The True Cost Of Lifestyle Inflation

Lifestyle inflation happens when your expenses increase along with your income. As earnings increase, it’s natural to want to buy a better car or take another vacation. After all, it seems feasible. But if your savings rate isn’t at least keeping up with your rising expenses, you could end up worse off compared to when you earned less. Lifestyle inflation can be hard to avoid because it isn’t always easy to detect. Unless you just won the lottery, the increase in spending tends to happen slowly.

How lifestyle inflation can derail your finances

In a simple example, assume you change jobs and earn a $35,000 raise. Your additional annual take-home pay after-tax is about $23,000. You were already maxing out your 401(k), so no other deductions have changed.

Your raise results in a net increase of $1,917 per month. Not bad! But here’s where it can go off the rails.

Throughout the year, you make some adjustments to your lifestyle:

• New car = $6,000 down payment + $800 monthly payment ($9,600/year)
• Buy new furniture = $3,000
• Increase use of personal services (upgrade gym membership, personal training, spa services) = $100/month ($1,200/year)
• Eat out more often = $200/month ($2,400/year)
• Take an unplanned vacation = $4,000
• Net savings = ($3,200)

Despite earning a $35,000 more, you’ve decreased your bottom line by $3,200! What’s worse, the car is an added ongoing fixed cost taking up 42% of your take-home pay from the raise.

So even if you cut back on eating out and vacations next year, unless your income increases, your ability to improve your bottom line is capped.

Lifestyle inflation is like running in place

The slow creep of lifestyle inflation can have significant long-term implications. When estimating your retirement expenses, you’ll likely want to maintain your current standard of living. As your living expenses increase, your savings rate must as well to accommodate additional income needs in retirement.

The cost of future income

An investor 50 years old would need to save an additional $745 per month for 15 years to spend an additional $10,000 per year in retirement, assuming a 6% rate of return in a taxable account.¹ And this example doesn’t even account for market volatility which would increase the required savings.

In another words, you need nearly $19,000/year in extra cash to add an additional $10,000 to your ongoing annual expenses. And this is just to keep you running in place. If you wanted to retire just five years earlier on the same income, you’d need to save almost $1,500 per month.

How to avoid the traps of lifestyle inflation

Automate your savings

It’s really easy to spend cash in the bank. If your emergency fund is full and you have no short-term goals to save for, consider automatically sweeping extra cash to a brokerage account for investment.

If you don’t set it up automatically, when the cash piles up it’s tempting to spend for today rather than invest for your future. People regret not having saved more along the way. Few look back and wish they took more vacations in business class.

Invest outside of retirement accounts

For high earners, a substantial income can make many lifestyle upgrades feel within reach. But keep in mind, you’re still limited to the same 401(k) contribution limits as individuals who earn significantly less.  So all else equal, if your lifestyle cost is above average, your savings rate to maintain it needs to be too. For this reason, maxing out a 401(k) often isn’t enough to fully fund retirement.

A brokerage account is often the best way to supplement retirement savings in a 401(k) or IRA. Money invested in a brokerage account is available if you needed it (subject to the prevailing market prices and taxes), but it’s not as accessible as a cash account, which is a feature not a bug.

Investing an extra $2,000 per month would equal about $536,000 after 15 years, assuming a 15% tax rate and 6% annual return. By dollar-cost averaging money from savings into your brokerage account each month, you don’t need to be overly concerned about current market conditions and whether it’s a good time to invest.

Spend responsibly

Life isn’t about being the richest person in the graveyard. But without proper attention to your finances, you may inadvertently put yourself in a poor financial position, especially if you unexpectedly lose your job. Work to balance your short-term wants with long-term needs as you weigh the pros and cons of adding new expenses.

¹ Assumes a 6% annual rate of return, 15% tax rate, income of $10,000 per year between age 65 – 90, increasing 3% each year. Does not account for market volatility. Monthly savings remains level during pre-retirement.