How much should I save?

“How much should I save?” – this is one of the most common questions coming from my clients. As a financial planner, part of my job is to help people figure out how much they should save once they have clearly defined goals: buying a house in five years with 20% down payment, sending children to private college in 10 years, retiring at 65, etc. However, many young people, facing the first substantial paycheck in their lives, simply want to know how much they should set aside so they don’t spend it all. A lot of people are seeking this confirmation of, “Oh, you’re saving 20% of your income, you will be fine.”

But is there a magic percentage to save that will guarantee your financial security? If you are a twenty or thirty something young professional who is still sorting through your goals in life while transitioning into financial independence, how much should you aim to save now to live a comfortable life while making sure you are saving enough for your future goals? Without a comprehensive plan to guide you, I would suggest a rule of thumb that I call “50/50” rule.

So what is this “50/50” rule? It means that you should aim to “spend half and save half” of your income after paying for all of your obligations, such as taxes, interest payments on loans and mortgages, and charitable giving if you are so inclined.

50% sounds like a lot, but is it really? Let’s assume that you earn $100,000 a year, paying roughly 25% in taxes (including federal, state, and payroll taxes), 3% in student loan interest, and 2% in charitable giving. The 50/50 rule will dictate that you should spend $35,000, or 35% of your total income, and save $35,000. See the illustration below.

35% still sounds a lot. Is it really necessary to save that much? Let’s further assume that you are now 30 years old and single. You would like to stop working for pay no later than when 60 years old, and you have a life expectancy of 90. You don’t plan to get married or have children, and don’t have any other major life goal that requires a big lump sum. This means you are effectively using next 30 years of your life to save enough for the next 30 when you do not have an income.

Let’s also say that you have a pessimistic outlook of the future: you think social security system is going to go bankrupt, and do not expect your savings to grow much above inflation. Therefore you have to spend and save roughly the same amount before you retire so your savings can sustain your same spending level in retirement; hence the 50/50 rule.

Of course, many of these assumptions do not apply in real life. You can accept more risks to increase your investments’ long-term return. You may very well still receive social security at an older age. These conditions would allow you to spend more and save less now. On the other hand, you can also end up married and have kids, (although you have vowed not too), so that your capacity to save is greatly diminished in those years. It will then be of great advantage if you have saved more than you spent when you could do so.

Another major benefit of sticking to the 50/50 rule is that it curbs your spending. Under the previous example, if you only aim to save 10% of your income, the flip side is that you are spending 60% of your income, and it will grow as your salary rises. When you finally stop bringing in income, it is very unlikely you would cut your standard of living drastically. So you are really expecting that 10% of your income accumulated over 30 years will grow to provide at least 80% of your highest pre-retirement income for another 30 years. (You still have to pay taxes, although the rate could be lower.) The power of compounding is strong, but perhaps not that strong.

As mentioned earlier, it can be much more difficult for you to achieve the 50/50 rule when your income doesn’t increase meaningfully but you suddenly have more mouths to feed. Therefore it is all the more important to “over save” when you have the opportunity to do so without sacrificing too much. (See my other posts about smart ways to save.) However, if you are already in the situation where you have to support a family, do not despair. You will have the chance to catch up on your savings once your children leave home. You just need to make sure that the extra spending is truly on your dependents and not on yourself, so you can easily appropriate the portion of expenditure back into savings.

The same principal applies if you have huge financial obligations even before spending and saving. For example, you might be swamped with student loan payment; instead of 3% of your income, you are paying 30%. So this leaves you 45% of the income to support yourself, and you can hardly save 10% due to the high cost of living. Just remember that loan payments are only for another few years, at which point you can start saving that 30% of income (or 25% so you can start spending a little bit more.)

At this point you may be thinking, “But I want more in life than expecting retirement!” I totally agree with you, and the 50/50 rule will actually help you with that. You may want to go back to graduate school, have a big wedding, or take one year off work to travel around the world. These require funds. Before you have a clear plan of when you want to achieve these short to mid-term goals, you should try double hard to get to 50/50; so when the opportunity comes, you have the money to fulfill your dreams. Otherwise you may never go for them, or have to resort to debt.

Eventually, the 50/50 rule does not substitute for a comprehensive financial plan that actually tailors to your goals and personal situation. In addition to knowing how much to save, you need professional advice on how to most effectively deploy your savings into assets that can achieve your goals, and how to protect against risks of income and property loss. Even if you don’t have a clear grasp of your goals now, a financial planner can work with you to clarify what you are saving for. After all, saving on its own is not a goal; it’s simply a way to help you spend on something that is meaningful for you in the future.