Your savings rate is critically important when achieving your financial goals, especially when considering retirement.
Other areas that are also important include how much money you earn, how much money you spend (in retirement), the age that you decide to retire, and your overall risk profile.
Whether it is a short-term, medium-term, or long-term goal, these variables play a big part in your success. This article focuses on diving deep into your savings rate to help you understand why it matters.
Key Takeaways:
Your savings rate is a function of how much money you save relative to your gross (pre-tax) income.
Your recommended savings rate is a personal number, dependent on several factors.
The earlier you start saving, the lower your savings rate needs to be, and the later you start saving, the higher your savings rate needs to be.
To increase your savings rate, you can (1) earn more income, (2) trim your expenses, (3) take advantage of retirement plan accounts, and (4) automate your savings.
Savings Rate Basics
The goal behind understanding your savings rate is to get a clearer picture of how much money you are saving relative to your total income. Therefore, at a basic level, you can think of your savings rate as the amount of money you save as a percentage of your gross (before-tax) income.
At any given time, there will be multiple financial goals that you are trying to achieve. For example, you may have a dollar amount for your emergency fund target, a target amount for a down payment on a new home in three years, and the biggest goal of retirement that is twenty years away.
Understanding your savings rate and focusing on increasing it over time, the higher the probability of success that you will have in achieving all of your goals.
How To Calculate Your Savings Rate - An Example
To get a sense of how to calculate your savings rate, an example may help. Imagine a household earning $100,000 (gross or before tax) in combined income. In monthly terms, they earn about $8,333 (gross or before tax).
For this same household, their monthly savings looks like this:
$1,000 | retirement
$1,000 | Home Down Payment Fund
$500 | College Savings
When looking at their monthly numbers, their savings rate is as follows: ($1,000 + $1,000 + $500) / $8,333 = 30%.
In our view, it is also vital to sometimes get more specific and make a calculation for the long-term goal of retirement. In this household example, their retirement savings rate is $1,000 / $8,333 = 12%.
What Should My Savings Rate Be?
Your specific saving rate can be challenging to determine. The main reason is that every household has different time horizons, risk preferences, and lifestyle needs.
Someone living in a lower-cost-of-living city with modest retirement spending goals will require a lower savings rate than someone living in a higher-cost-of-living city with extravagant retirement spending goals. Financial goals always need to be unique, personalized, and specific.
If you would like a few general rules of thumb depending on your situation, here are a few target ranges for savings rates:
Most resources you find will recommend 10% - 15% of your pre-tax income as the ideal savings rate.
However, if you haven't started saving yet and are in your 40s (or older), you may want to target 20% - 30% as your ideal savings rate.
Finally, for those starting early (20's), a solid range to target for your savings rate could be 8% - 12%.
4 Tips To Increase Your Savings Rate
If we take a focused approach to this conversation, targeting retirement, there are many different ways that you can increase your savings rate. Ultimately, by doing this, you will set yourself up for success and enjoyment once you retire.
1. Earn More Income
Earning more income will be one of the most significant factors in helping you increase your savings rate.
Cutting expenses is great, but sometimes your household has a minimum standard of living. In addition, there are specific IRS rules around how much you can save in retirement plan accounts.
If you find a way to earn more income by increasing revenue, finding new business, etc., as a small business owner, you can use that additional income to increase your savings rate. Avoid lifestyle creep as you increase your income, and save it.
For those that are not business owners, you could easily earn more income by starting a side business, finding a new position (with a new employer), or making a solid case for a raise (at your current employer).
2. Trim Your Expenses
Whenever the word "budget" comes up, most people cringe. However, we like to think about this concept in terms of "cash flow optimization". By minding the details of your personal and business expenses, you can open things up in ways to increase your savings rate.
On the personal side of your spending, make sure to not only review the small categories. Take an additional step and review the larger spending categories (vehicles, housing costs, insurance, etc.). See where you can make changes to decrease costs in these areas. You may be surprised that you can take back some of your hard-earned money and use that to increase your savings rate.
Regarding your business expenses, it is easy for any business owner to get complacent with their variable and fixed costs. However, imagine if you could cut some marketing spending that did not help your business. You would increase your profits and ultimately have more cash to put into a retirement plan you've established for yourself as a small business owner.
3. Take Advantage Of Retirement Plan Accounts
When saving for retirement, specific tax laws can incentivize individuals to optimize for this goal.
At a starting point for employees, you always want to make sure that you consider your employer-sponsored retirement plan (if it is offered to you). In most cases, it may be a 401(k) Plan. See if your employer provides a match, and make sure to contribute enough to take advantage of the full match offered by your employer. When calculating your savings rate, the conservative approach is not to include your employer match as part of that calculation.
Outside of the 401(k) Plan and depending on your income levels, you may be able to contribute to an Individual Retirement Account (IRA). If you already contribute to your 401(k) and are within the income limits for Roth IRA contributions, this may be a beneficial savings bucket to fill.
Retirement Plan Accounts For Small Business Owners
However, for most reading this, you may own your own business. In that case, you have plenty of options for taking advantage of retirement plans. Specifically, you want to make sure that you contribute the maximum that you can, depending on the type of account that you establish as a small business owner. The type of account may be a Solo 401(k), SEP IRA, SIMPLE IRA, or Defined Benefit Pension Plan. By utilizing this approach, you can increase your savings rate and decrease your taxes.
4. Automate Your Savings
When it comes to retirement, sometimes it is hard to imagine such a distant future. That is one of the reasons (and behavior traps) why most people seek immediate gratification over delayed gratification. For example, when you get paid a large bonus or close on a large, new client, it is easy to use the excess income to spend today (and more challenging to stash it all for retirement).
By automating your savings, you can avoid falling into traps like this. In a sense, you are just paying yourself first with your income. For small business owners, this could be set up with the institution where your retirement plan accounts are held. This could be set up every two weeks, monthly, or whatever fits your cash flow situation.
We Can Help!
How much money you save is crucial in achieving your financial goals. As a small business owner, you must take this seriously. While small business owners have so many responsibilities at any given time as it relates to their business, saving for retirement is often neglected.
Our firm is here to partner with you to ensure you achieve all you want in life, your finances, and your business. We are a planning-focused firm specializing in working with Minority Business owners seeking to make smart decisions with their money. AWM is a virtual firm based out of South Florida, serving business owners nationwide. Please contact us by Clicking Here to schedule an introductory call.
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