A gap between your income and expenses is necessary for your freedom, no matter what stage you are at in your financial journey:
- Paying Down Consumer Debt;
- Building an Emergency Fund; or
- Investing To Grow Wealth.
Do you want to pay down debt, build an emergency fund, save for a vacation or invest more aggressively? If so, you must increase the gap between your income and expenses.
There are only two levers you can pull to increase savings: Increase income or cut expenses. You know this already, but you may not know that there is a combination of these two levers that is optimal for your specific situation.
Saving is difficult. Unless you enjoy suffering, you don’t want to make it harder than it is.
This post will help you find the right balance between expense reduction and increasing earnings to increase savings.
Jake's Expense/Income Focus Spectrum
One extreme (the left side of the spectrum) is to focus 100% on expense reduction while keeping income fixed.
The other extreme is to focus 100% on increasing income while keeping expenses fixed (right side of the spectrum).
In practice, there are infinite possible combinations between the two extremes, resulting in a continuum (or spectrum).
I could not find a diagram representing the spectrum between increasing income or cutting expenses. So I built one.
And my ego got involved … so I named it after myself.
Your ideal place on the spectrum will depend on your unique situation, including:
- Your tax rate;
- The value of your time;
- Your non-essential expenses; and
- The strength of your expense management habits.
Let’s dig into these considerations.
Income taxes reduce the amount of money that ends up in your pocket. Shift to the left side of the spectrum (reduce expenses) if you have a high tax rate. And shift to the right side of the spectrum (increase income) if your tax rate is low.
Your marginal rate is the fraction of each extra dollar earned that goes to tax. The marginal tax rate increases with employment income and depends on your country and region.
For example, a Canadian in Ontario who makes $100,000 per year has a marginal tax rate of 43%. So, $430 is lost to tax for every extra $1,000 of employment income. Read my tax guide to better understand taxes.
Income. Your income drives your tax rate. The higher your employment income, the higher your marginal tax rate. Therefore high income is an incentive to focus on expense reduction, and vice versa.
Let’s consider a Canadian making $80,000/year who wants to save an additional $10,000. We will look at the difference between decreasing expenses by $10,000 and increasing income by $10,000.
Cutting Expenses by $10,000: By cutting expenses by $10,000 the entire amount is pocketed. In fact, $1,300 of the $10,000 would have been allocated to13% sales tax. So, the Canadian pockets $10,000 by eliminating $8,700 of spending.
Increasing income by $10,000: If our Canadian make’s $80,000 per year by taking on overtime, they have to work an additional 243 hours to make $10,000. Then, taxes reduce the take home amount to $6,860. The Canadian has an extra $6,860 in savings and has lost 243 hours of time.
This brings us to the consideration of time!
Your Time Value
Your time has value. It is the one thing you can never get back. Consider how much of your valuable time must be sacrificed to meet your savings goals.
Your Time: Increasing Income
Ask yourself, do I have to trade time for money to increase employment income through a second job/overtime, or can I boost my income without extra time commitments?
If you must trade time for extra income, move to the left on the spectrum to account for the value of your time. Any income that requires you to trade time for money is non-scalable income.
Increasing employment income through higher wages takes up no extra time and is an incentive to move right on the spectrum (increase income). Income that can be increased without additional time requirements is scalable income.
Increasing wages is best accomplished by investing in yourself – acquiring valuable knowledge and skills. Keep note that increased stress levels and long hours normally come with high-income work.
You are incentivized to focus on expense reduction if you must trade time for money. On the flip side, you are incentivized to focus on increasing income if you can increase your wage.
Your Time: Expense Reduction
Reducing non-essential expenses requires no extra time. In fact, lower non-essential expenses will increase your free time, because you will have less stuff to store, clean, and maintain. This is a form of freedom!
Slashing expenses isn’t easy. It requires changes to your habits, environment or both. Have a look at these 3 simple expense categories for expense reduction approaches.
As mentioned above, cutting non-essential expenses will save your time and add to your freedom. Focus on expense reduction if you have high non-essential expenses.
But first, you need to understand where your money is going. If you don’t track your expenses, then you don’t have control of your money. To get started with expense tracking, check out this article and you can use my free expense audit tool.
Cutting expenses is great, but there comes a point where it is not realistic to cut non-essential expenses any further. This occurs when expenses are reduced to essentials of basic shelter, transport, food, and clothing.
At this extreme expense floor, all efforts to increase savings should be allocated to increasing income, fully to the right-hand side of the spectrum.
The key with expense reduction is to achieve balance by identifying the spending areas that bring true value to your life.
For example, I’m about a frugal as it gets. I have a 10 year old car, and get excited about my free annual issue of 5 free tee-shirts from work. However, I drop dough on my bikes, because cycling brings value to my life.
Lifestyle Creep and Expense Management Habits
Lifestyle creep is a tendency for non-essential expenses to increase as your standard of living (income) increases. This is a natural, slow, and progressive process so keep an eye on it like your listening to popcorn pop.
The creep has a psychological effect where non-essential goods tend to feel essential over time, making it more difficult to cut back on our lavish lifestyle down the road. I view it akin to an addiction.
Lifestyle creep is an incentive to maintain strong expense management habits like consistent expense auditing, setting/meeting expense targets and setting/meeting investing targets.
You can focus on increasing income if you have your expense habits are deeply established.
If you don’t have strong expense habits, you need to focus on developing them before focusing on increasing income. Otherwise, money will go out just as fast as it comes in. You will be a hamster in a hamster wheel, going nowhere regardless of your income.
The optimal balance between expense cutting and earning extra income depends on the value of your tax rate, time value, and the amount of your non-essential expenses.
Due to taxes most people have to earn an extra $1.50 to spend $1.00. So, you pocket more money if you can cut expenses vice increasing income by the same amount. A high tax rate amplifies this effect.
If you have large non-essential expenses you need to focus on expense cutting. Similarly, you need to gain money management habits before increasing income. Otherwise, you will be a hamster as lifestyle creep sucks up all of your extra income.
Your time is valuable. Therefore, it is favorable to seek wage increases, rather than trading more time for money. Growing your wage requires that you invest in your knowledge and skills, rather than working longer hours.
You should always aim to increase investment income as it’s generally taxed less than employment income and require none of your valuable time.