The 3-Step Process to Saving 40 Percent of Income

14.5 MIN READ

Prefer to listen rather than read? Pair this post with Episode 25 of the Beyond Finances podcast, where we talk about the process of saving 40 percent of income and the steps to take to make that happen.

Do you know how much money you save right now?

And perhaps more importantly… do you know if it’s enough?

Percent of income saved is one of the leading metrics we use at Beyond Your Hammock to determine if our clients are on the right track to meet their biggest goals.

We also use our own advice in our personal lives. Saving 40 percent of income is one of our biggest personal financial goals every year, because we know how powerful this action is for those who want to grow assets, build wealth, and reach financial freedom.

But there’s no doubt: saving 40 percent of income means putting a lot of money away for the future, and that’s not always easy (or even possible) to do.

If you’re interested in trying to set a similar goal for yourself, it helps to start by understanding what we mean by “savings rate,” how you can contribute large percentages of your income to long-term investments, and what kinds of processes or systems can make it easier to accomplish.

What Do We Mean by “Long-Term Savings Rate,” and How Can You Calculate Your Savings Rate?

At BYH, we define your long-term savings rate as the percentage of your gross income that you put toward long-term investments. That “long-term” phrase is really important here; in fact, it’s the key to connecting your savings rate with goals like financial freedom and independence.

Investing for the long term is how you build significant assets. Your money needs time in the market to earn compounding returns, and you never want to interrupt that process prematurely. If you can commit to keeping your money invested for decades of time, you provide yourself with better probabilities for a successful investing experience.

Money that you contribute toward the following accounts could be included in your savings rate calculation:

• Employer-sponsored retirement accounts, like 401(k)s or 403(b)s – and yes, you can include your employer contribution in your total annual amount saved
• Personal retirement accounts, like traditional, Roth, SEP, or SIMPLE IRAs
• Taxable investment accounts (or brokerages)
• HSAs – as long as you invest the cash and leave that money invested for the long-term; this doesn’t count if you use the money in the short-term instead!

What you should not include in your savings rate? Anything you set aside in cash that you plan to use in the next 12 months to 5 years (for a trip, a car, a house, a new computer, etc) doesn’t really count, for the purposes of reaching long-term financial freedom goals.

Money you save to spend within the next 1 to 5 years is important and you need to plan for it. Short-term goals need funding, too, which might require setting aside cash from cash flow each month… but because you’ll use it in the near future, it’s not working to build your assets or contributing to the wealth you’ll have to fund your future.

It’s also for this reason that money you set aside to spend even on bigger goals like paying for college for your kids doesn’t count toward the savings that that we’re talking about here.

Again, that’s money that will be spent – and it can’t be used to achieve financial stability or security for yourself, or to make work and earning an income optional.

So let’s look at an example to better understand how to determine your own savings rate.

If you earn $100,000 per year and:

• You save $10,000 annually to your 401(k)
• You put $1,000 into your HSA every year
• You max out your Roth IRA at $6,000

That brings your total contributions to investments that can compound over the long-term to $17,000 for the year. You might also set aside some money each month into a child’s 529 plan, or save $300 per month to fund a big trip you want to take next year, but remember: that money doesn’t count toward your long-term savings rate.

$17,000 represents 17% of a $100,000 gross income, so 17% is your savings rate. Once you determine your current rate, you can begin the 3-step process outlined below to increase it up to 30-40%.

Why Saving 40 Percent of Income Can Set You Up for Financial Success

Let’s be really clear here before we move on: you don’t need to start saving 40 percent of income to be financially successful.

Such a high savings rate is not the only way to build a sound financial plan. Saving less does not mean you’re doomed to miss the mark on your goals. And you may not need to save anywhere near this much in order to have what you need in your life.

In fact, our baseline recommendation for financial planning clients is to save 25 percent of income. If our financial planning clients manage this year over year, this is a great achievement and most have fantastic probabilities of long-term success with this level of contributions to long-term investments.

So why focus on saving 40 percent of income? Why even have this conversation – especially if it feels like taking things to an extreme?

One main reason: you have very big, very expensive financial goals. If you want things like…

• Financial freedom (or, as we prefer to think of it, financial power)
• Early retirement
• Lots of choice and flexiblity in your lifestyle spending
• Multiple major priorities that you don’t want to choose between (you want them all!), or a combination of big goals that all require a lot of funding to achieve

Again, there’s no universal law of nature that requires you to have a certain percent of income saved.

Let’s say you started earning an income around 22, after you graduated college. If your main plan is to keep working and earning that paycheck until 70, at which point you’ll retire to a modest life of leisure — well, in that case, the more traditional rule of thumb that says to save 10-15% of your income throughout your working years is probably sufficient.

Saving 15% of your gross income or less, however, is not sufficient for reaching financial freedom in your 40s, 50s, or even 60s. Even saving 20 or 25% of your income may not be able to get you there if you want to make earning an income optional by 55 and fully fund college tuition for two kids and quit your job at 40 to start your own business and paying for weeklong vacations to Europe each year from now until retirement.

The more you want to have your life…

The more goals

The more flexibility

The more choice over how you spend your money (and how much you spend)

…then the more you need to focus on setting a high savings rate to give you the financial ability to do all the things, with a high degree of certainty that you’ll have the assets available in the future that you need to both fund your goals and your basic needs and wants throughout your lifetime.

The Argument Against Saving More Than Your “Enough”

For some people, saving 40 percent of income is extreme, even unreasonable.

On the flipside, you don’t have to look far to hear from other people who think saving 40 percent of income is mere peanuts compared to what you really need to contribute to your long-term investments.

Fans of the FIRE movement, for example, tend to cheer for hitting 60-70 percent of income saved.

And in our professional opinions, that’s objectively too much.

We want to strike a balance between enjoying today and still planning responsibly for tomorrow. Saving above 40 percent of income starts putting you in the path of a different kind of risk than what you usually hear people talk about: the risk of missing out on experiences today in exchange for the hope that you’ll have the time, ability, health, and interest in pursuing what matters to you tomorrow.

You’re more than welcome to hit bigger targets, of course, but we think it certainly counts as high-achieving if you are anywhere in the range of 25 to 40 percent of income saved.

As financial planners, planning for the future is a huge priority. Obviously! But there’s an exception. We don’t want to overplan. We don’t want you to sacrifice the ability to experience your life in the present moment.

You don’t have to put your life on hold until you have “enough” money or go to extremes to meet your goals.

From our experience, it’s somewhere in the 25 to 40 savings rate range that gives you the ability to build significant assets for the future while also enjoying your life right now. The exact savings rate that’s right for you depends on precisely what you want to achieve and have in your life.

When we see people saving 30 percent, saving 40 percent of income, that’s where things like making work optional by your 50s becomes possible.

Depending on your income level and current lifestyle, that rate should also leave some money in your bank account to use freely on the things you want right now – so you’re not just waiting around for 10-30 years to actually start living.

While that may not be as exciting as headlines that proclaim “employee #3 of tech startup retires at 30 after living exclusively off company cafeteria leftovers” or whatever the latest trending storyline is… it is a more realistic approach.

It also tends to be a more appealing method to people who don’t loathe their jobs to the extreme that they want to quit working forever before they even hit 35 years old — and most of the people we serve in our Financially Sound program actually enjoy their careers and want to stay engaged with their work until at least their 50s or 60s.

At that point, they’re most interested in having the choice to continue or not on their terms; saving 40 percent of income (and sometimes lower amounts, between 25 and 30 percent) lets them to meet this future goal without sacrificing what they want to enjoy in the present.

A 3-Step Process for Saving 40 Percent of Income

OK: you’re interested in saving 40 percent of your income (give or take; your exact percentage target may be a little lower and that’s fine!). The question to ask next:

How do you manage this, and actually make it happen?

The very first thing to do is to know where you’re starting from today. What’s your present income, and how much are you currently saving?

When you look at your numbers, remember that money you “save” for the short-term doesn’t count! Take a look at your contributions to long-term investment accounts, from employer retirement plans (and their matches) to personal retirement accounts to non-retirement accounts like taxable investment accounts.

Annual Savings Rate = Your Total Contributions to Long-Term Investments / Your Gross Household Income

Here are some examples:

• If you contribute $25,000 total to long-term investments per year and earn an annual gross salary of $75,000, your current savings rate is about 33%.
• If you contribute $25,000 to investments and earn $150,000, your current savings rate is roughly 17%.
• If you contribute $50,000 to investments and earn $150,000, your savings rate is 33%.
• If you contribute $50,000 to investment accounts and earn $250,000 per year, that gives you a savings rate of 20%.
• If you contribute $75,000 to investment accounts and earn $200,000 per year, that gives you a savings rate of 37.5%.
• If you contribute $75,000 to investment accounts and earn $400,000 per year, your savings rate is just under 19%.

These examples show why we want to look at the percentage of money you save, not the dollar amounts contributed or earned. They should also highlight that it’s not all about how much you make, but what you do with the money you earn.

Looking at your savings rate this way keeps things relative. It also means you may need to do this exercise annually, or at least when you know your income changed to go up or down.

A change in earnings means a charge in targeted dollar amounts you’ll want to get into long-term investment accounts for growth over time.

Once you know your savings rate as it stands today, you can decide if you want or need to make any changes. For anyone below the 20 percent marker, getting to at least 20 percent would be the first goal to set.

If you’re at 20 percent or higher and want to get to saving 40 percent of income (or somewhere in a higher range), this simple 3-step process can help you get there.

Step 1: Set Your Savings Rate Target

Again, regardless of the specific amount you choose, keep it in percent format. Interested in saving 40 percent of income? Figure out what that is in dollars, and target that.

Using percentages doesn’t just keep your savings relative to what you actually earn – it’s a good way to guard against lifestyle creep, too.

If your income goes up and your goal is to save a percentage of what you earn, then your total dollar amounts saved go up automatically, too.

Similarly, if your income goes down, the dollar amounts you’re saving should adjust accordingly, as well. This will keep your income and your savings targets in sync, so you’re not left stressing out about an unrealistic goal in either direction.

Step 2: Design Your Savings System

When it comes to meeting goals around percent of income saved, systems and processes can help make sure the right actions get done at the right time. For savings, automating contributions to investments accounts as much as possible is a key process you’ll want to use.

Creating automated contributions helps you to:

• Avoid decision fatigue
• Limit human error (which can be as simple as just forgetting to make your regular monthly contribution)
• Cut down on distraction and temptation… because money that just hangs around in a bank account is money begging to be used for better or for worse!

Even with automated contributions, you need to keep an eye on your bank account balances and ensure excess cash isn’t building up when it could be saved instead. “Extra” cash is anything over and beyond what you need for emergency savings, monthly expenses, and short-term goals.

Don’t let money sit around. Give it a job and put it to work making more money!

How much those automated contributions should be will depend on your specific savings rate, and the dollar amount that translates into. How you get paid will also factor into this decision.

Once you know how much you need to save on an annual basis to hit your savings rate goal, the simplest approach is to divide that total by 12. That tells you how much you need to contribute to long-term investments each month to have what you need to meet the goal by the end of the year.

Of course, this may or may not work if your earnings aren’t just straight salary. If you have equity comp, earn commissions, or expect bonuses, your cash flow might not be perfectly even throughout the year.

In that case, you might need to do a combination of:

• Automated monthly contributions to investment vehicles
• Periodic lump-sum contributions as big cash inflows occur throughout the year

For most of our clients, that looks something like:

• Contributing the maximum amount to their employer-sponsored retirement plan (usually a 401(k), so $19,500 per year as of 2021)
• Contributing a set amount to vehicles like IRAs, HSAs, or ESPPs
• Evaluating cash inflows from bonuses, commissions, etc as they occur, and immediately setting aisde a certain portion of that money to go toward investments and hitting the annual savings rate goal (and then being able to spend or use the rest however they’d like)

Usually, folks choose to max out tax-advanaged accounts like 401(k)s or HSAs and automate those contributions. Then any money above and beyond those totals goes to a taxable brokerage account, which has no contribution limits or restrictions.

Other steps to your savings system include knowing precisely what savings vehicles you need to use. Again, appropriate vehicles might include retirement accounts (through work and things you can open on your own like IRAs or HSAs) and brokerage accounts.

You’ll have to revisit this piece of the plan quarterly or annually to ensure those dollar amounts add up to a total amount that corresponds to your set savings rate target, and to confirm you’re still using the right savings vehicles over time.

Step 3: Focus on What You Can Control with Your Cash Flow

This means looking at what you can influence with your income, and what you can control with your expenses.

Managing expenses often comes down to aligning your spending with your values… and then cutting out spending that does not match up with your priorities.

To actually execute on this idea, you must:

• Get very clear on what actually matters to you. This is a process! It’s okay if it takes some time to gain clarity, and it’s also okay (and even expected) if your priorities and goals change over time.
• Be confident in what you say yes to, and what you say no to – and you will have to say no. You will have to turn down things you want to do in the moment to prioritize what is most important to you over the long term.
• Pay attention to the little stuff… but know you have to get the big stuff right even it only comes up every once in a while. Don’t overspend on things like your housing, cars, or let lifestyle creep get out of control over time.

Controlling your cash flow also means staying engaged in the financial conversation. That can look like periodically assessing your values, your budget and your spending, your goals, and more.

Consider asking the following questions to help you stay mindful and aware of how you use your money both in the moment and for the long-term:

• How excited do you feel about this purchase, or this particular use of your money?
• Are you going to feel like you missed out if you don’t have this experience or go to this event?
• Is this truly something you feel good about spending money on? Or does it make you feel uncertain, maybe even bad?
• Does this align with what you say is most important to you?

This process can help you tune in to what you really want and where you get the most value from your money. It can also help you avoid chasing experiences that aren’t really as fulfilling as you might have hoped or wished for.

And of course, keep a budget! It sounds basic, but having some way to track your spending is what keeps your day-to-day finanical life organized and running smoothly.

On the income side of things, you can also look at what is within your control. You can decisions that you believe will boost your total household income.

For myself personally as the founder of BYH, that’s usually around reinvesting in the business I own and work within to add value, enhance the service provided, and attract more financial planning clients who want to be part of what we’re doing: building more wealth for more people.

But in the past, it was the initial decision to pursue self-employment in the first place. And my wife still makes that choice in little ways all the time – even though she works full-time at BYH too, she also regularly seeks out additional freelance gigs.

She loves that work and it’s something she would do (and has done) even when it doesn’t pay. She’s a writer, so her freelance writing brings her joy.

It’s a literal bonus that 9 times out of 10, it brings in extra money that can be added to the amount we save.

Saving Big Percentages of Your Income Is Never Easy – But It’s Possible If You Want to Pursue It

Ultimately, the act of saving money is never easy to do. Depending on your situation, circumstances, experiences, and obligations, saving even a single dollar can feel as challenging as saving $10,000.

I will never tell you this work is so easy anyone can do it. All the determination in the world isn’t always enough (although the will to act certainly helps; it’s just not the only thing that you need on your side).

Saving money, especially when you start talking about saving almost half of what you make, takes commitment and work.

It takes a colossal effort not just to start the process or set up the system, but also to consistently stick with the strategy and manage this whole thing over time.

To make the right choices over and over again. To choose the work over easier routes. To choose to take responsibility and focus on what you can control, even in the face of things that don’t feel right or fair.

It’s not easy, but it is possible to increase your savings rate. To contribute 20 percent or more of your earnings to long-term investments… and even to start saving 40 percent of your income.

These 3 steps — setting your target, developing your system, and focusing on what you can control in your cash flow — are a great place to begin for anyone interested in increasing the amount of money they save each year.

About the Author
Eric Roberge, CFP®, is the founder of Beyond Your Hammock, a fee-only financial planning firm based in Boston, Massachusetts that specializes in providing planning services and investment management to professionals in their 30s and 40s.

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