings rate to evaluate/monitor. This conclusion was reached and defended in detail on the Early Retirement Now blog in this post.

For example, if you are using the savings rate computation to motivate/evaluate your efficiency in spending the discretionary funds available to you each month, after all of your tax and benefit deductions, you might ignore taxes and use the after tax savings divided by the net pay figure to keep a gauge on much you are spending on food and clothing and other discretionary spending.

If your purpose is to create some clickbait, you might include the pretax savings in the numerator and only include the net income (after taxes and other deductions) in the denominator. That will really jack up your percentage saved!

I’ve even seen one prominent blogger fail to net withdrawals for spending from one tax-advantaged account while including all the contributions going into another account. It doesn’t make a lot of sense from a critical evaluation perspective, but in this case it seemed like the author was using it to motivate himself and his readers to aggressively save into tax vehicles.

Why I Treat Taxes as Spending

So, how do I treat taxes? Well, I thought about just saying: “Taxes are probably the largest single line item in my annual expenditures (certainly top 3 every year). Taxes are definitely an expense and I treat them as such for purposes of my savings rate calculation.”

To elaborate, I really am using the savings rate as a metric for how efficient I am being with my available income overall (currently, not all that damned efficient, tbh). I think life is largely about opportunity costs. So the real reason I include taxes, is that I want to highlight the opportunity costs (including tax impacts) of various decisions via the savings rate.

For example, if I’m at 40% combined federal and state marginal tax bracket and weighing leasing or buying a new car versus maxing out another tax advantaged account, with $19,000 annually, I could save myself almost $8,000 a year in taxes. I want to see what that decision would do to my savings rate when I’m making the call. I also want to see a big fat impact on the rate if I go ahead and make the smart play.

Another way to state this might be to say that at a 50% marginal bracket, every $1 of spending costs $2 in pretax/salary earnings. I have to feel that in my savings rate or I’m could miss the boat. This sort of relates to framing life for different purposes by Jacob Lund Fisker in the book Early Retirement Extreme (e.g., increase dissatisfaction with current, suboptimal lot, reframe alternative more preferable lifestyle to increase psychological appeal). It is also often discussed from a broader perspective by many stoic philosophers. I definitely want to employ this strategy via my savings rate to give myself the psychological “attaboy!”

Turning back to the example of maxing the 401(k) versus grab a new whip, I would show this by including the full $19,000 in both the numerator (savings) and denominator (available income) of the savings calculation. I want to reflect the foregone spending as well as the tax savings related to that decision. I am basically saving 100% of these pretax contributions. Granted, the cash comes with a contingent liability for future taxes attached, but I can deal with that intelligently down the road.

So, let’s say I’m making $100K pretax and receive $60K after tax currently (assuming a flat effective and marginal rate of 40%, for simplicity). In the example, I currently spend all of available funds and am debating whether to continue to do so and get a new Tesla (or whatever) for $19K per year (maybe I just paid off my Jaguar and am thinking of trading it in). But I recently read this Suze Moron story about how financial independence is crazy, so I went down the rabbit hole and checked out this stuff out. I came across the concept of FI and the savings rate and thought, “Hmm. What would my savings rate be if I put the money in my 401(K) instead?”

So if I put the $19K in my 401(K), I now only bring home $48,600. To get my $19K I had to give up $11,400 in take home pay. So I add the $19,000 to the numerator (savings) and denominator (income available for savings) as I’m saving 100% of that amount. So I get $19,000/ ($48,600+$19,000). So the savings rate is about 28%. [Full disclosure…lawyer + math.]

Boom, that sounds like a good start. I think I will pass on the new Tesla (or G-wagon…whatever) for now and save in the 401(k).

Why You Might Want to Do the Same

Not to be belabor the point, but I think we generally benefit by factoring in the effect of taxes. If you don’t you could do something dumb like getting hammered in the face with a ~50% combined federal state and local marginal tax rate on your high bay area salary, and saving in an after-tax account to fund your impending FI move to Texas, Puerto Rico, U.S.V.I., or Florida (or simply to spend/withdrawal a much smaller amount than your current working income, placing you in a much lower set of brackets). Sorry…you played yourself.

I also think a few analogies might help crystalize the thinking on this point. Would we exclude the sales tax in the calculation of spending? I don’t think so. If I can live a lot more cheaply in Texas versus Manhattan and sales taxes are a contributing factor, I want to include that in a pro-forma savings rate. Same deal with property taxes (I actually think these sales and property taxes usually offset some of the relative attractiveness of the low income tax jurisdictions…but the point is I don’t want to exclude any of it).

I would also want to account for income taxes in an analysis of relocation across countries. If I have an opportunity to teach abroad for three years and there are no taxes on my income in Saudi or China or whatever, I would need to evaluate that tax impact as part of the estimated savings rate that I can expect to achieve and how that would impact my financial plans.

All of these scenarios seem to me to clearly support the conclusion that taxes are just a (huge) expense and most people will want to treat them accordingly in the savings rate calculation.

Including Mortgage Principal in Savings Rate

One other related question that FI people always debate is whether they should include the principal portion of mortgage payments in their savings rate. Everyone agrees the interest is an expense but a lot of people exclude principal reduction.

Again, I include this. With my mortgage I’ve got to pay a certain amount of principal in each payment based upon the agreed amortization schedule. I don’t prepay the principal (article planned on that soon, if interested shoot me an email or comment), but if I did, I would include that too.

An analogy made this one clearer for me. To me, the payments to eliminate the mortgage over the 30 year term are really no different from building up an investment fund to purchase the house. In that case, I would clearly be saving every month (and everyone would include it in the savings rate). Same deal if I were saving up for a huge downpayment to end up with a smaller mortgage loan.

I understand that some people say, “Well I’m not planning to sell my house, so it’s not going to fund my financial independence.” Assuming you want to set it aside like that (even though you could sell it or reverse mortgage it, or do a cash out refinance, rent it out, etc…during your post FI journey) I still think the analogy above holds.

So the mortgage principal, by analogy, goes toward a “sinking” fund and I know with certainty it will offset my housing costs because they will (at least aside from maintenance and property taxes) be locked in/hedged. It is sort of like building an additional fund to invest in a perpetual rent derivative or something. You end up basically hedging out your housing costs (and any related inflation).

To sum things up, I include the impacts of mortgage savings and taxes in my savings rate. While I am not claiming there’s a definitive answer, I use the savings rate primarily to frame choices and motivate myself to increase savings. A couple of the above analogies helped to make it clear how I wanted to handle these items. Maybe you will find them useful too.

Thanks for reading! I think my next posts will be the monthly savings update and a one year update to The Tesla Tithe. It looks like the capital raise/time to deploy “the tithe” might be approaching!