The new year is a good time to assess how you are doing financially. Do you have a framework to think about your finances?
To do so, first determine four values:
1. Net worth
Your assets minus your liabilities. Assets are things you own (i.e., your investments and savings, including real estate and retirement savings) and liabilities are things you owe (i.e., your debts, including any mortgages). When you are young, your net worth might be negative, especially if you are paying back student loan debt.
2. After-tax income
Your earnings over a full-year after paying income and payroll taxes. Ignore health insurance or 401K contributions as they factor in below.
3. Living expenses
Your total spending over a full year, ignoring income and payroll taxes. Include health insurance and loan repayments, as well as spending from debit and credit cards and cash. Exclude contributions to your retirement savings (see my next point). You want a sense of what your expenses would be during retirement or a period of unemployment.
Your retirement contributions, including any employer match, plus any other savings you do over a full year. Your savings should roughly match the difference between your after-tax income and your living expenses.
With these four numbers, you can use this framework to assess whether you are financially on track:
- Your savings rate (savings divided by income) indicates how quickly your net worth will grow over time and whether you are on track to save enough for retirement. Depending on your income, your age, and your current savings level, your retirement savings should be 10% to 25% of your income.
- Your net worth divided by monthly expenses is the number of months of spending you have available in case of unemployment or other emergencies. Depending on your circumstances, you should have 3 to 6 months of emergency savings. Discretionary spending should be deferred until you have this amount saved.
- Your net worth will fund your retirement — from investment income, drawing down your principal, and Social Security benefits. Depending on your income, retirement age, life expectancy, and other factors, your net worth should be 6 to 12 times your income at retirement to maintain your standard of living.
Questions about your personal finances? Get in touch.
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PS: If you want more specifics on how much to be saving for retirement at various ages, I wrote about that here.