Why reduced spending is the most significant change you can make

If you read along in my previous posts you’d know that I advocate:

  • Spend less than you earn
  • Invest the difference

This is very simply put what you need to do. Taking it one step further – in order to maximize progress, you’ll need to:

  • Cut spending as much as you can while still enjoying life
  • Increase salary as much as you can or get additional sources of income
  • Invest in a way that earns you the best possible investment return

While all three are important cutting spending has the biggest impact. Let’s try to look at it through a concrete example. Meet Sarah:

  • Sarah earns 200,000 kr each year after taxes.
  • Sarah saves 100,000 kr and spends 100,000 kr each year for a savings rate of 50%
  • Sarah invests her 100,000 kr at 4%

We can quickly calculate that after about 21 years she will have 3,200,000 kr which per the trinity study would allow for her to pull out 128,000 kr pretax. After taxes (if utilizing tax efficient investments) she will have around 100,000 kr and is financially independent. Actually, she will have a bit more since she can take out her cost basis tax free, but let’s not dwell on that.

3 scenarios

So, what happens now if Sarah invests her money 50% better and earn 6% yearly real return on her investments. Well again we can run the numbers and now it only takes her around 19 years to amass the same 3,200,000 kr to sustain her spending. Investing a lot better cut a few years off the timeline.

Well then, let’s try instead to alter the initial scenario so that she now earns an extra 20,000 kr per year pretax, while still spending 100,000 a year and still investing at 4%. Since the expenses are still at the same level she will again need 3.2 million kr which now takes her 19 years instead of 21 because of her extra 20,000 a year that she puts into investments.

Now let’s look at the initial scenario one last time and see the benefits if she could cut 20,000 out of her spending. The impact of doing so is three-fold. First she has 20,000 a year extra to invest even while staying at the same salary level. Second her total investments needed to be financially independent is lower due to her lowered expenses. At 80,000 kr expenses per year she will only need just above 2.3 million to live off the interest. Third – her total tax burden on her withdrawals is a lot lower due to the progressive nature of capital gains taxes. So, in total just by cutting her expenses she would now be financially independent at 2,350,000 after 15 years.

To sum up our example results; With an example earnings of 200,000 kr a year after taxes, we could reach financial independence after 21 years if we maintained a 50% savings rate and invested the money at 4% interest (after fees and inflation). Altering the setup in the following ways gave us a shorter timeline:

  1. Investing better (at 6%) saved us 2 years on the timeline
  2. Earning a 20,000 higher salary and investing them also managed to save us 2 years
  3. Cutting expenses by 20,000 and investing those saved us an impressive 6 years

Of course, cutting 20,000 out of a 100,000 budget is a 20% cut in expenses whereas a 20,000 increase on a 200,000 salary is only 10%. But even a 40,000 salary increase in that case wouldn’t catch up (17 years to FIRE). This is partly cause the savings rate in that scenario (140,000 / 240,000) is still lower than the one in the cutting expenses scenario (120,000 / 200,000) and partly because of a lower tax burden on withdrawals.

While cutting expenses seem to be the most efficient way to optimize your FIRE-timeline another important note is of course that you should aim to do all three things. If Sarah in the example managed to both cut expenses by 20,000 kr, get a salary increase of 20,000 kr post tax and invest at 6% then she would be financially independent after only 12 years – so almost at twice the speed. How is that for motivation?!

Reality check

Before ending for now I know a reality check is due. Are those numbers even realistic? Let’s take them one at a time. Regarding investment performance going from 4% expected return to 6% expected returns might be the consequence of switching from a rather defensive portfolio with a lot of cash and bonds to a more aggressive portfolio with more stock while at the same time going for the lowest fees available. Fees alone can often cost you 1% of your portfolio value a year and is one of the most significant factors in allocating your portfolio. More on that in a later post. 6% is not unrealistic historically although it might be unrealistic over the next 10 years. Most of us will be in this for longer than 10 years and there really isn’t much difference we can make to the markets so after optimizing our asset allocation for growth and low fees we should focus on the other two points.

Is a 20.000 kr cut in spending possible? Well that depends what you spend now. But for me there are very small everyday decisions I can make that heavily cuts my expenses. Bringing a lunch for work is 4-5 kr a day vs. buying lunch there at 35 kr and over a year this sums to around 6.000 kr. Cutting TV and only having either Netflix or Hbo at any time is another 3-5000 expense reduction. Driving a used car could probably save you a few thousands a year and living where you work is another few thousands (not to mention the time savings). Cutting travel by 30% would be a big one for me, but is one of those I have a hard time doing 😉 You might already be living on a minimal amount, but take a hard look and see if there isn’t something stupid you throw money at that doesn’t really increase your happiness enough to justify the spending.

Is a 20.000 kr increase in post-tax salary possible? Again, that’s hard to say in the general case. You might be capped out in your field. But in a lot of situations it’s not unreasonable. If you can take paid overtime at 1,5 times the going rate and take 3 extra hours a week (40 instead of 37) that is a 12,2% increase in pretax salary which may translate to 10% post tax depending on your specific tax situation. You might also be able to apply for a similar job at another company – this is often when you can receive very big raises since you are not bound by some max % raise internally in your current company. You can also work for a big raise in your current job by either asking your direct superior specifically how you can increase your value to the company or perhaps by picking up more education on the sidelines. And then there is side income by either working in your free time during the week or grabbing a week or two of work during the holidays. So again, I don’t think a 10% raise in income is impossible if you want to work for it.

Well I guess that’s it for now. I created a google spreadsheet that illustrates these examples so you can examine the math and see if I made any errors or obviously stupid assumptions. You can also copy the sheet to your own google drive and edit it with your own data and assumptions for a quick glance at your own situation. I will create a more complete planning spreadsheet at some point so if you have any input for what you’d like to see in that let me know in the comments.

The 3 above scenarios are modelled in this spreadsheet – make a copy to check your own.

Link to spreadsheet

4 thoughts on “Why reduced spending is the most significant change you can make”

  1. Hej Asbjørn
    Tak for et fint indlæg. Skattesituationen er dog ikke helt så simpelt som du beskriver det her i indlægget, ellers er det mig som ikke kan gennemskue dit regneark til fulde. De første 51700kr (http://www.skat.dk/skat.aspx?oId=satser) af aktieindkomst bliver altid beskattet med 27% (http://www.skat.dk/SKAT.aspx?oId=121163&chk=206510). Aktieindkomst over progressionsgrænsen bliver beskattet med 42%. Denne aktieindkomst over progressionsgrænsen kan du derimod modregne med skatteværdien af dit personfradrag, samt værdien af evt. ligningsmæssige fradrag (befordring, velgørenhed osv.). Skatteværdien af personfradraget er 0,37*44000kr = 16280kr (ca, skattesatsen varierer fra kommune til kommune). Man kan således få udbetalt 16280kr/0,42 = 38760kr til den høje skattesats uden at skullebetale noget skat. I alt kan man ved dette mest skatteeffektive eksempel få udbetalt 51700kr*(1-0,27)+38760kr = 76502kr i dette mest skatteeffektive eksempel, hvilket er en effektiv skattesats på 15%.
    Der kommer udover det jeg har udregnet her også noget grøn check og tillæg til grøn check, men det trækker i den rigtige retning, og hvem ved om det stadig findes når vi nærmer og FI.
    Du kan selv lege med forskellige scenarier her (specielt rubrik 66): https://www.tastselv.skat.dk/borger/beregn2016/IndberetServlet

    Håber det giver nogenlunde mening

    1. Hej Daniel

      Godt at se dig her – har kun set relevante og gennemtænkte kommentarer fra dig så er super glad for dine input.

      Jeg har haft lidt bøvl med kommentarer i WordPress (begyndervanskeligheder) så jeg retter lige mit svar her.

      Hvis man investerer alle sine penge i aktier har du selvfølgelig helt ret. Jeg har ikke rigtigt skrevet om skatteeffektivitet på investeringer endnu, men det er faktisk muligt at bruge sit personfradrag fuldt ud før man begynder at svare skat. Det kan gøres gennem kapitalindkomst som f.eks. afkast fra obligationer. Om situationen er dertil om mange år når vi evt. skal pensioneres er svært at sige, men generelt vil man nok gerne have en del obligationer lige efter pensionering da det er det tidspunkt hvor ens succeschance påvirkes mest af markedsudsving. Når man så skærer ned på obligationerne kommer arbejdsmarkedspensionsudbetalingerne så man stadig kan udnytte sit personfradrag. Om det så er realistisk at udnytte personfradrag på obligationer og stadig forvente 4-6% vækst med den i eksemplet angive størrelse formue; tjaeh 😉

      Det er en super beregner du har linket – den kommer jeg til at bruge meget. Du kan jo lige prøve at vælge “ikke medlem af folkekirken” og så sætte 44.000 kr. i rubrik 32. Så får jeg umiddelbart en nulbeskatning (lad os se bort fra grøn check). Sætter man derefter 50600 i rubrik 66 får man netop en 27% beskatning på de midler.

      Ret mig endelig hvis jeg tager fejl.

      Mvh Asbjørn

      1. Hej Asbjørn
        Du har helt ret i at man kan bruge personfradraget til at undgå at betale skat på obligationer. ETF’er bliver desuden beskattet på samme måde (indtastes i rubrik 346 i skatteudregneren), så igennem ETF’er kan man også få effektiv beskatning af aktier helt fra bunden.
        Jeg tror dog at du misser pointen med min kommentar lidt. Beskatning af aktieindkomst er nøjagtigt lige så skatteeffektivt som alle andre måder, vel og mærke hvis du har en aktieindkomst som overstiger de 76502kr som jeg udregnede i kommentaren ovenover.
        Grunden til at man skal bruge skatteværdien af personfradraget i udregningen, og ikke bare personfradraget, er fordi den høje skattesats (42%) og skatten på personlig indkomst (ca. 38%) er forskellig, hvilket man bliver nødt til at tage højde for når man laver udregningen.
        Håber det giver mening.

        1. Hej igen

          Ja så det er ikke helt så simpelt som jeg angiver det med 2 skattetakster og et fribeløb. Har man ikke personlig indkomst eller kapitalindkomst (obligationer eller som du nævner ETF’er) der kan beskattes til den “lave” 38%’s-sats så skal man lige i arket justere den effektive størrelse på fradraget i C2 ved at gange med 0,38 og dele med 0,42 for at tage højde for forskellen i skat. Og har man årlige indkomster under grænsen du beskriver (76502 kr.) betyder kilden til indkomsten rigtig meget da den afgør om man udnytter sit personlige fradrag (ned til 0% skat) eller ej (op til 27% skat).

          Men som du siger er det lige effektivt skattemæssigt (så længe man udnytter hele personfradraget). Man sparer præcis de samme kroner/ører i skat (nemlig 44000 kr *0,3798), men på en 42%’s skat svarer det bare til at et lidt mindre beløb holdes skattefrit end på en 38%’s skat. Til gengæld er det jo rarere at beskattes på 38%’s niveauet end på 42% såfremt man effektivt kan investere i kapitalindkomst fremfor aktieindkomst – der er dog mange flere nuancer her end jeg tænker vi lige kan dække i en kommenter (bl.a. forskellige fradrag på tab som jeg husker det?). De 38% er selvfølgelig ved bundskat, men jeg mindes at der er et loft på 42% beskatning på kapitalindkomst selv hvis man er i en højere skatteklasse ift. lønindkomst?

          Synes du der er nogen ændringer jeg bør lave i arket for at afspejle det eller skal vi lade det ligge til jeg laver et mere gennemført ark der opdeler i forskellige indkomstrubrikker?

          Mvh Asbjørn

          P.s. Fantastisk at man kan bruge ETF’er som du nævner til at udfylde sit personfradrag før 27%’s beskatningen hvis man har et år eller to med meget lave udgifter

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