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I struggled a lot with this question when I first started making money. First, I didn’t make that much, so saving seemed impossible. Second, everything was so manual back then. Phones had a dial to turn, and this weird thing called a cord. Lastly, I was young and did not know the importance of saving and investing.
If I could go back and save all the money I spent on frivolous, stupid things I bought when I was young, and saved and invested instead, I would do it in a heartbeat.
The majority of Americans don’t have enough savings to cover life altering events that could happen to anyone. In fact, almost 50% of Americans don’t have even $1,000 saved, which is crazy. They are just walking around hoping they make it to the next paycheck. Believe me, the stress and anxiety this creates is terrible for you, and paycheck to paycheck is no way to live.
To put it bluntly, saving is extremely important, and you should put money away every paycheck. I stress paycheck here because it’s the simplest way to save.
So, the big question is: How much should I save from each paycheck?
There are many rules of thumbs out there, but thankfully, they aren’t all radically different.
If one of the approaches just doesn’t work for you because you don’t make enough money or you are buried in debt, it’s okay. Make one your goal and start saving what you can. I guarantee, you can get there. It might take a little time and some lifestyle changes, but you can get there!
This is a very popular strategy that states you should save 20% from every paycheck.
The allocation of your pay goes like this:
Life Expenses (50%):
Notice how I didn’t call this “living expenses”, which you are probably more used to seeing. I call this category Life Expenses because this includes the money that is just a part of life. No way around these.
If you don’t own your home outright, which barely anyone does, you have rent or a mortgage. You probably own a car, which means you probably have a car payment, and you have to pay for gas and insurance. Your phone bill, utilities, etc…they all go here. You have to eat, so your groceries go here, too.
You see what I mean. These are the bills and cash out of pocket that you can’t get away from. They are just a part of life.
The goal is to keep your life expenses below 50% so you can live your full life and save.
Living Money (30%):
This is the money that can be used for going out there and living your best life. You shouldn’t feel guilty for wanting the things that give you joy. That’s what this money is for.
If you want to go out to eat with friends, go for it and have a great time without dwelling on the money. If you want to stay at a resort for the weekend and throw in a massage, go find your Zen. Take a class. Go out on that date. Do whatever makes you happy and do it guilt-free.
Just try to keep it within that 30%. If you don’t spend it all…great! Put that money in short or long-term savings and your future self will thank you.
Savings (20%):
“Savings” is a broad term that covers an emergency fund, long-term savings, short-term savings, and retirement. This means that the entire 20% isn’t just putting money into a savings account. It includes investing and retirement.
You might want to try a 10%/10% split between investing (long-term saving for your future) and traditional saving when you first start out. You should definitely be putting money into your 401K, if you have one. A ROTH IRA is a good long-term investment tool, as well.
The 50/30/20 ratio is popular for a reason, mainly in that is pretty easy. Say you make $2,500 a paycheck after taxes, your ratio is $1,250 for life, $750 for living, and $500 goes to savings. You’re smart. You can easily do the math.
0.5 X 2,500 = 1,250
0.3 X 2,500 = 750
0.2 X 2,500 = 500
By the way, notice how I use paycheck instead of month. A lot of things you read will refer to savings each month. Again, simplify by applying this to your paycheck.
There are a few of reasons to do this. It’s easier to automate this way. Also, saving should become a habit, and there is no better way to make saving a habit than to automatically save each time money flows in. Things also get complicated when you get paid every other week, other than twice a month, etc. And things can get really complicated when you don’t make the same each paycheck.
Apply the ratio to your paycheck instead of month and make it simple.
This is by far, one of the simplest ratios to follow. Sure, you are still going to have to figure out what 20% of your paycheck is, but once you’ve crossed that extremely small hurdle, the rest is cake.
The allocation of your pay is as follows:
This might be a good place to start, especially if you are new to the money game. And it’s easy to tweak.
Automatically put money towards savings without thinking about it, and then go out and do your thing. You should still track your money a bit, but this is by far the easiest way to save money.
You don’t have to spend 80% on everything else if you don’t have to or want to. If you can live happily with 70% of your pay, you don’t have to go out and blow an extra 10% on something stupid that doesn’t bring you joy just because the ratio tells you to.
And if you have to start with less than 20%, no worries. Choose a number that works for you now, and make 20% a goal.
Note:
Out of the two, I like the 50/30/20 ratio because it gives more focus on life expenses versus living money and savings. You want to keep life expenses below 50% so you can free up money for living money and savings. By separating life expenses from living, it is easier to keep life expenses in check.
Now let’s talk about Financial Independence. (You might have heard about FIRE (Financial Independence, Retire Early), too.)
This is the concept of living frugally and saving and investing as much as you possibly can so you can live off your savings and investments without having a to have a job. Once you reach financial independence, you can either retire, or work doing what you love rather than working at a job you’re not happy with just because it pays more.
It doesn’t mean you cut all joy out of life. It means you cut way back, especially on your life expenses, in order to reach the goal of not being dependent on a job.
If you can cut your life expenses (basic needs) drastically and increase your savings radically…while still enjoying life…you could get to a point where you are financially independent and retire extremely early, if you want to.
Your ratio might be 30% life expenses, 10% living money, and 60% savings. It’s up to you and what you are willing to live with.
Imagine not having to work anymore. You could retire if you want or do what you love instead of chasing a paycheck. Sounds great, doesn’t it?
Personally, I’m a big proponent of financial independence. Just make sure you have balance in your life. Don’t go live in a cardboard box and rely on hitchhiking to get to work. Become a minimalist where you can, while still living your best life.
Note to my kids:
I want you to be financially independent. Being financially stable and not having to worry about having enough money in the bank will make your life so much better. I define truly wealthy as not having to work if you don’t want to.
And I want you to be wealthy. You don’t have to have a mansion with a five-car garage filled with Ferraris to be rich. Rich is being able to do whatever you want in life without having to worry about money. The best way to get rid of stress and anxiety over money is to be financially independent.
This does not mean I don’t want you to enjoy life in the present. Just keep your life expenses as low as possible, be responsible with your living money while still doing the things you want to do and save and invest as much as you possibly can.
You’re young. If you start now you could easily be financially independent in as early as your 30’s. I’m not kidding. Form the right saving habits now and in time, you will be financially free.
You should save automatically without thinking about it. This is “paying yourself first”.
But where should you put this money? Good question. This is where “buckets” come into play. Here are the buckets (accounts) you should put your money in:
Emergency bucket:
Commonly called an Emergency Fund. This is where you keep money in case of a major emergency, like the loss of a job or an insane medical bill.
This needs to be equal to greater than 3-6 months of life expenses. Preferably, this should be in a bank account at a bank that is different from your main bank. I know this sounds weird, but you want to keep it safe and sound and not easily accessible. This means not directly transferable to your checking account at a moment’s notice, so you don’t make a split-second decision to buy a jet ski.
Not that buying a jet ski is a bad thing, but you should save for that somewhere else.
This money is “break glass in case of emergency” money. It should be by itself.
Retirement bucket:
This is the place where you pay your future self. You should put at least 5%-10% into a retirement account. This includes your 401K (if your company has one), a ROTH IRA, etc.
Automate this as much as possible. Thankfully, especially in the case of a 401K, you can ask your employer to send a portion of your paycheck into a retirement account (and its pre-tax!). You won’t even see this money on your paycheck. It is a no brainer because you don’t have to do anything. If your employer can’t do it, then you can automate this yourself. The goal here is to put this money away to pay your future self without thinking about it.
Big ticket bucket:
This is the place where you save for things like a down payment on a house, a wedding, a new car, etc. You might want to call this longer-term savings. It usually takes a while to save for big ticket items, so you have to be forward thinking with this money.
Short-term bucket:
This is money earmarked for things you want to buy/do pretty soon, say within the next year. This money can be used for something like a new electric bike, a trip to Hawaii, etc. This is that money for the jet ski.
It’s also the place where you put money for the boring things you know are coming, but you have to save money for. Yearly property taxes or car registration, for example.
There are all sorts of savings philosophies and ratios out there. Choose the one that is right for you. But you need to choose and start saving now if you haven’t already.
I am an advocate for Financial Independence, but you might not have that as a goal. Maybe the 50/30/20 ratio is a solid choice for the way you want to live. Or maybe the 80/20 model is easiest for you, and you don’t care about breaking things down further.
The most important thing you can do is to make savings money a habit. The best way to do that is to automate your money plan.
Yes, you can still enjoy life today while saving for the future. And trust me, the more you have saved, the more you will enjoy life.
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