When you make money, it can only go to four places.
You can pay taxes.
You can pay down debt.
You can spend it.
You can save it.
That’s it.
The basis for determining if you’re using your money wisely comes from measuring what percentage of your income goes to each of these four categories—and if it’s the appropriate amount for where you’re at in life, and where you want to go.
Tax Rate
To calculate your tax rate, add up your total federal income tax, state and local income tax, and payroll tax paid for the year. Then divide that number by your annual gross income.
Example:
- Gross income: $120,000
- Total taxes paid (federal + state + FICA/payroll): $23,000
- Tax rate: $23,000 ÷ $120,000 = 19.1%
This is an honest measure of your real tax burden. It cuts through the noise of marginal brackets and tells you exactly what percentage of everything you earned actually went to taxes.
Now, I’m sure there are people reading this who think that your ideal tax rate should be 0%. But unless you’re continuously reinvesting all of your income back into your business, or buying underperforming real estate every year while also executing cost segregation studies, or giving away all of your money to charity, you’re going to owe taxes.
Paying taxes is a good thing. It means you’re making money.
You can either have an income problem or an income tax problem. And you want an income tax problem.
This is the hardest of the four to give a general benchmark for because it’s completely dependent on your income and how you make your income. But if you’re above $200,000 in household income, you should reasonably expect to pay around 25% toward taxes each year.
Debt Rate
To calculate your debt rate, add up all of your monthly debt payments. This includes a mortgage, car loans, student loans, business loans, a boat loan, etc. Figure out your annual debt obligations, then divide that number by your annual gross income.
Example:
- Gross income: $120,000
- Total annual debt payments (mortgage + car + student loans): $35,000
- Debt Rate: $35,000 ÷ $120,000 = 29.2%
Similarly to paying taxes, there are plenty of people who will tell you the ideal debt rate should be 0%.
However, unless you’ve been brainwashed by Dave Ramsey, I think most people understand that debt can be used as a powerful financial tool.
Certain debts, like student loans, a business loan, or a mortgage, can be used to increase your skills, increase your income, and buy appreciating assets to grow your net worth at a much faster pace than if you refused to go into debt.
As you’re nearing retirement, you’ll likely want to get rid of any, if not all, lingering debts to lower your monthly expenses. But for those in the early or middle stages of their career, there’s typically a healthy amount of debt payments to have. Your ideal rate will also depend on your personal feelings toward debt. Some people have no problem at all stomaching debt, while for others, merely the thought of debt causes a loss of appetite.
Here are some general benchmarks:
- Low: 0% to 15%
- Average: 15% to 35%
- High: 35%+
Spending Rate
To calculate your spending rate, add up all of your monthly expenses (excluding debt payments). This includes utilities, food, entertainment, vacations, insurance premiums, charitable giving, a gym membership, etc. Figure out your annual living expenses, then divide that number by your annual gross income.
Example:
- Gross income: $120,000
- Total annual spending (food + transportation + entertainment, etc.): $40,000
- Spending Rate: $40,000 ÷ $120,000 = 33.3%
It’s crucial to track how much money you spend. You don’t need to have a strict budget, but at a minimum, you should monitor where your money is going. Speaking from personal experience, those who don’t track their spending will underestimate their expenses by at least 10% to 20%.
Personal finance gurus love to spend-shame you into saving every last penny, but the truth is there can be room for both saving and spending, frugality and extravagance, delayed gratification and enjoyment.
The key to smart spending habits is to align your spending with what’s most important to you. Studies have found that value-aligned spending was a stronger indicator of happiness than an individual’s total income or total spending.
A powerful exercise is to actually sit down and make a list of your priorities, values, and favorite activities. Then compare that list with your purchases. You might be surprised at how many dollars you’re spending on things in the middle and bottom of your list.
Your spending rate will largely depend on your income. If you make $100,000 a year and have a family, you might have a 50% spending rate simply due to cost-of-living needs.
There’s a baseline amount of costs to live a decent life that you can’t get around — you can only reduce your expenses to a certain extent.
But if you make $2,000,000 a year, a 50% spending rate might be excessive.
Here are some general benchmarks:
- Low: 15% to 25%
- Average: 25% to 45%
- High: 45%+
Savings Rate
To calculate your savings rate, add up everything you’re saving. This includes contributions to a 401(k), an IRA, a brokerage account, an HSA, an emergency fund, a down payment on a house, etc. This should not include saving for kids’ college, a vacation, a couch, or even a car. That’s not really saving, it’s just deferred spending. Your savings rate is any money put into appreciating assets that can be used to replace your income.
Example:
- Gross income: $120,000
- Total annual savings (401k + after-tax investments): $22,000
- Savings Rate: $22,000 ÷ $120,000 = 18.3%
If I only had one number to determine how well someone is doing financially, their savings rate would probably be sufficient. If you have a consistent, healthy savings rate, it almost doesn’t matter what you do with the rest of your money.
As I mentioned above, there can, and should, be room for both spending and saving in everyone’s budget. But if there’s one part of that balancing act we’re better at as a society, it’s definitely spending. We are a nation of spenders.
The national average savings rate is currently hovering around 4%.
And that number is brought up by people who are good savers. The median savings rate is 0%.
And I get it, saving is one of those things that’s far easier said than done. However, being able to set aside money for your future, regardless of external economic conditions, is perhaps the most important financial skill you can possess.
Here are some general benchmarks:
- Low: 0% to 5%
- Average: 10% to 20%
- High: 20%+
Thanks for reading!
Jake Elm, CFP® is a financial advisor at Dentist Advisors. Jake a graduate of Utah Valley University’s nationally ranked Personal Financial Planning program. As a financial advisor at Dentist Advisors, he provides dentists with fiduciary guidance related to investments, debt, savings, taxes, and insurance. Learn more about Jake.