For most people how much they earn and how much they spend is connected.
They are either always spending too much, or managing to save too little, and this remains the same no matter how much their income increases … it seems to be simply the ‘way they work’!
In a recent post, I illustrated this concept with this chart provided by Trent over at a Simple Dollar (in this post):
In a visual way, my spending used to look something like this over time (with green representing spending and blue representing income):
Most personal finance blog readers understand by now that their spending should be less than what they earn … they now understand at least the green line should be somewhat disconnected from the blue!
Think about it:
If you want to build up a nest-egg for retirement, how much of your current salary can you afford to spend?
100%? Of course not.
90%? Not likely.
85%? Nope. Won’t do it.
Michael Masterson publishes a neat set of guidelines for what % of your gross income you should save at various income/salary levels:
How Much You Earn What % of your gross Income You Should Save
If you are making less than $30,000 a year 15%
More than $30,000 but less than $50,000 20%
More than $50,000 but less than $150,000 25%
More than $150,000 but less than $300,000 30%
More than $300,000 but less than $500,000 35%
More than $1 million but less than $2 million 40%
More than $2 million but less than $5 million 50%
More than $5 million 55%
How would you achieve a 40% – 55% savings rate at higher income levels? Unfortunately, Michael doesn’t say!
But, it’s easier than you think if you have the luxury of starting when your salary is still in the $15,000 – $30,000 range:
1. You start by saving 15% of your gross (usually via your 401k – at least this is how most people will start), and then,
2. You add 50% of the gross value of all future salary increases (if you can’t manage gross, just pretend that really only receive half of any extra ‘take home’ pay),
3. You throw in 50% of any future ‘found money’: money you find lying in the street, spare change from your pockets, you tax refund check, lottery winnings (what were you doing buying lottery tickets, in the first place?!), inheritences, etc.)
You pretty quickly find that this approximates Michael’s recommendations.
The problem comes at higher income levels; once, I gave the real-life example of a guy who earns $3 million a year from his business (presumably after reinvesting some of his profits in the business to keep it expanding):
– He pays one third in taxes
– He invests (saves) another third
– He spends a third
Seems sensible, except that Michael suggests that he give Uncle Sam 33%, that he saves 50%, and that leaves just 17% – or, $510,000 – for spending. And, our ‘friend’ is spending $1 million!
The problem is this:
When his income stops, his lifestyle will have to stop because it’s unlikely that his investments would be able to support a $1 million lifestyle.
At any income level, as your income increases it’s important to disconnect how much you earn from how much you spend …
… for example, even if you think you are a millionaire, cap your spending when you get to the $150,000 – $250,000 level and put all the rest into passive investments.
That means that you can spend $150,000 – $250,000 or 5% of your passive investments (not including the value of your primary business or source of income), whichever is the greater.
Because that is sustainable, even if your income eventually stops.