Is the 15% rule for investing before tax or after tax?

Once you’re out of debt, you’re ready to start saving for retirement.

(Before you’re out of debt, you’re probably better off just focusing on that, though I think an exception is fair for extremely large debts like mortgages).

A good rule of thumb is that once you’re ready to save for retirement, 15% of your income is a good amount to save.

Sure, the FI/RE movement wants you to save 97% of your income while subsisting on moss and lichen, living on a rock in the middle of the woods while harvesting rain water.

But back here in the real world, let’s stick with 15%. Personally, I’ve found that showing off extreme feats of frugality is actually counterproductive, since it can lead to feelings of futility and hopelessness, not motivation.

You can do more, I just wouldn’t recommend less.

But 15% of what? How do you calculate this 15%? Is it gross or net?

15% of what?

Because your after-tax salary is going to be less, 15% of your after tax salary is going to be less as well. Potentially much less.

Let’s see an example. Let’s say you have an income of $50,000. 15% of that is $7,500.

Now, taxes are hard to calculate as they are state-dependent, but let’s be generous and say that your taxes take away 30% of your gross. So that means that your after-tax salary is $35,000.

And 15% of $35,000 is $5,250.

What kind of difference does this make?

Well, if you invest $7,500 a year for 30 years, and receive an average annual return of 8%, you’ll end up with about $910,000.

With $5,250, same situation, you’ll end up with about $640,000.

Now, no one is going to make the same salary for 30 years, so this example is necessarily incomplete, but still, do you see a significant difference here? I think so. That’s a 30% decrease.

Funny thing, that number.

Estimating taxes is hard

Here’s another thing to consider: it’s hard to estimate taxes in advance. There was that tax bill in the U.S. recently, which totally changed people’s tax situations. Some paid less, some paid more, and it was pretty much impossible to tell.

Who knows what’s happening down the road with taxes? I hope taxes go up personally, as we need to start better funding our infrastructure and social services, and we have to do it somehow.

But either way, our tax rate is tied to investments enough as it is (with our 401(k)s), so do you want what we put in to be affected by our tax rates too?

Determining your 15% based on your gross salary is so much simpler, because most people know what their salary is, unless you have an irregular income.

And now for something completely different

I’m reminded of this less-than-well-known Monty Python skit.

In it, an accountant is telling the board of a multi-million pound corporation that after all the income and expenditures are tabulated, the firm made a profit of…a shilling.

(For those of you who are mystified by the pre-decimalization of British currency, conversions are hard, but I believe one shilling in 1969 was equal to about two dollars today.)

The chair: “This shilling, is it net or gross?

The timeless reply:

It’s British, sir.

(Seriously, if you don’t think Monty Python is brilliant, I don’t know if we can be friends.)

Strange as it may seem, I think that’s the best answer I can give to this question.

Because whether you put in based of pre-tax or post-tax calculations, it’s just your money. It may not be British, it may U.S., but same result.

You will save more if you calculate based on your gross salary, and it’s certainly easier to calculate, but the most important part is that you’re putting something significant away.

The better calculation to make is: what gets me to my financial goals? And what will keep me from having to eat moss? Those are the really important questions.

Are you working on a plan to save enough for a comfortable retirement? How are you doing it?

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