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Here are simple ways to check if you are spending too much. Money is meant to be spent .. sooner or later. Sometimes we spend because we want to and sometimes because we need to. Money spent sooner will affect our ability to spend as we much need to or want to later. It might help to put a red, amber and green kind of perspective on the spending process.
How much are you spending per year?
Exclude EMIs and other liabilities. Exclude expenses that will not last beyond a few years. Include only those expenses that will persist as long as you or your spouse. Call this Mexp (mandatory expenses).
Method 1: Determine, using the calculator available in this post, Should You Invest For Retirement as Much as You Spend?, what percentage of Mexp should you investment per month for retirement.
Here is an example: Consider a 25-year-old who wishes to work for the next 25 years. Assuming the inflation to be 8% and that his portfolio will beat that by 4% (portfolio return after tax = 12% is unrealistic, used just to point the high savings required even for this situation). And assuming his salary (and investment capacity) will grow at the rate of inflation (again not realistic, but same reason as above)
About 50% of Mexp has to be invested each month. This number is independent of what Mexp is! Now if you put in more realistic values, the monthly investment needed will only increase.
If the amount to be invested sounds too much, then for reasons good or bad, you are spending too much.
Method 2: This gives you a different sense of perspective and may not be as direct as the one above.
Step a: What is your current tax slab?
Step b: Suppose your net taxable annual income were to reduce to Mexp today, how much tax would you have to pay?
Step c: What is the difference between the answer to step 1 and step 3?
Suppose current tax slab = 20% and tax slab with Mexp as income = 20% would typically mean things are tight. It could mean that you are spending too much.
Both slabs being 10% is unlikely. If both slabs are 30% then I hope you will need to validate again with the first method!
Generally, if tax slab with Mexp as income is one step lower then current tax slab, it is most likely a healthy sign wrt spending and investment.
If tax slab with Mexp as is income (eg. 10%) is two steps lower than current tax slab ((eg. 30%), it could mean a frugal lifestyle.
Of course this a very rough indicator. The main aim is to estimate the tax slab after retirement (and how best to reduce it – more later). Some of my earlier retirement calculators included this logic. Somehow I did not continue it in the latter ones: Online version of the low-stress retirement calculator.
Over to you
Do these methods make sense? If so, please give them a shot. If not, let me know why.
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About the Author
M. Pattabiraman(PhD) is the author and owner of freefincal.com. He is an associate professor at the Indian Institute of Technology, Madras since Aug 2006. Follow @freefincal “Pattu” as he is popularly known, has co-authored two print-books, You can be rich too with goal based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice.
Pattu publishes unbiased, promotion-free research, analysis and holistic money management advice. Freefincal serves more than one million readers a year (2.5 million page views) with numbers based analysis on topical issues and has more than a 100 free calculators on different aspects of insurance and investment analysis.
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