Figuring How Much You Need to Save
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One of the most common financial questions people have is: Am I saving enough? That’s a tough question to answer, since the amount you need to save depends on so many factors; your age, your goals, whether you expect to borrow to reach your goals, your income, and the rate of return on your savings, for starters. A general guideline is that you should try to save at least 10% of your gross income each year. That many sound impossible. If so, don’t just throw up your hands. Instead, try a strategy of saving 4% to 8% of your gross income in your twenties and doubling that percentage in your thirties and forties. In your fifties, when your children’s college bills have been paid off and thus your expenses have dropped but retirement looms, you should attempt to squirrel away 20% of your pay.
But rather than rely on general rules, you’ll help safeguard your future by plugging in some real numbers for your financial situation. The key is to determine what your financial goals are and when you want to pay for them. The worksheet below will show you how much you should save each month to meet a specific goal. Here’s what you need to know to fill in the rows:
Column 1: When you make a list of your objectives, include your short-term and long –term goals plus some that are just for fun, like spending two weeks at spa or buying that shiny Harley-Davidson. You’ll see that there’s a special place at the bottom of the worksheet for you to list the amount you think you need to save for college and retirement; you’ll find specific advice about figuring out how much to set aside for your golden years and your kids’ college educations in its respective topics. If you’re planning to buy a new home, assume that the amount required for a down payment and closing costs will equal roughly 16% of the price of the home.
Column 4: A car that sells for $12,000 today may cost $14,000 in three or four years. So you’ll need to consider how inflation will raise the cost of whatever you plan to buy in future years. It’s impossible to determine exactly just how much inflation will add to the price of a new car or a new home, since no one knows exactly how the economy will fare. But you can use the factors shown here for a quick-and-dirty estimate of the future cost of goals that are a year or more away. They assume that prices will increase by 5% a year, close to the historical average inflation rate.
Column 6: Subtract any savings you already have from the amount you think you’ll need. For example, if you already have $5,000 to put toward a $25,000 down payment in 1998, list just the $20,000 short-fall. Don’t plan to use any of the cash you have earmarked for your emergency fund, since you shouldn’t tap that reserve for any purpose other than a true financial crisis.
Column 7: Here’s where you need to forecast the interest rate your savings will earn after taxes. You can make an educated guess for the average rate of return on your investments by using the average annual returns for the types of investments you expect to use. Historically, stocks have earned about 10% a year on average, while taxable bonds have returned 5% and Treasury bills roughly 3%.
Unless you plan to keep your savings in a tax-deferred savings plan like an IRA, Keogh, or 401(k), you’ll have to reduce your return by the rate at which you pay federal income taxes each year. For example, if you are in the 28% tax bracket, your after-tax return on an investment that pays an average of 10% a year would be about 7.2%, which is calculated like so:
10 – (10 x 0.28) = 7.2%
This method may exaggerate the amount you’ll lose to taxes if you’re in a high tax bracket and decide to keep your savings in growth-type investments, however. That’s because growth stocks and growth mutual funds often pay out little by way of taxable income each year. Instead, most of their gains consist of an increase in their share price. That price appreciation is taxed at the long-term capital-gains rate –the maximum rate is 28% -only when you sell the stock or mutual fund. So you would lose less of your return to taxes if you bought a growth stock or growth mutual fund and held on to it for at least a few years.
You’ll also have to adjust your return for inflation. You can do this by subtracting an expected rate of inflation from your expected after-tax return. For example, if you think your savings will earn 7.2% after taxes and you think inflation may average 5% or so, your real return is about 2.2%. To find a more accurate real return, get a calculator and use the following formula:
1 + after-tax return - 1 x 100
1 + inflation rate
So, for example, if you think inflation will average 5%, your real after-tax return on an investment that pays 7.2% a year after taxes would be 2.1%.
1.072 / 1.05 – 1 x 100
Column 8 and 9: Once you have an estimate of your return after taxes and inflation, use the divisor table to look up the approximate divisor for your time horizon. Divide it into your savings shortfall. The result is the amount you need to set aside each month in order to meet that goal.
On the next blog post, I’ll put together all the puzzle so stay tune.
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3 Responses to “Figuring How Much You Need to Save”
Awesome site, I am going to read more of your posts soon.
By
Allison Sellers (Who am I?) on Nov 22, 2008