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There isn’t a one size fits all answer to the question, “how much of your salary should you save?”. It really depends on your financial goals, how much money you currently have saved, how old you are, and what your appetite for risk is.

If you are in your 40s, don’t have any money saved to date, and have a low risk tolerance, you’re going to need to save much more than someone in their 20s who already has $100,000 and is willing to invest in riskier and higher returning investments like stocks.

Ideally, you should save as much as possible to be in the best position to achieve your financial goals. Learn how below.

Your Financial Goals

To determine how much you need to save, you first need to determine what your financial goals are. These could include buying a car or house, starting your own business, or even achieving financial independence.

Spend time thinking about your short-term and long-term financial goals. Write them down. Do some research and assign a value to them. These financial goals will inform you how much you need to save and when.

Short-Term Goals

Short-term goals are typically goals that you can complete in a year or less. Some examples include saving the maximum for your Roth IRA, getting a raise at work, paying off your credit card debt, etc.

Long-Term Goals

Long-term goals are typically goals that take longer than a year to complete. Some examples include paying off your house, saving for your child’s college, financial independence, etc.

The 50-30-20 budgeting rule

One simple rule to follow to ensure you’re saving a reasonable amount for retirement is the 50-30-20 budgeting rule. In essence this rule breaks down your income into three categories: needs, wants, and savings. No more than 50% of your income should be spent on needs and 30% on wants, with at least 20% left over for savings.

To start, figure out what your gross income is. Take out the things you don’t control like taxes. Everything else is fair game for budget purposes.

Needs

No more than 50% of your income should be earmarked for needs. Needs are those things that are necessary for survival like housing or rent, groceries, heating/cooling, transportation, etc. You should strive to keep your needs lower than 50% because you never know when an emergency (job loss, major medical event, etc.) may decrease your available monthly income. Also, the more you devote to savings and investments, the faster your net worth will increase and the quicker you’ll be able to reach your financial goals (including financial freedom or retirement).

Wants

No more than 30% of your income should be used for wants. Wants are all those budget items that aren’t needs or savings and investments. This includes items like entertainment, eating out, furniture, etc. Just like needs, you should strive to keep your percentage of income devoted to wants as low as possible.

Savings

You should reserve at least 20% of your income for savings. Savings include your savings accounts, emergency fund, and any retirement and investment accounts.

Why 20 percent?

Assuming you’re starting early (20s or 30s) and can earn an average investment return of 5 percent a year, you’ll need to save approximately 20 percent of your income to achieve financial independence at normal retirement age (60s to 70s).

For reference, the period from 1950 to 2009 (if you adjust the S&P 500 for inflation and account for dividends) returned an average of 7 percent a year. So, assuming the market continues this overall trend, it’s conservative to assume 5 percent a year.

The 4% Withdrawal Rate Rule

The calculations behind the 20 percent rule for savings come from a retirement rule of thumb, the 4% withdrawal rate rule. What this rule states is (assuming the stock market and economy behave similarly than they have in the past) you can withdraw 4% of your principal balance each year and never run out of money in your retirement account.

The 4% rule was created using historical data on stock and bond returns over the 50-year period from 1926 to 1976. This time period was chosen to include the severe market downturns in the 1930s and early 1970s as a worst-case scenario in retirement. Even using this worst-case scenario, the shortest time frame someone would theoretically exhaust their principal using the 4% withdrawal rule was in 33 years.

How Much Do You Need Overall?

Using this rule, you can determine a simple formula to determine how much principal you’ll need in retirement, to retire comfortably. To determine the total amount of money you need in retirement to use the 4% withdrawal rule successfully, you first need to determine how much your yearly expenses are. Now, multiply that amount by 25 (4% of 100 is 25, so even if you didn’t make any interest from your total for 25 years, you would still have enough to live off of for 25 years). Remember, in the study above, even in the worst performing period in modern stock market history, the principal still lasted 33 years. This is how much you’ll need to save to reach financial independence.

As an example, let’s say you spend about $40,000 per year. You anticipate that you’ll need roughly $30,000 in retirement (you assume your house will be paid off). The amount that you need to save in order to withdraw 4% each year is roughly $750,000 ($30,000 * 25 = $750,000).

This sounds like a lot, but this also assumes that you won’t receive any other income such as a pension or social security. If you save 20% and achieve a 5 percent return on investment, you’ll reach that number in 41 years. If you’re able to save 25% it goes down to only 37 years. As you can see, the more you can contribute earlier, the faster you’ll achieve financial independence.

How Age Affects How Much of Your Salary You Should Save

The earlier you start saving and investing in life, the more time you potentially have for compound interest to work on your investment accounts.

In the example above, if you started saving and investing 20% of your income when you were 23, you would be able to retire comfortably at 64. However, if you started when you were 40, you would be 81 before you could retire comfortably using the 4% withdrawal rule. This, of course, assumes that you would still potentially be drawing on it for a minimum of 33 years which most likely wouldn’t be the case if you started in your 80s.

The point is if you start later in life, you may need to make some adjustments like committing more to saving than just 20%, planning on lower expenses in retirement, not strictly adhering to the 4% withdrawal rule, or working part-time for a few years in retirement.

Related: How Much Money Should You Have Saved by 25?

How Risk Tolerance Affects How Much of Your Salary You Should Save

The 50-30-20 budgeting rule and 4% withdrawal rule both assume that you will generate an average of at least 5 percent annual return while you’re saving. This requires a fairly aggressive asset allocation to achieve this. If you are extremely risk averse, you may have difficulty finding investments that are both low on risk and generate a high level of annual return. Typically, it’s one or the other.

If you choose less risky investments like bonds or treasury notes, it’s going to take considerably longer to save up your nest egg.

Also, the 4% withdrawal rule also assumes that you continue to leave your retirement invested fairly aggressively. This is how you can potentially live on the retirement account forever because if you make more money in interest than 4% on average, your retirement account will actually grow in retirement. If you don’t invest it, you’ll run out of money in exactly 25 years.

Get Started Saving Money Now

As you’ve seen in the examples above, the longer you wait, the longer it will take to achieve your goals. So, get started now. The first step is creating a budget.

Create a Simple, Monthly Budget

To create a simple, monthly budget record your monthly gross income and expenses for the month. Next, using the data you’ve collected, tell each dollar you earn each month where to go. First, take out taxes as you have to pay this (check your dependents and make sure you’re getting as much as you should be getting through out the year). Next, take the remaining income and assign it to each budget item like healthcare, rent/mortgage, car payment, utilities, etc.

Next, look through your budget and try to identify any opportunities for savings. Things like insurance, entertainment, food budget, etc. are all common place where you could potentially find savings by either cutting back or shopping around.

Next, run our budget through the 50-30-20 budgeting rule. Remember, 50% for needs, 30% for wants, and at least 20% for savings. If the needs or wants are over their respective percentages or the savings is under 20%, you need to adjust your budget. The needs and wants should be thought of as a maximum while the savings is a minimum.

As an example, if you make $5,000 a month gross, let’s say you pay $1,000 in taxes. You now have $4,000 left to assign to budget items. You assign $1,200 to rent, $500 to utilities, $300 to car payment, $600 to food, $100 for household supplies, $100 for clothes, $100 to gas for your car, $100 for entertainment, and $1000 left over for savings/investments.

In this example, let’s assume the taxes, rent, utilities, car payment, food, and gas are needs. This is $3,700/$5,000 = 74%. The wants are $300/$5,000 = 6%. The savings is $1,000/$5,000 = 20%. Although this doesn’t strictly meet the definition of the 50-30-20 budgeting rule and you should try to identify opportunities to reduce your expenses so you can save more, you do still meet the minimum requirement of 20% savings.

Save for an Emergency Fund

Before you start paying extra towards debt or investing for retirement, you first need to give yourself a little cushion for unexpected financial emergencies. To start, save a small emergency fund ($1,000 – $2,000) to be able to weather any small financial bumps in the road.

Next, make an effort to pay down any debt you have as quickly as possible, preferably highest interest rate debt first. I prefer not to include your home in this calculation because if you do it delays the start of your investing.

Once you’ve paid off your debt, you should consider saving a larger emergency fund. It’s typically recommended that you save 3-6 months of expenses to be able to weather larger financial events like losing your job, a medical emergency, etc. This amount varies based on how secure you perceive your job and how steady your income is. If you and your spouse both work in sales and make money off of commission or you’re a one-income household, you may want to consider saving 6+ months expenses.

Take Advantage of Employer Retirement Match

Next, identify any opportunities for free money by taking advantage of an employer match. If your employer offers a match on your retirement contributions, you should make every effort to contribute as much as you need to in order to take full advantage of the match.

Invest the Rest of Your Savings and Put Your Money to Work

Once your debt is paid off (except your home), you’ve got a substantial emergency fund, and you’ve taken advantage of any “free money” at work, you need to put the rest of your money to work for you.

This means saving and investing for your short-term goals in accounts where you can readily access your money. For long-term investments like retirement, you should invest your savings into tax advantaged retirements accounts like a 401k, 457b, or IRA.

To meet the best of both worlds, you could invest in Roth options for the tax-advantaged accounts and be able to pull the principal back out when you need it.

Conclusion

The question, “how much of your salary should you save” has a different answer for everyone.

First, identify your financial goals and assign values to them (for financial independence, use the 4% withdrawal rule).

Next, create a budget and ensure you start saving as soon as possible. Create an emergency fund, pay off debt, then upgrade your emergency fund. Take advantage of any employer matches.

Then, start saving towards your financial goals. For short-term financial goals, make sure your money is somewhere you can access it easily. For long-term financial goals, consider placing your money in tax-advantaged accounts like a 401k, 457b, or IRA.

The sooner you start saving and the more you save earlier, the faster you’ll reach financial independence.

How much of your salary do you save? Any pointers for people just starting out?

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