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# Your capital to income ratio

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In personal finance, all decisions you make should help you move from a being a laborer to being a capitalist. As a laborer you are paid a wage for your services. As a capitalist, you are paid not for the value of your labor, but for the use of your money.

The concept of moving from laborer to capitalist sounds like a nice theory, but what you probably want to know most of all about retirement is this: "How much savings (capital) will I need to retire?" A good estimate is that you will need to accumulate capital worth about 12 times your income. If you have capital worth about 12 times your gross annual income at age 65, this should put you in a position to live on about 80 percent of your pre-retirement income.

This is the transformation from laborer to capitalist. You start out with zero capital when you are young, save a portion of your income each year, and ultimately try to accumulate capital worth 12 times your pay. To help you track and benchmark this process, I have developed the Capital to Income Ratio, or CIR. The CIR tells you how much capital you should have accumulated at various points between ages 25 and 65 so that you stay on track to reach 12 times pay at retirement.

To begin, find your age and the corresponding Capital to Income Ratio figure in the chart below. Then multiply your household income by the Capital to Income Ratio. This tells you how much capital you should have accumulated at your age. If you are saving adequately, you should be hitting these ratios along the way. Since your goal is to accumulate capital worth at least 12 times your income, this ratio lays out your path from ages 25 to 65. All you need to do is keep driving your Capital to Income Ratio up so you are hitting each benchmark as you progress toward retirement. You do that by consistently saving each month, as well as properly managing your debt, investments, and insurance.

Example: Let's assume you are 40 and have a household income of \$100,000. The Capital to Income Ratio at age 40 is 2.4. This means you should have 2.4 times your income in savings, or \$240,000 saved. Now add up what is in your 401(k), IRAs, savings and investment accounts and compare it to that figure. This will tell you if you are ahead or behind in your goals. By using the ratios, you can quickly benchmark your progress and stay on track for retirement. If you are not on track, you can make adjustments and get back on track in a few years.

Capital to Income Ratio

Your
age                  Capital to Income Ratio (the multiple of your annual income you should have accumulated)
25                   0.1
30                   0.6
35                   1.4
40                   2.4
45                   3.7
50                   5.2
55                   7.1
60                   9.4
65                 12.0

For the purposes of the CIR, capital means:
• The savings in your 401(k) plan, IRAs, annuities and CDs
• The cash value of your life insurance
• The amount in your checking and savings accounts
• Equity in commercial real estate
• The fair market value of any business interests.

For most people, the income component of the CIR will be easy to calculate. If you are paid a stable salary each year, you simply use your total household income for purposes of the CIR. But some people have a more volatile income stream. It might rise and fall as the result of a year-end bonus; or it is volatile because they run their own business.

In these cases, you want to use your "core" annual income for purposes of the CIR calculation. To calculate your core annual income, take a simple average of your pay for the last four years. This average will help smooth out the ups and downs, and give you a better sense of the average income you are living on each year.

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Charles Farrell

Charles Farrell is CEO of Northstar Investment Advisors, LLC, and author of "Your Money Ratios: 8 Simple Tools for Financial Security," called "one of the best financial books to cross our desks this year" by the Wall Street Journal in 2009. Farrell previously served as a tax attorney representing privately held businesses on tax, retirement and estate planning matters.

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