The expression “rule of thumb” is believed to have derived from carpenters of generations past who used their thumbs to make rough estimates of length rather than using a more precise instrument such as a wooden ruler. The idea was to provide a quick and easy way to make measurements when such precision was not practical or necessary. In much the same way, financial planners at times may use rules of thumb when discussing financial behavior, or when quickly assessing a situation. These rules of thumb may especially be useful for people who don’t have the time, inclination, resources, or desire to perform precise calculations, and instead end up doing nothing (something referred to as “financial inertia”).
Everyone has a unique situation, and there are no concrete financial numbers that define success, but there are some rules of thumb that can help you gauge your progress. While using these rules won’t guarantee success, they may be a starting point or put you on the right track.
What should your net worth be? According to the bestselling book “The Millionaire Next Door,” if you’re interested in being a “wealth accumulator” your net worth should equal your age times your gross income divided by 10. That number, minus any money you inherited, should be your net worth for your age and income. So if you’re 40 and make $80,000 a year, you should have a net worth equal to $320,000. If you want to secure your position as “wealthy”, your net worth should be double that number.
The 50/30/20 Rule
This is a popular rule for allocating your budget. With the 50-30-20 rule:
50% of your take-home income is allocated toward non-discretionary expenses, like housing and bills,
20% of your gross income is allocated toward financial savings goals, like saving for retirement or college education, and
30% of your take-home income can be allocated towards discretionary expenses, like dining out or entertainment.
Total Debt Payments < 36% of your Gross Annual Income
Your total monthly long-term debt payments – including your mortgage, credit card payments and all loan payments (education, auto, etc.) – should not exceed 36% of your gross monthly income.
Save 10% for basics, 15% for comfort, 20% to escape…(in terms of gross income)…these rates increase higher the longer you delay saving
3-6 months of essential expenses.
You should have between three and six months worth of expenses available in the event of an emergency. So, if your monthly obligations total $5k, you should target to maintain between $15k and $30k in your emergency fund.
X months of essential expenses – where X is the current unemployment rate
Your emergency fund should cover X months of expenses, where X is the current unemployment rate. This rule is interesting in that it uses the current unemployment rate as the basis for determining your target emergency fund reserve – the higher the unemployment rate, the higher the amount of savings needed.
Below are three different, but somewhat comparable rules of thumb for life insurance coverage:
1) 10x your gross income
2) 5x – 7x your gross income + mortgage balance + other debt balances + college expenses
3) 25x your annual expenses + mortgage balance + other debt balances + college expenses
RETIREMENT ANNUAL INCOME REQUIRED
~75%-80% of your current gross income in retirement.
Note: this rule uses gross income as it’s basis, not projected expenses. If you earn $80k per year, you’ll require ~$64k per year in retirement income. The premise with this rule of thumb is that (a) your expenses and tax structure likely changes in retirement (for the better), (b) you no longer will be saving for retirement (~10%-15%), (c) no more FICA (Social Security) taxes (~7.65%), and (d) you may be mortgage free (~20%).
RETIREMENT NEST EGG
25x Your Annual Projected Retirement Expenses (excluding social security or pension(s)).
Note: this rule uses projected expenses as it’s basis, not gross income. If you need ~$60k in annual retirement income beyond social security and pension income, you’ll need ~$1,500,000 in personal savings to retire.
20x Your Gross Annual Income.
Another approach to retirement savings says that you’ll need to save 20x your gross annual income to retire. Using this rule of thumb, if you earn $80k per year, you’ll need $1,600,000 to retire. Note: this rule uses gross income as it’s basis, not projected expenses.
RETIREMENT WITHDRAWAL RATE
4% Sustainable Withdrawal Rate in Retirement
Simply stated, this rule states that you can withdrawal 4% of your total retirement savings each year in retirement. So, if you have $750,000 in all your retirement accounts, you would withdraw $30k each year in retirement have a relatively high level of assurance – generally an 80% or so probability – that your savings will last 30 or more years. Increase your withdrawal rate beyond 4%, and the probability of success diminishes significantly.
Conservative Investor = ~100 – your age in equities, the remainder in bonds
Moderate Investor = ~115 – your age in equities, the remainder in bonds
Aggressive Investor = ~130 – your age in equities, the remainder in bonds
The First-Year Salary Rule
You shouldn’t take out more in student loans than you expect to make your first year on the job.
~2.5x Your Gross Annual Income
Don’t buy a house that costs more than three years’ worth of your gross annual income (target 2-3x your gross income). For example, if you and your spouse together earn $100,000 per year, you shouldn’t spend more than $250,000-$300,000 on a home…try to swing that in high-priced cities like New York and San Francisco…
Housing Costs < 28% of your Gross Annual Income
Your housing costs (including PITI: mortgage payments, property taxes, and insurance) should be less than 28% of your gross income.
BUYING A CAR
The 20/4/10 Rule
Using this rule, when buying a car, you should put down at least 20%, you should finance the car for no more than four (4) years, and you should spend no more than 10% of your gross income on transportation costs. The first part of this rule prevents you from owing more than the car is worth, and the last two parts prevent you from buying more car than you can afford.
The New Car 5 Year Cost of Ownership Rule = Price Tag / 30
To approximate a new vehicle’s five-year cost of ownership (in monthly terms), take the car’s price tag and divide by 30. Looking at a loaded Mini Cooper S? Take that $30,000 sticker price and divide by 30…$1,000 a month…
These are just a few of the financial planning related rules of thumb. Again, the most important thing to remember is that these are just guidelines, and while they may help get you started on the right path, a more personalized review of your financial picture may be needed to determine if in fact you are on track to reach your goals.
Paul Staib | Certified Financial Planner (CFP®), MBA, RICP®
Paul Staib, Certified Financial Planner (CFP®), RICP®, is an independent Fee-Only financial planner. Staib Financial Planning, LLC provides comprehensive financial planning, retirement planning, and investment management services to help clients in all financial situations achieve their personal financial goals. Staib Financial Planning, LLC serves clients as a fiduciary and never earns a commission of any kind. Our offices are located in the south Denver metro area, enabling us to conveniently serve clients in Highlands Ranch, Littleton, Lone Tree, Aurora, Parker, Denver Tech Center, Centennial, Castle Pines and surrounding communities.
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