Some numbers matter more than others. How much you make is important, for example, but your financial health depends far more on how much you keep.
Knowing certain numbers can help you understand how well you’re converting income into wealth, as well as the impact of your spending and tax situation on that process. The following calculations can help you make better decisions.
Your wealth ratio
A wealth ratio is a measure of how effectively you’ve converted your lifetime income into wealth.
Calculating the ratio is a key exercise in “Your Money or Your Life,” a guidebook for the simple living and early retirement movements, first published in 1992. Authors Joe Dominguez and Vicki Robin suggested adding up the annual earnings over your entire life, as reported in Social Security statements or old tax returns. To that total, you can add in other money received that wasn’t reported to Social Security, such as investment and interest income, inheritances, gifts and gambling winnings.
The next step is to calculate your net worth — what you own (the value of your assets) minus what you owe (your debts).
Your net worth divided by your lifetime income, expressed as a percentage, is your wealth ratio — or what you have to show for all the money flowing into your life. If you’ve earned $500,000 and your net worth is $125,000, your wealth ratio is 25%. If you’ve earned $1 million and your net worth is $2 million, your wealth ratio is 200%.
There’s no pass/fail here. Younger people likely will have lower ratios than older people who’ve been saving and investing for decades. Knowing your number can motivate you to look for ways to save and invest more so that your ratio grows.
Your overhead ratio
How much of your after-tax income is eaten up by basic, must-have expenses? If you’re having trouble making ends meet, calculating your overhead ratio can help explain why. It also can be handy to know when you’re determining if you can afford new loan payments or how much to save in an emergency fund.
A must-have expense is one that can’t be delayed or skipped without serious consequences. They include shelter costs, transportation, groceries, utilities, insurance, minimum loan payments and child care. In their book “All Your Worth,” bankruptcy expert (and current Massachusetts senator) Elizabeth Warren and her daughter Amelia Warren Tyagi recommend limiting must-haves to 50% of after-tax income.
A 50% limit isn’t easy to achieve, but it frees up money for “wants” (30%) and savings or debt repayment (20%). Sticking to a 50/30/20 budget also helps people better survive job loss and other economic setbacks by limiting their overhead. Having an emergency fund equal to three months’ worth of must-have expenses is a good goal after you get on track with retirement savings and have paid off troublesome debt such as credit cards. Any loans may be affordable if the payments doesn’t push your must-have expenses over the 50% mark.
Your tax rates
Your tax bracket doesn’t reveal the amount of taxes paid on your total income. Instead, the bracket (also called the marginal tax rate) reflects how much Uncle Sam claimed of the last dollar you earned. If you’re a single filer in the 25% federal tax bracket, the first $9,275 of your 2016 taxable income is taxed at the 10% rate, the next $28,375 at 15% and the amount above $37,650 at 25%.
Your bracket determines the value of your itemized deductions and tax-advantaged investments. Someone in a low tax bracket, for example, doesn’t get much value from write-offs, such as mortgage interest deductions or investments such as municipal bonds or variable annuities, that can benefit people in higher brackets.
Your future tax bracket matters, as well. If you anticipate your bracket will drop in retirement — which happens for most people, according to experts — making deductible contributions to individual retirement accounts now is a good plan, because the tax breaks from those contributions likely will outweigh any taxes you’ll pay on future withdrawals of the IRAs. If you expect your marginal tax rate to be higher in retirement, making nondeductible contributions to a Roth IRA, which offers tax-free withdrawals in retirement, could be the better plan.
Your tax bracket, like your overhead and wealth ratios, can change over time. Check these numbers regularly to stay on track with your financial life.
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View more information: https://www.marketwatch.com/story/three-money-numbers-you-need-to-know-2017-01-18