Author Topic: Saving 50% of gross or net?  (Read 27592 times)

SpendyMcSpend

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Saving 50% of gross or net?
« on: May 20, 2012, 03:06:51 PM »
Also, does paying down debt count as "savings"?

For example, my last paycheck I made $3729 gross.  A few pre-tax deductions were about $50 (health insurance, dental etc.)  I saved $576 in my 401k.  $821 was paid in taxes.  I paid off $420 of a work loan (0%) I took pay off high-interest credit card debt.  $387 or so will be put into short-term savings in my ING account.

Gross income 3729
(50) insurances pre-tax
(576) 401k savings pre-tax
(821) taxes, FICA, state income tax
(420) after tax pay-off of loan
(45) after tax gym
= 1817
(387)

1430 will be used for various expenses including rent, utilities, food, volleyball sign-up, getting a new wheel for my bike.

If you include the $420 debt paydown I saved 37% of my gross income.  Is that the right way to count it?

Next paycheck I will save more because rent and utilities won't be on there.

SpendyMcSpend

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Re: Saving 50% of gross or net?
« Reply #1 on: May 20, 2012, 04:27:12 PM »
Ok I included 2 paychecks (month) in this analysis:

Before tax
$3729 x 2= $7458
(1832) taxes
(1152) 401k
(62) health insurance
(13) Dental insurance
(125) before tax transit

After tax
(840) employee loan
(90) gym
(155) after tax transit

Left approximately $3700

"Savings" = $1152+840+ whatever I use towards stormclouds fund/snowball

It looks like I will be saving about $1100 this month towards stormclouds so my total "savings" will = $1152+840+1100 = $3092

41% of my gross towards savings/debt payoff

JJ

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Re: Saving 50% of gross or net?
« Reply #2 on: May 20, 2012, 04:34:43 PM »
I wouldn't worry about the right way to count it.  If it is a large percentage of either gross or net and you are aware of where you are spending, and reducing / eliminating wastage you're on the right track.  It's all about time from now to FI - you can pick for yourself whether measuring absolute monthly savings ($s), percent of gross or percent of net is a more important short term indicator of progress.  Similarly, you can pick for yourself whether you want to count paying down debt as savings (which, I think, most would).  You just need a measurement that works in the short term to confirm you are on track for your long term objectives.

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Re: Saving 50% of gross or net?
« Reply #3 on: May 21, 2012, 02:49:17 AM »
I have wondered if you could count paying off as debt as savings too.  I think so - just to make up #'s,  if you have assets of $100,000, and debt of $10,000, your net  is $90,000.  If you pay off that debt, now your net is $100,000 - so it is the same as saving $10,000.  When I did my calculations I counted debt payments, and the amount of my house payment that goes to principal.  Don't know if that is the right way, but it made me feel good.
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velocistar237

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Re: Saving 50% of gross or net?
« Reply #4 on: May 21, 2012, 05:24:19 AM »
The savings rate is usually figured using your net income. This is because once you're retired, taxes usually go down. If you use gross income, you have to count taxes as an expense.

I count debt payments as savings, but if you want to split hairs, you can count the interest portion as an expense.

To some extent, like JJ says, it doesn't matter. I like to be very precise with my finances, but in the end, the savings rate is used to predict the future, and really it's up to the markets, so it's kind of like measuring with calipers when you're going to end up using an ax. Precision is important for getting your expenses down to the lowest level you can be comfortable with, and that's about it.

Mr Mark

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Re: Saving 50% of gross or net?
« Reply #5 on: May 21, 2012, 09:05:15 AM »
I like the axe analogy!

For your house & mortgage, the payments against principal should be counted as savings. The interest payments (net of tax unless you are below the standard deduction limit) & property taxes, etc as expenses.

In the short term the stock market is yielding around 3-4%. So if you repay a loan that's charging you, say, 6 or 7% that is a great investment.

But in the end the target is a big 'Stash of net worth, so debt should be a minor player in your finances as soon as you can, [except perhaps for low rate, long term fixed loans secured on property].

Bank

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Re: Saving 50% of gross or net?
« Reply #6 on: May 21, 2012, 11:23:14 AM »
The savings rate is usually figured using your net income. This is because once you're retired, taxes usually go down. If you use gross income, you have to count taxes as an expense.


Star, how do you personally account for pre-tax savings and expenditures in your calc?  I've struggled with this one.  Pre-tax retirement plan contributions are definitely savings, but it feels like gaming the ratio to add them to both savings and net income without adjusting for taxes --- you'll have to pay them at some point, after all.  However, to tax effect retirement savings and pre-tax health insurance premiums can get complicated. 

I like to know my savings rate for personal bragging rights and face punching purposes.   As others have pointed out, it's the size and growth of the 'stash that really matters, so I don't want to make it too complicated.  Just curious how you think about this issue.

SpendyMcSpend

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Re: Saving 50% of gross or net?
« Reply #7 on: May 21, 2012, 11:44:38 AM »
The savings rate is usually figured using your net income. This is because once you're retired, taxes usually go down. If you use gross income, you have to count taxes as an expense.


Star, how do you personally account for pre-tax savings and expenditures in your calc?  I've struggled with this one.  Pre-tax retirement plan contributions are definitely savings, but it feels like gaming the ratio to add them to both savings and net income without adjusting for taxes --- you'll have to pay them at some point, after all.  However, to tax effect retirement savings and pre-tax health insurance premiums can get complicated. 

I like to know my savings rate for personal bragging rights and face punching purposes.   As others have pointed out, it's the size and growth of the 'stash that really matters, so I don't want to make it too complicated.  Just curious how you think about this issue.

Exactly!  The math is so fuzzy so I ended up doing it off of my gross.

velocistar237

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Re: Saving 50% of gross or net?
« Reply #8 on: May 21, 2012, 11:57:23 AM »
The savings rate is usually figured using your net income. This is because once you're retired, taxes usually go down. If you use gross income, you have to count taxes as an expense.

Star, how do you personally account for pre-tax savings and expenditures in your calc?  I've struggled with this one.  Pre-tax retirement plan contributions are definitely savings, but it feels like gaming the ratio to add them to both savings and net income without adjusting for taxes --- you'll have to pay them at some point, after all.  However, to tax effect retirement savings and pre-tax health insurance premiums can get complicated. 

I like to know my savings rate for personal bragging rights and face punching purposes.   As others have pointed out, it's the size and growth of the 'stash that really matters, so I don't want to make it too complicated.  Just curious how you think about this issue.

Exactly!  The math is so fuzzy so I ended up doing it off of my gross.

It wasn't until recently that I counted my health insurance benefit as income and my health insurance as an expense. I used to multiply my 401k savings by 0.7 or 0.8 when I used a spreadsheet, but now I just count the whole thing. My total income now comes out to 10% less than my gross salary. If you use gross and include health insurance as an expense, you won't be far off in your years-to-retirement calculation. I think I'll continue to use (net income + 401k savings + health insurance benefit - charity giving) as income.

Mr Mark

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Re: Saving 50% of gross or net?
« Reply #9 on: May 21, 2012, 12:15:02 PM »
I didn't realise it was so complicated.

How about:
Net income = what you could have saved assuming you had no expenses at all. Imagine some sugar-daddy had paid all your bills.
Net savings = assets created or added to, plus debt reduced; so = net savings + net portfolio additions + principal repayments + increase in any pension fund*

*accounted as best you can in today's $

SpendyMcSpend

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Re: Saving 50% of gross or net?
« Reply #10 on: May 21, 2012, 12:19:04 PM »
I didn't realise it was so complicated.

How about:
Net income = what you could have saved assuming you had no expenses at all. Imagine some sugar-daddy had paid all your bills.
Net savings = assets created or added to, plus debt reduced; so = net savings + net portfolio additions + principal repayments + increase in any pension fund*

*accounted as best you can in today's $

The problem is accounting for taxes.  You are taxed less if you put aside money pre-tax so it's hard to get the right numbers. 

Are you suggesting taking your net income after taxes as if you hadn't put anything into your 401k?

Mr Mark

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Re: Saving 50% of gross or net?
« Reply #11 on: May 21, 2012, 12:45:50 PM »
I didn't realise it was so complicated.

How about:
Net income = what you could have saved assuming you had no expenses at all. Imagine some sugar-daddy had paid all your bills.
Net savings = assets created or added to, plus debt reduced; so = net savings + net portfolio additions + principal repayments + increase in any pension fund*

*accounted as best you can in today's $

The problem is accounting for taxes.  You are taxed less if you put aside money pre-tax so it's hard to get the right numbers. 

Are you suggesting taking your net income after taxes as if you hadn't put anything into your 401k?

Nope, the opposite. Actual net income (cash in your bank account) , which means 'counting' any tax deductions you're due, even if those deductions are related to your savings.

arebelspy

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Re: Saving 50% of gross or net?
« Reply #12 on: May 21, 2012, 12:47:40 PM »

The problem is accounting for taxes.  You are taxed less if you put aside money pre-tax so it's hard to get the right numbers. 

Are you suggesting taking your net income after taxes as if you hadn't put anything into your 401k?

In a similar problem, how do you treat money saved pretax vs post tax?  Money saved in a Roth is worth more than money saved in a 401k.
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warped

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Re: Saving 50% of gross or net?
« Reply #13 on: May 21, 2012, 01:01:47 PM »
I use net = Gross - taxes - health insurance.

I know the difference between 401k, Roth, and non-retirement accounts, but I don't adjust for that in these calculations.

I also count debt paydown as savings.

The 401k, Roth, investment accounts, debt paydown, etc debate is an issue of how to allocate savings, the percentages are looking at how well you're saving.

Two different questions, imho.

Mr Mark

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Re: Saving 50% of gross or net?
« Reply #14 on: May 21, 2012, 01:05:07 PM »

The problem is accounting for taxes.  You are taxed less if you put aside money pre-tax so it's hard to get the right numbers. 

Are you suggesting taking your net income after taxes as if you hadn't put anything into your 401k?

In a similar problem, how do you treat money saved pretax vs post tax?  Money saved in a Roth is worth more than money saved in a 401k.

Pre-tax. The assumption that Roth savings are worth more is a matter for calculating portfolio ROI and eventual passive income estimates, but not annual savings rate I'd say.

arebelspy

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Re: Saving 50% of gross or net?
« Reply #15 on: May 21, 2012, 02:29:46 PM »

The problem is accounting for taxes.  You are taxed less if you put aside money pre-tax so it's hard to get the right numbers. 

Are you suggesting taking your net income after taxes as if you hadn't put anything into your 401k?

In a similar problem, how do you treat money saved pretax vs post tax?  Money saved in a Roth is worth more than money saved in a 401k.

Pre-tax. The assumption that Roth savings are worth more is a matter for calculating portfolio ROI and eventual passive income estimates, but not annual savings rate I'd say.

(Emphasis mine.)

Pretax?  So if you save 5k in your Roth, you count that as saving 6.5k (or whatever, depending on your tax rate? I assumed approximately 25% there), but 5k saved in a 401k you count as 5k?
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Mr Mark

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Re: Saving 50% of gross or net?
« Reply #16 on: May 21, 2012, 02:53:56 PM »

The problem is accounting for taxes.  You are taxed less if you put aside money pre-tax so it's hard to get the right numbers. 

Are you suggesting taking your net income after taxes as if you hadn't put anything into your 401k?

In a similar problem, how do you treat money saved pretax vs post tax?  Money saved in a Roth is worth more than money saved in a 401k.

Pre-tax. The assumption that Roth savings are worth more is a matter for calculating portfolio ROI and eventual passive income estimates, but not annual savings rate I'd say.

(Emphasis mine.)

Pretax?  So if you save 5k in your Roth, you count that as saving 6.5k (or whatever, depending on your tax rate? I assumed approximately 25% there), but 5k saved in a 401k you count as 5k?

No, I'm trying to keep it as simple & fundamental as possible.

If you put 5k into anything savings-wise, it counts the same (a $5k investment expense). In the year you're talking about, any tax implications are part of income. Gross income (X), less taxes/SS/deductions taken etc paid  (Y) = net income (X-Y) = cash you could choose to 'stash.

You can't save more than your net income. (? hmm, I think?)

arebelspy

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Re: Saving 50% of gross or net?
« Reply #17 on: May 21, 2012, 02:57:44 PM »
So if you contribute 17k to a 401k (which reduces your net income), how do you count that?
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gecko10x

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Re: Saving 50% of gross or net?
« Reply #18 on: May 21, 2012, 03:01:28 PM »
What about employer matching? If you contribute 4% and your employer contributes 4%, do you count it as 4% or 8%?

Bank

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Re: Saving 50% of gross or net?
« Reply #19 on: May 21, 2012, 03:22:15 PM »
What about employer matching? If you contribute 4% and your employer contributes 4%, do you count it as 4% or 8%?

I count that as additional income AND additional savings.  And like Star used to do, I reduce my 401K contributions by a small percentage to reflect the implied tax liability.  It's not by 30%, however, because the present value of that tax liability (realized, say 15 years down the road) is much lower than its current value.  I generally use 10%, just because it's a nice round number that doesn't make my head hurt.

And to chime in on one of the earlier issues above, in my opinion there is no difference between savings and debt reduction.  Debt reduction is savings starting from a negative basis, rather than a positive one.
« Last Edit: May 21, 2012, 03:23:47 PM by Bank(rupt$y) »

Mr Mark

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Re: Saving 50% of gross or net?
« Reply #20 on: May 21, 2012, 03:44:17 PM »
What about employer matching? If you contribute 4% and your employer contributes 4%, do you count it as 4% or 8%?

I count that as additional income AND additional savings. 

Exactly. The employer contribution would could as income, and as a savings investment too, boosting your measured savings rate in the process.



And to chime in on one of the earlier issues above, in my opinion there is no difference between savings and debt reduction.  Debt reduction is savings starting from a negative basis, rather than a positive one.
Also agree.

Mr Mark

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Re: Saving 50% of gross or net?
« Reply #21 on: May 21, 2012, 04:02:22 PM »
So if you contribute 17k to a 401k (which reduces your net income), how do you count that?

Contributing 17k to a 401k counts as a $17k investment/saving, and if it generates a tax deduction or an employer match, those both would count as contributions to net income.

I'd count Employer provided or subsidised health care as income too.

velocistar237

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Re: Saving 50% of gross or net?
« Reply #22 on: May 21, 2012, 05:38:48 PM »
You can count 401k income without discounting it if you plan on living below the standard deduction. Otherwise, scale it by the overall tax rate you expect to have in retirement. The only reason I count the whole amount now is that I just use the net worth number in Mint. Does NetworthIQ account for taxes on the 401k?

Oh, and this:


Mr Mark

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Re: Saving 50% of gross or net?
« Reply #23 on: May 21, 2012, 08:57:47 PM »
You can count 401k income without discounting it if you plan on living below the standard deduction. Otherwise, scale it by the overall tax rate you expect to have in retirement. The only reason I count the whole amount now is that I just use the net worth number in Mint. Does NetworthIQ account for taxes on the 401k?

Oh, and this:



sorry I really don't see how eventual 401k tax rates on withdrawal impact your savings rate (now) at all.  Maybe I'm missing something.

arebelspy

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Re: Saving 50% of gross or net?
« Reply #24 on: May 21, 2012, 09:33:31 PM »
sorry I really don't see how eventual 401k tax rates on withdrawal impact your savings rate (now) at all.  Maybe I'm missing something.

Because if I put $5,000 in a 401k or I put $5,000 in a Roth, you may want to call them both $5,000, but one is worth about 25% more than the other.

So if I (hypothetically) save 5k in the roth of a 20k gross, or I save 5k in a 401k of a 20k gross, either way you want to say I saved 25%, but I don't necessarily agree that's the case.  Do you see how they're different, and that saying both are 25% savings rate may be simpler, but it's not necessarily the same?
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arebelspy

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Re: Saving 50% of gross or net?
« Reply #25 on: May 21, 2012, 09:34:41 PM »
You can count 401k income without discounting it if you plan on living below the standard deduction. Otherwise, scale it by the overall tax rate you expect to have in retirement.

That's not a bad idea.

And yes, cutting with an axe, but still interesting to discuss and think about, regardless of the fact that it's (mostly) unimportant.
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Mr Mark

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Re: Saving 50% of gross or net?
« Reply #26 on: May 21, 2012, 11:31:31 PM »
sorry I really don't see how eventual 401k tax rates on withdrawal impact your savings rate (now) at all.  Maybe I'm missing something.

Because if I put $5,000 in a 401k or I put $5,000 in a Roth, you may want to call them both $5,000, but one is worth about 25% more than the other.

So if I (hypothetically) save 5k in the roth of a 20k gross, or I save 5k in a 401k of a 20k gross, either way you want to say I saved 25%, but I don't necessarily agree that's the case.  Do you see how they're different, and that saying both are 25% savings rate may be simpler, but it's not necessarily the same?

Once the investment has been made, I count the differential performance of the investments, say 401k vs Roth, within the overall performance of the 'Stash, and nothing to do with annual savings rate. You could also invest in cash, or real estate, or... loads of stuff. They all have different 'after tax ROI' and other qualities. This is not a savings issue, but a portfolio performance issue and an income issue.

'I have $5k to invest. This counts as the savings. Where to invest that $5k, is a portfolio issue.

Plus, if investing it one way gives me a tax deduction now, I'll add that impact to the income side when considering where to invest, because the deduction increases net income (subject to exceeding minimum deduction) and, all other things being equal, actually lowers your savings rate.

If what you want to measure (see OP) is annual 'savings rate' from earned income, future performance and future tax efficiency of the investments doesn't matter. (not to say it isn't important overall)

arebelspy

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Re: Saving 50% of gross or net?
« Reply #27 on: May 22, 2012, 08:33:55 AM »
You missed my point. I'm not talking about performance going forward.  I'm talking about right now.

Hypothetical:
I'm in a 25% tax bracket.  I make 20k/yr.

Option 1: I could contribute $6,666 to a 401k.
Option 2: I could take that money, (which becomes 5K after 25% taxes) and put it into a Roth.

Ignoring going forward, just counting the value of the money NOW, you seem to want to say that in option 1, I saved 6,666/20K = 33%, but in option 2 I saved 5/20 = 25%.

Is that correct?
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Bank

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Re: Saving 50% of gross or net?
« Reply #28 on: May 22, 2012, 09:19:09 AM »
This may be getting pedantic, but it's not really accurate from a financial standpoint to count the full tax load unless you are close to retirement.  Say your current pre-tax savings are $4,000 and your tax rate is 25%.  If the money were taxed today, you would pay $1,000 in taxes BUT you are not being taxed today.  You will pay that $1,000 when you retire and withdraw it -- say in 15 years.

If we assume a discount rate of 4%, the present value of your tax liability is $1000/(1.04^15), or $555.  $555/4000 = 13.9%.

This is the real power of tax deferred savings --- it doesn't just put off tax payments, it actually reduces them (in real terms).
« Last Edit: May 22, 2012, 09:21:56 AM by Bank(rupt$y) »

Mr Mark

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Re: Saving 50% of gross or net?
« Reply #29 on: May 22, 2012, 09:36:50 AM »
You missed my point. I'm not talking about performance going forward.  I'm talking about right now.

Hypothetical:
I'm in a 25% tax bracket.  I make 20k/yr.

Option 1: I could contribute $6,666 to a 401k.
Option 2: I could take that money, (which becomes 5K after 25% taxes) and put it into a Roth.

Ignoring going forward, just counting the value of the money NOW, you seem to want to say that in option 1, I saved 6,666/20K = 33%, but in option 2 I saved 5/20 = 25%.

Is that correct?

I think 'savings rate' should refer to amount saved vs effective net income after tax. That way it's possible to have a 100% saving rate (if all expenses are paid for). If you reference the gross income, savings rate can't be 100% (assuming there's always some tax).


So I'd say:

Option 1
You earned 20k gross, and invested 6.66k in a 401k (from pre-tax income). Your net income was 20k gross - 5k tax + 1.66k deduction = 16.66k, Savings rate is 6.66/16.66 = 40%

Option 2
You earned 20k gross, and invested 5k in a Roth (after tax income). Your net income was 20k gross - 5k tax  = 15k, Savings rate is 5/15 = 33.3%

arebelspy

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Re: Saving 50% of gross or net?
« Reply #30 on: May 22, 2012, 11:31:10 AM »
And you're okay that in both instances you have the same gross and same in pocket at the end, but two different savings rates?
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Re: Saving 50% of gross or net?
« Reply #31 on: May 22, 2012, 11:32:54 AM »
This may be getting pedantic, but it's not really accurate from a financial standpoint to count the full tax load unless you are close to retirement.  Say your current pre-tax savings are $4,000 and your tax rate is 25%.  If the money were taxed today, you would pay $1,000 in taxes BUT you are not being taxed today.  You will pay that $1,000 when you retire and withdraw it -- say in 15 years.

If we assume a discount rate of 4%, the present value of your tax liability is $1000/(1.04^15), or $555.  $555/4000 = 13.9%.

This is the real power of tax deferred savings --- it doesn't just put off tax payments, it actually reduces them (in real terms).

Do you have some links that explain this more?
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Re: Saving 50% of gross or net?
« Reply #32 on: May 22, 2012, 11:56:36 AM »
If you include the $420 debt paydown I saved 37% of my gross income.  Is that the right way to count it?

Aside from all the talk about tax differed accounts and all that jazz,
I read this as simply a question of whether paying debt counts in the "savings rate" calculation, and to that a simple "yes" would suffice.
The net effect is that your net worth is increasing by the amount you are putting aside, whether to debt or to savings.
True, at some point in your non-mustachian past you did spend that debt on something, but what's done is done.  As of now, you are spending money on goods or services by paying down old interest bearing debt.  Not paying interest is effectively equivalent to passive income.  Once that debt is paid, you have free up an amount of cash (which was going to payments) which you have been living without, which can now be transferred to an equal amount of monthly savings.


I look at it simple:
It doesn't matter what you do with those savings.  Sure, investing them and generating passive income is wise, but savings rate is just savings rate.  You could stick it all under the mattress in cash, and its still money you are saving.

Income would be all money coming in from all sources... which you can actually spend.
Your discretionary income.
I.e. whatever the number says on the very last line of your paystub.  For purposes of savings rate, ignore any taxes or adjustments in either direction to your gross pay, because you have no control over them. (Exception would be retirement accounts, where you do choose how much goes into it - that counts as income)

Then, look at how much of your discretionary income was spent on stuff - on everything, no matter what it is - and how much went into some form of savings (or debt repayment)

Total amount saved / Take home pay = savings rate

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Re: Saving 50% of gross or net?
« Reply #33 on: May 22, 2012, 12:09:15 PM »
This may be getting pedantic, but it's not really accurate from a financial standpoint to count the full tax load unless you are close to retirement.  Say your current pre-tax savings are $4,000 and your tax rate is 25%.  If the money were taxed today, you would pay $1,000 in taxes BUT you are not being taxed today.  You will pay that $1,000 when you retire and withdraw it -- say in 15 years.

If we assume a discount rate of 4%, the present value of your tax liability is $1000/(1.04^15), or $555.  $555/4000 = 13.9%.

This is the real power of tax deferred savings --- it doesn't just put off tax payments, it actually reduces them (in real terms).

I also don't understand this. Why are you discounting?

Compare a Roth to a 401k for simplicity. The reason the tax burden is the same for the same tax rate is because multiplication is commutative.

Roth: take earnings E, gets taxed to E*T, grows to E*T*G.
401k: take earnings E, grows to E*G, gets taxed to E*G*T.

The only difference is if the taxes are different.

For a taxable account, you would also have to pay taxes on dividends and on capital gains if you don't buy-and-hold long-term.

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Re: Saving 50% of gross or net?
« Reply #34 on: May 22, 2012, 12:14:10 PM »
And you're okay that in both instances you have the same gross and same in pocket at the end, but two different savings rates?

Yes, plus you saved different amounts: 6.33k vs 5k

But it's just a question of definition, right? I think the thing the OP wants to measure is better based on net income, not gross.

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Re: Saving 50% of gross or net?
« Reply #35 on: May 22, 2012, 12:18:13 PM »
If you include the $420 debt paydown I saved 37% of my gross income.  Is that the right way to count it?

Aside from all the talk about tax differed accounts and all that jazz,
I read this as simply a question of whether paying debt counts in the "savings rate" calculation, and to that a simple "yes" would suffice.
....
 For purposes of savings rate, ignore any taxes or adjustments in either direction to your gross pay, because you have no control over them. (Exception would be retirement accounts, where you do choose how much goes into it - that counts as income)

Then, look at how much of your discretionary income was spent on stuff - on everything, no matter what it is - and how much went into some form of savings (or debt repayment)

Total amount saved / Take home pay = savings rate

Thanks Bakari! Fully agree.

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Re: Saving 50% of gross or net?
« Reply #36 on: May 22, 2012, 03:28:01 PM »
I also don't understand this. Why are you discounting?

Compare a Roth to a 401k for simplicity. The reason the tax burden is the same for the same tax rate is because multiplication is commutative.

Roth: take earnings E, gets taxed to E*T, grows to E*T*G.
401k: take earnings E, grows to E*G, gets taxed to E*G*T.

The only difference is if the taxes are different.

For a taxable account, you would also have to pay taxes on dividends and on capital gains if you don't buy-and-hold long-term.

Actually, your example is making things more complicated because you're not only looking at what you're saving today, you're also looking at future earnings.  My response (which I admitted might be pedantic) was more focused on how does one account for taxes avoided/postponed on a particular sum of money when computing a savings ratio.

One of the bedrock principles of modern finance is Time Value of Money.  http://en.wikipedia.org/wiki/Time_value_of_money  This states that a dollar today is worth more than a dollar tomorrow.  Tax deferred plans allow us to postpone a tax liability from the present day to some point in the future.  The government does not charge us interest for this "loan" -- it will be the same dollar amount in the future as it is today (assuming tax rates don't change and your marginal tax rate doesn't either).  Therefore, every year you can expect to avoid paying that fixed amount of tax lowers the current value of the liability.

Take my example again.  You have $4,000 in gross income.  You can pay the $1,000 in taxes you owe on that today, or you can pay that same $1,000 15 years in the future by utilizing a tax deferral strategy.  Both logic and Time Value of Money, indicate that the $1,000 you avoided paying today is worth more than the $1,000 you will owe in 15 years.

 There is an equation that allows you to compute the current value of money paid or received at a future date.  It's called the Present Value formula, which you can read about here  http://en.wikipedia.org/wiki/Present_value.

Present Value = Future Value / ((1+discount rate)^Time)

Therefore, in my hypothetical:  PV = 1000 / ((1 + .04)^15);  or PV = $555.  Voila, the present value of your tax liability has declined from 25% of the amount you saved to just over half that.



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Re: Saving 50% of gross or net?
« Reply #37 on: May 22, 2012, 03:52:56 PM »
Take my example again.  You have $4,000 in gross income.  You can pay the $1,000 in taxes you owe on that today, or you can pay that same $1,000 15 years in the future by utilizing a tax deferral strategy.  Both logic and Time Value of Money, indicate that the $1,000 you avoided paying today is worth more than the $1,000 you will owe in 15 years.

Uh, no.  Because the amount you pay in the future will grow.

If you were JUST paying that 1k in the future, you'd be correct.  But your tax liability will be greater because the amount earned will be greater.

In the end, it's a wash.
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Re: Saving 50% of gross or net?
« Reply #38 on: May 22, 2012, 03:57:41 PM »
Take my example again.  You have $4,000 in gross income.  You can pay the $1,000 in taxes you owe on that today, or you can pay that same $1,000 15 years in the future by utilizing a tax deferral strategy.  Both logic and Time Value of Money, indicate that the $1,000 you avoided paying today is worth more than the $1,000 you will owe in 15 years.

Uh, no.  Because the amount you pay in the future will grow.

If you were JUST paying that 1k in the future, you'd be correct.  But your tax liability will be greater because the amount earned will be greater.

In the end, it's a wash.

No, it's really not a wash.  The tax you pay on that $4,000 will not grow. 

It may be a wash compared to a Roth (because earnings are also tax free in that vehicle) but I wasn't comparing it to a Roth.  We were comparing it to taking the money in cash today. 

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Re: Saving 50% of gross or net?
« Reply #39 on: May 22, 2012, 05:58:03 PM »
Take my example again.  You have $4,000 in gross income.  You can pay the $1,000 in taxes you owe on that today, or you can pay that same $1,000 15 years in the future by utilizing a tax deferral strategy.  Both logic and Time Value of Money, indicate that the $1,000 you avoided paying today is worth more than the $1,000 you will owe in 15 years.

Uh, no.  Because the amount you pay in the future will grow.

If you were JUST paying that 1k in the future, you'd be correct.  But your tax liability will be greater because the amount earned will be greater.

In the end, it's a wash.

No, it's really not a wash.  The tax you pay on that $4,000 will not grow. 

It may be a wash compared to a Roth (because earnings are also tax free in that vehicle) but I wasn't comparing it to a Roth.  We were comparing it to taking the money in cash today. 

No, it's a wash. 7500 after tax in a Roth with tax free growth is the same as 10000 in a 401k taxed later, both in nominal and NPV terms, as long as the tax rate doesn't change. Exactly the same. Even if there's inflation.

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Re: Saving 50% of gross or net?
« Reply #40 on: May 22, 2012, 06:37:42 PM »
No, it's a wash. 7500 after tax in a Roth with tax free growth is the same as 10000 in a 401k taxed later, both in nominal and NPV terms, as long as the tax rate doesn't change. Exactly the same. Even if there's inflation.

This.  You could, of course, be in a different tax bracket, but we're assuming the same.  You don't discount, because the tax liability grows as well, it would discount back to 1k in today's dollars.
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Re: Saving 50% of gross or net?
« Reply #41 on: May 22, 2012, 07:31:20 PM »
No, it's a wash. 7500 after tax in a Roth with tax free growth is the same as 10000 in a 401k taxed later, both in nominal and NPV terms, as long as the tax rate doesn't change. Exactly the same. Even if there's inflation.

This.  You could, of course, be in a different tax bracket, but we're assuming the same.  You don't discount, because the tax liability grows as well, it would discount back to 1k in today's dollars.

We appear to be talking past each other, because the point I am making is not what you are responding to.  To recap, we were discussing savings rates, and how you would treat pre-tax savings within that calculation to account for the fact that you hadn't paid tax on it yet.  Generally, people were reducing their pre-tax savings by their tax rate, either current or estimated at retirement. My point was that the present value of your future tax liability on that savings is smaller than your current tax, because you don't pay it right away.  If you wanted to be a stickler, therefore, you would use a discounted present value of the future tax liability.  It was a minor point, but it definitely is not wrong.  I have about 50 finance textbooks that will back me up, and each year companies spend an extraordinary amount of energy deferring as well as reducing their tax payments.  They do this because it always makes sense to pay later rather than pay now, assuming you don't have to pay interest for the privilege. 

So, as I've mentioned before, the point I was making has nothing to do with Roths, or whether a Roth is better than a pre-tax savings vehicle.  I agree with you that they usually wash because the Roth earnings are after-tax, while a tax deferred vehicle's are not.  But, again, this was never part of the point I was trying to make.  Hope this clears things up.  If not, feel free to message me.

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Re: Saving 50% of gross or net?
« Reply #42 on: May 22, 2012, 08:23:52 PM »
Take my example again.  You have $4,000 in gross income.  You can pay the $1,000 in taxes you owe on that today, or you can pay that same $1,000 15 years in the future by utilizing a tax deferral strategy.  Both logic and Time Value of Money, indicate that the $1,000 you avoided paying today is worth more than the $1,000 you will owe in 15 years.

Uh, no.  Because the amount you pay in the future will grow.

If you were JUST paying that 1k in the future, you'd be correct.  But your tax liability will be greater because the amount earned will be greater.

In the end, it's a wash.

You just read my mind!

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Re: Saving 50% of gross or net?
« Reply #43 on: May 22, 2012, 08:30:52 PM »
I have about 50 finance textbooks that will back me up

I asked you for links earlier to explain more, but you didn't list any.

So far we have three people who are disagreeing with you.  Doesn't mean you're wrong, just that none of us understand what you,re saying, and from our understanding, that's not how it works.

So again...links that explain what you're talking about?

(Go ahead and start with the assumption that I fully understand NPV.)
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Re: Saving 50% of gross or net?
« Reply #44 on: May 22, 2012, 08:36:41 PM »
No, it's a wash. 7500 after tax in a Roth with tax free growth is the same as 10000 in a 401k taxed later, both in nominal and NPV terms, as long as the tax rate doesn't change. Exactly the same. Even if there's inflation.

This.  You could, of course, be in a different tax bracket, but we're assuming the same.  You don't discount, because the tax liability grows as well, it would discount back to 1k in today's dollars.

We appear to be talking past each other, because the point I am making is not what you are responding to.  To recap, we were discussing savings rates, and how you would treat pre-tax savings within that calculation to account for the fact that you hadn't paid tax on it yet.  Generally, people were reducing their pre-tax savings by their tax rate, either current or estimated at retirement. My point was that the present value of your future tax liability on that savings is smaller than your current tax, because you don't pay it right away.  If you wanted to be a stickler, therefore, you would use a discounted present value of the future tax liability.  It was a minor point, but it definitely is not wrong.  I have about 50 finance textbooks that will back me up, and each year companies spend an extraordinary amount of energy deferring as well as reducing their tax payments.  They do this because it always makes sense to pay later rather than pay now, assuming you don't have to pay interest for the privilege. 

So, as I've mentioned before, the point I was making has nothing to do with Roths, or whether a Roth is better than a pre-tax savings vehicle.  I agree with you that they usually wash because the Roth earnings are after-tax, while a tax deferred vehicle's are not.  But, again, this was never part of the point I was trying to make.  Hope this clears things up.  If not, feel free to message me.

I think we all get NPV and time value of money.

I think what you're saying then is it's better to invest in a 401k type with pre-tax money and pay tax later than invest in a taxable account?

Fully agree a gazzillion %.

Over 30 yrs difference (assuming no changing tax rates)the investment stash is at least 33% more with the pre-tax 401k type than a tax-paid.

But I did find it interesting to learn that the only difference between the Roth and the 401k was if the tax rate is different. I had to work it out a few times, just to convince myself. It felt counter-intuitive. Love it when that happens

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Re: Saving 50% of gross or net?
« Reply #45 on: May 23, 2012, 04:05:11 AM »
I have about 50 finance textbooks that will back me up

I asked you for links earlier to explain more, but you didn't list any.

So far we have three people who are disagreeing with you.  Doesn't mean you're wrong, just that none of us understand what you,re saying, and from our understanding, that's not how it works.

So again...links that explain what you're talking about?

(Go ahead and start with the assumption that I fully understand NPV.)

There aren't a lot of links on the correct way to compute savings rates, and you already understand NPV, so I'll hold off on belaboring that.  I think the one misconception here is that the tax liability on the original $4,000 you save grows.  It does not.  The tax liability on that $4,000 + EARNINGS grows, as earnings increase.  But (at least for computing a savings rate at T=0) those earnings are separate and apart from the original $4,000 for which (to go back to the original point of the post) we were trying to compute a savings rate. 

As Mr. Mark pointed out, the added benefit of the tax deferral was why we invest in these accounts to begin with.  (Deferral - PV of Tax Liability) > (Cash in Hand - Nominal Value of Tax Liability) at T = 0.

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Re: Saving 50% of gross or net?
« Reply #46 on: May 23, 2012, 04:20:33 AM »
Take my example again.  You have $4,000 in gross income.  You can pay the $1,000 in taxes you owe on that today, or you can pay that same $1,000 15 years in the future by utilizing a tax deferral strategy.  Both logic and Time Value of Money, indicate that the $1,000 you avoided paying today is worth more than the $1,000 you will owe in 15 years.

I think you misunderstand how tax deferred accounts work. With a 401k, you're taxed on the entire amount you withdraw, not just the principal you put in. If your 401k invested money grows from $4000 to $100000, you pay taxes on that entire $100000 when you withdraw it, at whatever tax rate you get when you withdraw. Hence, no discounting.

With a Roth, you aren't taxed on the earnings beyond the tax you already paid on the principal. Because multiplication is commutative, it ends up being the same thing as the 401k if the tax rates are the same.

The power of tax-deferred accounts is that you can defer the taxes until your tax rate is lower, and you can hold investments with dividends and such that you wouldn't have to pay taxes on every year. The only way around paying taxes on earnings is to withdraw tax-deferred funds when you have a 0% tax liability.

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Re: Saving 50% of gross or net?
« Reply #47 on: May 23, 2012, 07:24:28 AM »

So, now that distraction is dealt with, are we agreed on a definition for savings rate?

I think we all agree paying down the principal of any debt counts as savings, of course.

The question is:
- gross or net income?  [I think it should be net]
- scale the 'value' of the savings depending on the type? [I say no, deal with that as a portfolio ROI issue, so those assumptions can join the rest]

velocistar237

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Re: Saving 50% of gross or net?
« Reply #48 on: May 23, 2012, 07:54:51 AM »
I think we all agree paying down the principal of any debt counts as savings, of course.

Yes, both are an increase in net worth.

The question is:
- gross or net income?  [I think it should be net]
- scale the 'value' of the savings depending on the type? [I say no, deal with that as a portfolio ROI issue, so those assumptions can join the rest]

Net, because the savings rate is about what you actually save, not what you could save if you didn't have taxes. For some people, though, after various adjustments, such as benefits, gross is close enough.

Scaling is up to the individual. Scaling on tax-deferred accounts approaches one as retirement expenses approach the standard deduction. Absorbing it into the ROI sounds fine to me.

arebelspy

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Re: Saving 50% of gross or net?
« Reply #49 on: May 23, 2012, 07:58:07 AM »
Yes
Personal preference, I like net for a few reasons
Personal preference, Likely not
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