Note: This article is part of our Basic Banking series, designed to provide new savers with the key skills to save smarter.
If you’re going to reach your financial goals, you need to save regularly. But saving money is tough, so you need rules to stick with. One very effective rule is to set a fixed savings rate in your budget, where every month you save a percentage of your salary for retirement and an emergency fund.
For decades, a common rule of thumb has been that you should save 10% percent of your income for retirement. While that approach is clear and simple, it may no longer be appropriate for today.
Another rule that could be a better fit for modern life is the 50/30/20 rule. We’re comparing these two budgeting strategies as well as showing how you can create your own personalized savings rate.
What is the 50/30/20 rule?
The 50/30/20 rule is a budgeting strategy for how you should divide up your monthly income. The rule states that 50% of your income should go toward fixed costs, 30% should go to discretionary or optional spending and 20% should go toward saving.
Fixed costs are the monthly expenses you don’t have much control over, at least in the near term. These include rent or mortgage payments, utilities, car payments, debt service, insurance premiums and taxes; they are considered fixed because it’s often difficult to change these costs in the short term.
Discretionary spending is for purchases you have control over and can change quickly. These includes going out to the movies, taking vacations, buying new clothes or donating to charity. If your budget is tight, you can immediately cut back on costs in this category.
Finally, this rule recommends that the last 20% of your pay should go into savings. This includes putting money in the bank for your emergency fund, investing for retirement or signing up for a fixed rate IRA.
How to follow the 50/30/20 rule
Sarah earns $6,000 a month after-tax. If she followed the 50/30/20 rule, then every month she should spend $3,000 on fixed costs, $1,800 on discretionary spending and save $1,200. In reality, she is only saving $600 a month which is just 10% of her income. She can see that she’s spending too much in other categories and now needs to find the problem.
First, she should calculate what percentage is going to discretionary spending. If she is spending more than $1,800 a month on these expenses, then this is something she can fix quickly. Sarah can immediately get closer to her savings target by eating at restaurants less often, cutting back on shopping and taking fewer vacations.
On the other hand, if her monthly discretionary spending is around $1,800, then the problem is she’s spending too much on fixed expenses. This will take more time to fix because you can’t immediately change your car, housing and loan costs. In this case, Sarah should look for opportunities to lower her fixed costs when she is able to.
She should consider trading in her car for a less expensive model, downsize to a less expensive house or apartment, and pay off her debt more quickly so she no longer has large monthly payments. Over time, once she lowers her fixed expenses, she should aim to keep these costs at no more than 50% of her budget going forward so she can keep saving.
Where did the 50/30/20 rule come from?
The 50/30/20 rule became famous when Sen. Elizabeth Warren promoted it in her financial planning book All Your Worth: The Ultimate Lifetime Money Plan. Thanks to her connections with celebrities like Dr. Phil and her status as a U.S. senator, Warren gave a ton of publicity to this budgeting strategy. Financial experts think it can be a useful strategy for financial planning.
Ken Tumin, founder of DepositAccounts.com, says “the 50/30/20 rule is better because than previous recommendations because it allocates a higher percentage to saving. A higher rate of savings is more important these days now that defined pension plans are a thing of the past.”
Another financial guru, Dave Ramsey, recommends an even more thorough approach than the 50/30/20 approach. His budgeting plan has 12 categories, where you set a target a percentage for every single one. It’s more precise, but it’s also more work.
Finally, an old rule of thumb that people have been following for decades is that you should save 10% of your income for retirement, which we explain next.
What is the 10% savings rule, and is it enough?
The 10% savings rule is an old rule of thumb that became famous nearly 100 years ago, in a book called The Richest Man in Babylon. This book gave out several pieces of financial advice and the most important one was that everyone should save at least 10% of their income to reach their retirement goals.
While this target might have been appropriate when the book came out in 1926, saving 10% these days is probably not be enough to reach your retirement goals. Like Tumin mentioned before, pension plans are much less common. Chances are you’ll need to pay for retirement out of your own savings without help from your employer.
In addition, people are living longer than ever: the average life expectancy is just over 78 years, and it’s not uncommon for people to live past 90. When the 10% savings rule came out in the 1920s, the average life expectancy was just around 60 years, so people had much shorter retirements.
As a result, the 10% savings rule just isn’t enough anymore. The 50/30/20 rule is a better fit because it recommends saving twice as much of your income.
What is your personal savings rate?
As you plan your monthly budget, give yourself time to focus on your personal savings rate. This is the percentage of your income that you put aside each year for your long-term financial goals. Calculating your own personal savings rate is a three-step process.
- Calculate your total savings for the year: Add up anything you put into a retirement plan, your bank account, your emergency fund and other forms of savings. If your employer gives you a matching contribution into your retirement plan, count this too, since it is also considered savings. Don’t count your investment gains though — you’re focused on how much you save, not how much your portfolio earned.
- Find your total income: Your total income is your after-tax pay, plus any money you saved into a retirement plan. If you didn’t contribute to a retirement plan, your take-home pay would have been higher, which is why you add it back to see what your actual overall salary what have been.
- Divide the total savings by your total income: This measures the percentage of your earnings that you put aside for savings.
Personal savings rate example
Megan has an after-tax salary of $70,000. She also puts $5,000 a year into her company 401(k), which comes out of her paycheck pre-tax. Her employer gives her a $2,000 match. Finally, Megan puts another $3,000 in a certificate of deposit through her bank.
Her total savings will be $10,000 ($5,000 into the 401k + $2,000 from her employer match + $3,000 into her bank account.)
Her total income is $77,000 ($70,000 after-tax salary + $5,000 that went into the 401k instead + $2,000 from the employer match.)
Her personal savings rate is 13% ($10,000/$77,000).
What’s a good savings target?
Megan is doing better than the 10% savings rule, but isn’t saving enough to meet the 50/30/20 rule. Whether that’s enough really depends on her current goals and financial plan. As Tumin notes: “These rules should only be considered a basic rule of thumb for retirement saving. Each person should customize a savings rate that’s based on their own personal situation.”
If you already have savings, face decades until retirement or can get by with a lower income once you stop working, then you could perhaps hit your goals with a lower rate. If you haven’t started saving yet, are getting close to retirement and/or want to have a higher retirement income, then you will need a higher target.
Whether you follow the 50/30/20 rule, the 10% savings target or something completely different, the key point is you should set your personal savings rate and make sure to follow it every week, month and year.
As a final piece of advice, we recommend that you sign this pledge form from the Consumer Financial Protection Bureau. It’s a promise to yourself that you will hit your personal savings rate. Take action now and your future self will thank you.