Maybe you want to live free from money stress and anxiety. Or, perhaps you’re like me, pursuing a savings rate so you can aggressively invest and grow wealth to maximize future flexibility and freedom.
Measurements provide feedback that can help you make useful changes to your personal finance game. They allow you to make the most out of your money, to identify weak spots and room for improvement.
The metrics are listed in order of importance.
1. After-Tax Savings Rate
Your after-tax savings rate measures the gap between what you earn and what you spend. It is the fraction of your after-tax (disposable) income that you save. This is the #1 factor when it comes to building wealth.
Your savings rate determines:
- How quickly you can pay down consumer debt;
- How fast you can build an emergency fund; and
- How aggressively you can invest to grow wealth.
I like to focus my limited energy on things I can control. Otherwise, I’m wasting time and energy. Your savings rate is often 100% within your control.
Your Savings Rate and Financial Independence
Your savings rate determines how quickly you can pay down debt and build an emergency fund. Then, it is the single most important metric that determines the time needed to reach Financial Independence (FI). At FI, your investment income covers your lifestyle expenses and you no longer need to rely on your human capital to earn money.
I talk more about the savings rate in this post about the two most important factors to grow wealth.
How to Find Your Savings Rate
You need to understand two numbers:
- Your expenses; and
- Your after-tax income.
Savings Rate = (Expenses)/(After-tax Income)*100
Find your savings rate by using the expense audit and budget tool. The button below will bring you there. It’s on Google Sheets. You can make a copy in your own Google account, or you can download an copy for use in Excel.
2. Your Expenses
You can’t grow wealth until you can first control your expenses. Even if you make $900,000 per year. Without expense management, expenses will naturally creep up to match your income. This is called lifestyle creep, and it is common.
You don’t need to track every penny on a monthly basis, if you pay yourself first using forced savings. But you should be aware of your large recurring expenses. I use this expense audit tool to audit my expenses every two months. You can read more about the expense audit in this post.
Benefits of expense auditing include:
- Understanding essential expenses helps you properly size your emergency fund.
- Identifying where spending is misaligned with your values; and
- Helps identify problem areas. You may be surprised by the amount you spend on drinks, groceries, or dining out. You can’t solve a problem that you don’t know exists.
Large Infrequent Expenses
Some expenses come unexpectedly, like home and car maintenance. You can still plan for these expenses. For example, home maintenance can be estimated at 1% of the home value every year, while auto maintenance costs be estimated with Edmunds Total Cost of Ownership calculator.
3. Your Net Worth
Net-worth is your measure of wealth. It’s the difference between what you own and what you owe. Net worth is my measure personal finance progress metric as it directly relates to monetary freedom.
Net Worth = Total Assets – Total Liabilities
Assets are things that you own. How your wealth is distributed among these asset categories matters. The three categories are:
- Investment Assets. Stocks, Bonds, REITs and rental properties.
- Use Assets. Items that you “use” to maintain lifestyle.
- Monetary Assets. Physical cash, money in a chequing or savings account, or money in a money market fund.
Your liabilities are your debts – money owed to others. Examples include student loan debt, a mortgage, line of credit, a credit card balance and outstanding bills.
Net Worth Location Matters
The location of your assets influences the direction of your net worth over time. A concentration of net-worth in depreciating use assets will result in a plateaued or declining net worth. Although stable, net-worth held as cash will slowly erode to inflation over time.
Wealth concentrated in investment assets will grow exponentially over time using the compound effect. Plus, cash flow from investment assets can be used to cover your expenses, whereas money tied up in a home or cash generates no cashflow.
4. After-Tax Income
After-tax income is the amount available to spend, save and invest. I base my financial decisions on after-tax income. I do not control provincial and federal tax rates. Therefore, I don’t control the fraction of my pre-tax income that is lost to tax. But I am 100% in control of what I do with my after-tax income.
Someone making $100,000 per year in Ontario does not have $100,000/yr to spend. Instead, $72,870 is remaining after-tax. It is that amount that can be used to spend, save or invest.
In Canada, we can subtract the following from our pre-tax income:
- Federal and provincial tax;
- Canadian Pension Plan (CPP) deductions; and
- Employment Insurance (EI) deductions.
You can find after-tax income by using an income tax calculator like this one from intuit turbo tax. I like that it captures your tax deferred income as well, along with taxes on other income types like capital gains income and dividend income. You’re after-tax income will be equal to what you receive on your paychecks if you have one income source and don’t make RRSP contributions.
Your discretionary income is the amount left over after you pay for essentials such as shelter, transport, food and clothing. Now you can use your “discretion” to spend the rest on whatever you please. For me, nearly all of my discretionary income is invested.
5. Emergency Fund Target Amount
Your emergency fund size is unique to you and your circumstances.
A guideline for emergency fund size is that it should equate to 3-6 months of your essential expenses. These essentials are shelter, food, transport, and clothing.
I have a tiny emergency fund worth 3 months of essential expenses. I can use 3 months because I rent, have a stable income, and can live on some of my investment cashflow if needed.
Going to a festival or going on vacation is not an emergency.
Some factors the influence your emergency fund size include:
- Home maintenance costs – can be estimated at 1% of the home value per year.
- Income stability – If you are susceptible to job loss, you’ll need a larger emergency fund.
- How long it would take to find a new job.
- If you have a working spouse.
- Your unique willingness to take on risk.
6. TFSA Remaining Contribution Room
The Canadian Revenue Agency (CRA) sets an annual limit on the amount of money you can put into your TFSA. Your remaining TFSA contribution room is what matters. You don’t want to overcontribute because you’ll be hit with a fine equal to 1% of the overage per month.
So, knowing your remaining contribution room is especially important if you are close to maxing out your TFSA. You can find your remaining total TFSA contribution on your CRA My Account. Be careful, the CRA does not capture any contributions made in the current year. Check out my TFSA contribution room calculator to track your real-time contribution room, along with an estimate of future TFSA account value based on investment returns.
7. RRSP Deduction Limit
The RRSP deduction limit is the total amount you can contribute to the RRSP and “deduct” from your taxable income. It is based on RRSP room gained in the current year, plus any unused room from prior years. Your RRSP deduction limit can be found on your CRA My Account.
You can use the RRSP to invest pre-tax income, and shelter it from taxes on capital gains and dividends. Further, contributions to the RRSP allow one to make use of the Home Buyers’ Plan (HBP) and the Lifelong Learning Plan. The HBP allows first-time home-buyers to withdraw $35,000 to put towards a down payment on a first home.
8. Marginal Tax Rate
Your marginal tax rate tells you how much tax you pay on each extra dollar earned. It also determines how much tax you will pay on investment income in a taxable account. Your marginal tax rate depends on two factors:
- Your total taxable income; and
- The province you live in.
Combined Marginal Tax Rate
Your combined federal and provincial tax rates are what matter. To keep it simple, you can find your “combined” federal and provincial tax brackets at taxtips.ca. Check out the tax rate in your highest combined tax bracket. That is your marginal rate. Alternatively, you can punch your income into a tax calculator such as this one from turbo tax.
Increasing Income Does Not Reduce Your After-Tax Income
This is a common misconception. Earning extra income will increase your marginal tax rate if it pushes you into a higher tax bracket. So, a larger fraction of each extra dollar earned will go to uncle Sam.
You will always have more after-tax income if you increase pre-tax income.
Your Marginal Rate and Taxes on Investment Income
Once your TFSA and RRSP is maxed, it is time to invest in a taxable account where you’ll pay taxes on investment income. Now you care about tax rates on interest income, capital gains income and dividend income. Tax rates on these types of income all depend on your marginal tax rate.
I aim to maximize after-tax wealth. This requires an understanding of taxes and tax-sheltered accounts. You can learn more in this post – Understand Taxes for Investing: A Guide for Canadian Beginners.