Meet Bill and Suzie. They’ve decided that it would be good to double the amount they contribute to their 401K’s so they can retire earlier. They have a question though: “Should we try to spend less or try to earn more?”
Bill and Suzie currently have a combined gross income of about $72,000 before tax. After contributing about $10,000/year to their 401K’s and paying taxes, they have around $50,000 that they currently spend. Doubling their savings would require them to save $20,000/year into their 401K’s.
Doubling their contributions to $20K/year is a smart choice by them because they want to retire a little earlier than average! So is it better to increase their salaries or cut their expenses?
In short, I would argue that decreasing their expenses is the better option – if they are only going to do one of the two options. There are at least a couple reasons why.
1) They’d have to increase their salary more than they’d need to decrease spending.
Consider keeping spending the same and just increasing their income. To save an additional $10K per year in their 401K’s, they’ll need to increase their salaries by about $10K.
Next, consider keeping income the same and just decreasing their spending. Thanks to the tax benefits of a 401K, they’ll only need to decrease their spending by about $8K to put away an extra $10K in their 401K’s.
2) Decreased spending will be permanent if they stick to it.
Quite often, people end up living longer than they end up working. By developing a habit of living on less, their savings would benefit both while they work and while they are retired. Conversely, increases to their income will only benefit them while they’re actually working.
Let’s look at these scenarios a little further.
Consider that in both cases, Bill and Suzie’s after tax desired income are 80% of what it was when they were working. Not accounting for inflation, this amounts to about $40K/year for the option of simply increasing their income to save more. Alternatively, this amounts to about $34K/year for the option of reducing expenses.
With these two separate options, Bill and Suzie save the same amount, but by learning to live with less they can retire on a lot less. So how much do they need to save to fully retire in each scenario?
Using the 4% rule:
By learning to decrease spending: 25 x $36K/year pre-tax = $900K
By just earning a higher salary: 25 x $43K/year pre-tax = $1.08M
The idea behind the 4% rule is that past performance of the stock market indicates that you can withdraw 4% of your retirement savings for quite some time without running out of money. So these should be relatively safe numbers for retirement.
Even though both scenarios had Bill and Suzie saving $20K/year, by learning to spend $8K/year less, they can retire a few years earlier than if they had increased there income by $10K/year. I don’t know about you, but being able to retire a few years earlier sounds pretty nice.
Of course they should do both if they can.
In no way am I saying that Bill and Suzie shouldn’t try to increase their salary. If they increase their salary and decrease their spending by the same amount outlined above, they could start putting away $30K/year into a their 401K’s. There are clear benefits of both, so yes you should also try to do both.
That situation above may sound a little contrived. That’s because it is! I’m trying to make a point. A small number of people legitimately won’t be able to spend less money, but I’m convinced that most people can. For people who actually can’t decrease their spending much, the only way for them to save more is to increase their earnings.
Getting back to the original question. Earn more or save more? As should be clear by this post – focus on saving more, but it is good to try to do both. One thing you shouldn’t do – buy more.