Last week, I read a nice post on Chief Mom Officer on the challenges of calculating savings rates. Right around that time I was also revisiting our 2017 budget and the projections of how much we are going to save this year. This is the last full calendar year before our planned retirement in early 2018 and it’s imperative that we stay on track and keep a high savings rate on the home stretch. But how high is our savings rate? Is there even a generally accepted way of calculating a savings rate? What are some of the pitfalls? We were surprised about how easy it is to mess up a calculation as seemingly trivial as the savings rate.

So, here’s our situation: We group our annual compensation into six major categories:

*Side note: we plan our tax withholding so that we come within a few hundred dollars of our actual tax bill. If we were to expect a large tax refund or large tax bill in April we would certainly incorporate that number in the tax component T. *

How should we calculate our savings rate? Here are a few principles about what we should and shouldn’t include:

What **should always** be included in the savings rate calculations:

**Employer matching contributions (S1).**The reason why we’re getting matching benefits for the 401k and the HSA (Health Savings Account) is not because Mr. ERN’s employer is in a charitable mood. Some smart accountants and lawyers figured out a more tax-efficient way of forking over a compensation package that XYZ Inc. deems appropriate for Mr. ERN’s hard work. Whether XYZ Inc. pays it to me and I save it or XYZ Inc. uses the money to match my savings contributions is irrelevant. Money is fungible. So, the entire amount in S1 is included in our savings (but subject to some limitations, see below).**Debt principal payments (in S3).**For us, this is the mortgage principal paydown. From an accounting and economics point of view, there should be no discrimination between building assets and reducing liabilities. We increase our net worth and there is even a “return” on the “savings” in the form of lower future mortgage interest payments. It’s not a very generous return, but it surely beats the 10-Year Treasury yield right now! And of course, the number one reason for including the debt paydown as savings is that the reverse should be even more obvious.**Going further into debt**should be considered**negative savings**. Otherwise, lots of bankrupt folks would argue, “hey, we never had a negative savings rate, we only increased our credit card debt!” How preposterous is that? So paying down the principal of our mortgage is included in S3.

What **should never** be included in the savings rate:

**Mortgage interest.**We want to count our principal paydown as savings, see above, but including the interest portion is a big no-no. For us, the interest payment is essentially the equivalent of rent. We wouldn’t include rent for a house or apartment as savings and likewise, we shouldn’t include the money we pay to the bank to borrow (=”rent”) their money. Same goes for property taxes and homeowners insurance.**Capital income**(interest, dividends, capital gains) from**existing****assets**. This might a contentious issue, so let me explain where I’m coming from. Imagine two individuals, Anne and Ben who each earn $100 in wage income and save $50. They both have a 50% savings rate. But what if Ben has an additional $100 of capital income from retirement savings and it’s all reinvested. It’s probably a bad idea to call that a 150% savings rate. But even if we add the extra income in both the numerator and denominator we get (50+100)/(100+100)=75%. That 75% rate is an accurate estimate of*some*savings rate, for sure. But the question is how sensible and informative is that number? 25 of Ben’s 75% are merely a result of past savings efforts. We probably wouldn’t argue that Ben has a 50% savings rate if she consumed all of his wage income and simply reinvested his capital income: (0+100)/(100+100)=50%. If we want to measure our**savings discipline**and make comparisons between people who are at different stages in their retirement savings accumulation it’s best to set aside the capital income and keep that money behind a firewall! And of course, another reason why I don’t like to include capital income: It’s too volatile for equity-heavy portfolios.

### Our actual income vs. savings vs. taxes vs. consumption numbers.

So, keeping those principles in mind, how much do we save? See chart below, which is a breakdown of our annual gross compensation into the six components. We won’t post our actual annual income but this is all scaled; per $100 of total compensation:

- S1: The employer matching is not that high. That’s because more than half of Mr. ERN’s compensation is the annual bonus, which is ineligible for 401k matching. One of the disadvantages of working in finance!
- S2: We save a bit over 17% in 401(k), HSA and a plan for voluntary deferrals. The latter is a plan that allows saving a portion of the cash bonus to defer income taxes (though not payroll taxes).
- T: Taxes make up almost one-third of the total compensation. It’s one of the reasons we are planning an early exit from the job market. We are sick and tired of sharing one-third of our hard-earned income on average, and almost 50% at the margin. And this doesn’t even include property and sales taxes!
- D: Deductions for the company health plan, transportation benefits, etc. are only about 1% of the total compensation.
- S3+C: That’s our net income or take-home pay. Only less than half the total compensation. Out of that amount, we consume about 55% and save the rest in after-tax IRAs, taxable savings, mortgage principal reductions, etc.

### Savings Rate #1: Based on gross total compensation 41.24%

That’s the easiest savings rate to compute: Divide all the savings by the entire gross compensation:

In our case, that’s 41.24%. Not a very impressive number, but that’s an artifact of the 30%+ average tax rate. We have no illusion of ever generating a 60%+ savings rate based on gross compensation when we pay so much in taxes. It’s still a pretty decent savings performance because in the 3-way split of $100 worth of income we’ll save $41.24, pay $32.52 in taxes and consume $26.24 (actual consumption plus the deductions for healthcare and transportation, which we also consider consumption). Consumption is the lowest and savings the highest share, just like we want it!

### Savings Rate #2: Based on the take-home pay (a bad, bad idea!): 90.35%

Mr. Money Mustache has a classic post to calculate the time you need to reach FIRE as a function of the savings rate. He defines the savings rate as savings “as a percentage of the take-home pay.” What is our take-home pay? I guess it’s our net paycheck, right? If we were to calculate our savings rate as total savings (all the green bars) divided by that take-home pay number we’d reach a pretty impressive number: 90.35%!

How awesome is that? Not very awesome at all because it’s an utterly meaningless number. Specifically, this 90% number is a very bad measure of how frugal we are. Believe me, we’re modestly frugal, but not **that** frugal because this 90% “savings rate” doesn’t imply we consume only 10% of our take-home pay. Do you notice a problem with the formula above? We count the pre-tax savings in the numerator but not in the denominator. The way we calculated the savings rate violates the simple rule that every savings rate formula should satisfy:

#### Mr. ERN’s Essential Rule for Constructing a Savings Rate: Any component we count in the numerator has to also show up in the denominator.

If we don’t follow this rule we could get completely non-sensical results. If we had increased our 401k contributions (after-tax, because we max out the pre-tax) and bonus deferral, we could have achieved a 100% (!!!) savings rate, how crazy is that? But simply reshuffling savings should not impact our savings rate.

So, if we’re not careful about calculating our savings rate properly we could easily delude ourselves. Strictly speaking, S3+C is our “take-home pay” but if we look up the 90% savings rate in Mr. Money Mustache’s table and conclude that it should take only under 3 years to reach FIRE we just made a major miscalculation. The 90% savings rate we calculate here doesn’t imply we consume only 10% of our take-home pay. In fact, we consume more than half: 24.97/(24.97+20.68)=55%. Taking the term “take-home pay” in MMM’s post too literally and the formula for how long it takes to reach FIRE is completely wrong.

### Savings Rate #3 Based on after-tax compensation: 61.11%

A more sensible approach to a savings rate based on net income is to simply eliminate the tax component from the denominator but count all of the savings components. In other words, count all savings in both numerator and denominator:

The denominator is not really our take-home pay. But this savings rate is still what we want to use in the FIRE timing calculation a la Mr. Money Mustache or our own post from long time ago. In any case, by that measure, we get to slightly above 60%. Pretty good savings discipline, I would argue, but not crazy-frugal.

### Savings Rate #4 Based on after-tax total compensation, adjusting for deferred taxes: 57.65%

One little wrinkle in the calculation above: $1 worth of after-tax savings is worth more than $1 in tax-deferred savings. Physician on FIRE had a nice post on this topic. So, let’s give the various savings components a haircut to account for future tax payments:

- 401k savings: 15%, which is our estimated marginal tax rate on 401k distributions in retirement.
- HSA savings: no haircut! We plan to spend this money on health expenses. Tax-free!
- Voluntary deferrals: if Mr. ERN quits in 2018, the voluntary deferrals would be paid out and taxed at our 2018 marginal tax rate. So we discount the savings by that estimated rate. Ouch!

After applying the haircut to components S1 and S2 and adding a tax component T1 in our breakdown, this is how our total compensation looks like: We just got hit by another $5.51 in taxes for a total of more than $38 per $100 earned. That’s only the average. Marginal taxes are closer to 50%. It’s really time to leave this hamster wheel and retire early!

In any case, if we remove the $5.51 in future taxes from both the numerator and denominator we get a savings rate of just under 58%. Still pretty impressive, still above 50%, but not as high as some of the extremely frugal savers in the FIRE community.

### Conclusion:

Calculating savings rates is a can of worms. Gross vs. net income makes a difference of 20 percentage points. Fudge the numbers by using our take-home pay instead of after-tax compensation as the denominator and we’d make the not-so-frugal ERN family look super-frugal with a (completely meaningless) 90% savings rate.

Where would the Healthcare FSA and Dependent care FSA contributions go in this calculation? And then how would you treat it if for example you take out the 5k FSA once accumulated to pay for childcare expenses? Thanks!

The FSA is mostly a within-year planning tool to reduce taxes while still working. Since you can’t carry over (much of) the FSA it doesn’t really play a role here.

Now, the HSA, on the other hand, is really very useful. Keep that money around as a quasi-Roth-IRA!

The mortgage is a funny one, I see your point but not sure about it. I best illustrate my issue with an overly simplified scenario.

Suppose my mortgage costs me 1,000 a month and I earn 1,500 a month (no taxes) which I use to pay down my 0% Interest mortgage with the other 500 split 350 on consumption and 150 on savings. In this instance I’d have a 77% savings rate, but that rate has no bearing on when I can retire if I have 20 years left on the mortgage. In this case would it not make more sense to leave it out of the numerator but keep it in the denominator? I.e assume a 10% savings rate which seems more realistic but still not ideal as it ignores the mortgage will end in 20 years time. I suppose you could leave it out the numerator and deduct from the denominator, so long as you pay it off as retirement commences.

Good point. I’ve been grappling with that issue due to the ultra-low mortgage rates.

A compromise would be to apply a haircut to the “investment” of paying down the mortgage with the clearly very poor return.

I’m a huge fan of your writing and I know this post is far from new, but it was exactly what I was looking for. Thank you! In fact, I read this a year ago and haven’t thought about it much since. Today, I filed my taxes and just wanted to compute some numbers (effective tax rate, savings rate, etc…) I had some vague recollection of this article, but my memory was fuzzy and I thought this savings rate definition was on another personal finance site. My thinking was that savings rate was a topic that didn’t have enough nuance to be something you would have tackled. But about an hour of very simplistic discussions of savings rate, I rediscovered this article. And re-reading it I just truly appreciated the depth with which you look at this calculation. I really appreciate it and all the other great work you do.

Thanks for the feedback, Brian! 🙂

Yeah, the same issues creep up when calculating tax rates. What should be counted in the numerator and denominator!

I’m a bit late to the party but find your approach to savings rates makes a lot of sense. I’m curious how you would factor non-salary compensation from my employer. I have the common things (employer portion of benefits like health insurance). But I also have an employer-provided vehicle I can use personally.

I should probably numerate these as compensation and denominate these and consumption, right? If I retire tomorrow, I have to pay for my own “benefits” and go acquire a vehicle.

Thanks – LOVE your site.

Good point!

Yes, that seems to be the consistent and logical way to factor in benefits like that! 🙂

I really want to know this number…but so many factors to account for…Downpayment on a house is form of mortgage pay down but I am struggling with how to account for that in this calculation. We saved over multiple income years as well as sold some investments that had capital gains…so accounting for that is difficult without looking at every transaction over the last several years. Additionally, we invested in two real estate syndications each of which were each 6 figures so it’s a substantial impact to this calculation but again these were funded from the combination of savings over multiple years. Is there a way to use the end of year brokerage account statement to simplify this…maybe compare cost basis of brokerage account at 2020 year end to the cost basis of brokerage account at 2021 year end? I should probably stop putting more time into this…net worth almost doubled and really that’s the big picture….but I would like to grade myself on how efficiently I am progressing…any insights? Site is an incredible resource….hope you and your family are well

Saving for the down payment? That’s savings.

Once you have accumulated $x and put that down as the down payment, that has no impact on the savings rate. Or am I missing something?

Thanks for responding. We bought the house so it’s not in savings but rather in the home equity. It’s just that a portion of that downpayment was invested income that was earned in the prior tax year (2020). What complicates it further is when those investments were sold, there were some capital gains that I don’t think should count as income. So I think it comes down to I am having difficulty separating out what should go in the numerator of this equation for year 2021 because some of that “savings” for the downpayment was saved from 2020 income and not 2021 income.

I would not count capital gains or dividends as income in the savings rate calculations. Only “earned” income.

I think that the employer-paid portion of health insurance is also an important part of gross comp for most people. It probably isn’t easy to get a hard number for it, but you could fake it pretty well by finding the difference between your health insurance deduction and what a similar plan would cost on the open market.

Yes, analogous to the 401k matching, everything the employer pays for you is compensation.

When backing into consumption this way, it’s probably important to include any other non-employment cash flows in gross comp as well (rental property income, etc).

I wouldn’t. The income from investments is separate. Especially when doing a Mr-Money-Mustache-style simple math calculation, you

must notinclude any capital income that you make along the way (dividends, interest, rental income) as income and savings.I suppose it depends on how you account for it. In the scenario where you receive cash from a single tenant that is never reflected in your investment portfolio, aren’t you substantially understating consumption if you exclude it?

But I do assume that rental, dividend, interest, etc. income is reinvested in my portfolio, separate from my consumption vs. investment decisions. If you don’t, the MMM simple math is off.