When folks find out what I do for a living, most people want to talk to me about the complexities of finances. Those are fun, important topics to discuss, but until we get the basics down, the complexities just don’t matter. So today we’re going back to the basics…
Everyone wants to know how much they need to save to eventually retire and have a secure financial future. The answer to my clients is always case-specific because different people have different lifestyles, the cost of living can vary greatly from area to area, and the age at which you want to retire is a huge factor. But you’ll be glad to know there is a general rule of thumb that anyone can use to get a rough idea.
I call it
Here's how it works:
50% of your income pays for things that are not optional or negotiable. It includes things that you believe you must pay for each month like your mortgage or rent, utilities, and groceries. For me personally, this also includes my tithing and other charitable giving, so if you have similar items, make sure you include them here too.
30% of your income is allocated to spending on non-essentials and optional items like vacations, eating out, shopping, and leisure activities.
20% should be saved and invested. Your savings rate is THE most important predictor of long-term financial success. (Side note: I’ve heard 10% thrown around as a target savings rate, but the reality is that 10% is not nearly enough for most people unless you started saving around age 20… and I rarely encounter someone who has actually done that.)
For the record, we can debate about the difference between needs and wants or optional vs non-optional spending. But in the end, it doesn’t really matter to me how you categorize them. What matters most is the 20% saved, not where you include items in the other 80%.
Why You Probably Won’t Be a Millionaire
If you want all-out honesty, most of you reading this will never be millionaires, and there’s a very simple reason why. (Hint: If you ever plan to stop working one day, you will likely need more than $1,000,000 to do so. The rare exceptions would include those with a pension or other special circumstances.)
When 100 millionaires were asked how they spend, save, and invest, they responded exactly as I expected… Millionaires save and invest a large portion of their income.
I know, not a shocking finding, but let’s follow this for a moment. I live in an affluent area. In fact, it’s one of the wealthiest towns in my state. Needless to say, folks around here have plenty of income. But please hear me when I say that income alone is not enough. You must actually save it so that you can invest it to become wealthy. If you make $250k and spend $250k annually, you are no better off at the end of the year than someone who earns half as much. Yes, you’ve just spent a lot more money than they have, but you aren’t any wealthier.
Your Biggest Obstacle: Y-O-U
Saving 20% seems to be the challenge across all demographics and income levels. The reason is simple. We get in our own way of success because we don’t save first. Or worse, we don't save at all. In practice, we tend to spend our money and then attempt to save what’s left over. Our established lifestyle leaves us little left over… sometimes it’s 5%, at best it’s 10%, and often it’s 0%. This simply doesn’t prepare us for the future.
Once a lifestyle is established, it is very hard to reduce it. Do you make more money than you did 15 years ago? Probably. But do you spend more? Almost definitely. So the sooner you start doing the right thing, the easier it will be on you and your household.
What If You Don’t Save Enough?
If we live to our life expectancy, there will come a point when we will no longer be able to work. If we can’t earn money, then we will only be left with Social Security income to pay our bills. For the average household, Social Security income provides about 30% of the level of income annually received while working. So that means that we will eventually have to reduce our lifestyle by about 70%. If you think saving 20% is tough, how about being forced to reduce spending by 70%!?
This is not sustainable, nor desirable, for most of us, so we have to find a way to supplement our future income needs. That’s where your savings and investments come in. Aside from simple retirement survival funds, we will also need extra money to cover unexpected circumstances during our working years. There may be a temporary loss of employment, perhaps a large house repair, or unexpected medical expenses… whatever “it” is, something is going to happen. And, frankly, it’s not going to be just one thing. Life experience should tell us that there will be many things along the way. Ultimately, if we don’t save at the rate we should, a relatively small setback could destroy us long-term financially.
What We Can Learn from Paying Taxes
No one likes paying taxes, but we pay them because we have to. If you value your freedom, it’s non-negotiable, right? Just ask Al Capone. But do you know the percentage of federal and state income taxes you pay each year? Did you know that you and your employer are also paying Social Security and Medicare taxes? Most people don’t understand, nor do they tend to care, about the exact percentages. Why? Because paying taxes is required and usually our tax liability is automatically deducted before we ever get our hands on it. There’s a reason the government has set it up this way… it works! So, if we apply the principle to ourselves and save automatically as we do with paying taxes, then saving becomes easier. More importantly, it’s fixed and constant, and it's much more fun to pay yourself.
Automate it and forget it.
Think You Can’t Do It?
Getting to a 20% savings target is NOT IMPOSSIBLE. It can be achieved with ease and without pain if done gradually. My favorite place to start saving is through an employee-sponsored 401k plan. Take savings out of your paycheck before it gets into your checking account is the key to success. I recommend that people increase savings targets by 1% every 3 months. So you get to start wherever you are and then each successive 1% increase is not very noticeable and can be absorbed in monthly spending changes without making you feel deprived. These small increments can also be at least somewhat offset by standard annual inflation raises.
Just Do It
It’s more than a slogan. I’m challenging you today… begin right now!… log into your benefits plan or call your HR rep and increase your contributions by 1%. If you’re at 3%, go to 4%. If you’re at 9%, go to 10%. I encourage you to do it now before you talk yourself out of it or get distracted by something else. Then set a repeating reminder for yourself to do the same thing every 3 months. If you’re already at 10%, call me and let’s chat through where you go from here.
Remember: the percentage rate of savings is the most important predictor of long-term financial success. So let’s get that piece in place today!
Shoot me an email with any questions, comments, or tips that have worked for you... I love to hear from you.
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