How to Calculate Your Income Savings Rate

January 12, 2021

One of the most common questions I hear from our clients is, “How am I doing?” As we lean into this question, quite often, the clients begin to compare themselves to their peers. However, I believe that there is a much better example for them to compare themselves to… themselves! To truly know “how you’re doing,” all it takes is a simple calculation. Join me as I explain how to calculate your income savings rate.

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TIME INDEX:

00:49 – How to Calculate Your Income Savings Rate
04:22 – Don’t Bury Your Talents
07:06 – Self-Assessment Calculation
12:03 – What You Can’t Include
14:06 – Pay Yourself First
15:40 – What is Your Income Savings Rate?
18:21 – Summary

The Parable of the Talents

There is a story in the Bible—more specifically, in the Book of Matthew—about a rich man who was going away. Before leaving, he left several talents (the currency of the time) with his servants. To the first servant, the man gave 5 talents. The second servant received 2 talents. However, the third servant was only given 1 talent. The man went on his way and, when he returned, he wanted to know what his servants had done with the talents he entrusted to them.

The first and second servants had been shrewd in their investments and made more money with their talents. The man was very pleased by this and knew that he could trust them with greater wealth because they could be trusted with little. However, the servant to whom just one talent was given feared the man. As a result, he buried his talent and saw no growth from it. This made the man furious. He told the servant that he should have at least put it into the bank where it could have earned interest.

You see, many of us are like the third servant. We are stuck in this cycle of living hand-to-mouth and we never put our money to work for us. As a result, we have nothing to show for our hard-fought earnings. I know so many business owners who make over a million dollars per year in profit that would be bankrupt if they had to go 60-90 days without income. So, don’t bury your talents, folks!

Self-Assessment Calculation

So, what if someone entrusted you with their talents? Would you make the right decision? How would you measure up? Well, this is where calculating our income savings rate comes into play. In order to make that calculation, we must first conduct a self-assessment of the money we’ve been entrusted with. We will begin with one year to ensure that we understand the concept, and then we can expand to a larger scale. So, let’s look at the money we’ve earned in 2020.

Once again, to keep things simple, let’s assume that we earned $100K last year. When you begin your self-assessment, I want you to ask yourself what percentage of your income did you invest in something that will appreciate in value? But getting back to our example, let’s say that we placed $5,000 into an IRA. That puts our annual savings rate at 5%. That’s not very much though, is it? Well, believe it or not, that’s more than most people save on an annual basis. Friends, when I conducted my own income savings rate calculation, it changed my entire world. I knew I had to make some major changes, and fast.

Now, this is all a very simplified calculation and, in my next entry, things will become much more complicated. But, it’s vitally important that you understand how to find your income savings rate and what goes into it. Equally important, however, is what doesn’t go into the calculation.

Income Normalization & What Not to Include

In our example, we’ve determined that we are being entrusted with $100K per year. However, this isn’t the full measure of our compensation. You see, as business owners, we pay for a lot of the things that most consider the everyday cost of living expenses. We may pay our phone bills, car payments, internet, health insurance, and more through our businesses. Once we have sold our businesses, these expenses will be out of pocket. In addition, we will no longer receive a company match on our retirement accounts. All of these expenses add up and must be normalized and included as our annual compensation.

Once we’ve factored all of these added forms of compensation into our gross annual income, we can include our assets and payments toward appreciable assets. Think about the principal portion of payments on investment properties, investment properties, retirement accounts, etc. Each of these things counts as a re-investment and goes toward the annual income savings rate. However, there are certain expenses that do not count toward this end.

For example, many of us have a car payment. That’s $800-$1000 per month—I even have one client that had $25,000 in monthly car payments when we first began working with him—toward a depreciating investment. Now, there are exceptions to this rule. My father used to invest in collector vehicles. This is the only time that you can include a car payment into your appreciating assets because you could actually sell the vehicle for more than you paid. Additionally, you don’t want to include boat payments, or credit card and consumer debt.

Pay Yourself First

Entrepreneur and author, George Samuel Clason, is said to have first coined the term, “pay yourself first,” back in the 1920s. Clason authored the book, The Richest Man in Babylon and founded a successful publishing business in Denver. Following the financial success of his business, Clason began distributing pamphlets to banks, investment houses, and other financial institutions. These pamphlets used parables on the ancient city of Babylon to teach financial concepts. However, it’s the notion of paying yourself first that really has made a lasting impact on business owners around the world.

To this day, some of the greatest financial minds in the world teach this very principle. Without paying ourselves first, we will inevitably get stuck in the mud and never get anywhere when it comes to our financial journey. With that said, I don’t know what you make in your business. Whatever that number is, how much did you save last year? In my 20 years within this industry, one thing has been true in the vast majority of my financial planning cases; the more money you save the greater your net worth will be. In fact, I’ve seen this come to fruition so many times that, at a minimum, I believe that 20% of our income should go into income replacement assets.

At some point in our lives, we’re going to have to live off of our assets. That’s why all of this is so important. This is why knowing how to calculate your lifetime savings rate is an absolute necessity. So how do we make that calculation? Well, I’m going to dive deep into that calculation in my next post. But for now, think about this. A 20% savings into an income replacement asset, each year, could allow you to replace your income in the future. Most of us, aren’t even coming close to that figure.

In Summary…

Friends, too many of us have this “live in the moment” type of mindset. I’m not saying that we shouldn’t enjoy life as it comes. We absolutely should. However, I am saying that we need to make shrewd decisions with our money. Don’t simply bury your talents. In doing so, you will be robbing your future self. In my next entry, we will get into the complexities of this calculation. I will show you exactly how to see what your income savings results look like. I’ll warn you, the results will probably be a bit depressing, but they will allow us to make plans for improvement.

Look, life is hard. Life is good. Putting together the correct plan for your annual savings can be frustrating but it doesn’t need to be. With the right calculations and a well thought out financial plan, creating a savings plan that can replace your income can be at least financially simple.

Normalizing your personal income and calculating your income savings is a complex issue. One that we have much experience in. If you have questions or feel that you could benefit from having a professional guide you through the process, reach out to us. A member of the Financially Simple team will gladly assist you.