If it is your first time creating a budget for yourself then knowing how to manage your money every month can be a bit challenging. Aside from learning how to organise, you also need to make difficult decisions when it comes to spending your money. Most often, we rely on the experience of other people. However, other people’s income and expenses are entirely different from yours. Perhaps they would spend $2,000 per month on rent, however, this kind of spending might not be appropriate for you.
The good news is, there is no need for creating intricate spreadsheets with numerous categories. In fact, you don’t have to be a financial expert in order to know your limitations on spending. All you have to do is simply follow the 50/20/30 Rule.
Money just comes and goes since there are a lot of ways that we could spend it. For instance, food, medicine, education, clothing, gifts, gas, gadgets, rent, etc. Hence, it would be hard for us to create a budget. Sometimes we are tempted to throw up our hands and say, “Let’s just forget it!” All we can do is hope for the best.
Want to switch to More Than Accountants? You can get an instant quote online by using the form below. In a like for like comparison for services we are up to 70% cheaper than a high street accountant.
The best thing is, we have the best and the simplest solution for you. This is the 50/20/30 Rule. Regardless if you are working on your first job after graduating from college or you are a mother of two, this rule will likely apply. It can help you in determining how much should you spend in every area for each month. Aside from this, you will also learn how to prioritize your spending.
What Is The 50/20/30 Rule About?
The 50/20/30 Rule was created by Elizabeth Warren and was mentioned in her book entitled “All Your Worth: The Ultimate Lifetime Money Plan.”
With the 50/20/30 Rule, there is no need for breaking down your budget into different categories, making it so easy to track. All you have to do is divide everything into three major categories. These are the necessary expenses, financial priorities, and lifestyle options.
50% of your take-home pay should be allocated for the necessary expenses. These are actually the expenses that are needed so that you can sustain the fundamentals of your life. This includes food, shelter, heat, and others. There are only four expenses that belong in this section. These are groceries, housing, utilities, and transportation.
20% of your take-home pay should go to financial priorities. This category consists of the goals that are needed in order to have a strong financial foundation. For instance, your savings, retirement contributions, payments for debts, in case you have debts or loans. These payments and contributions should be done only after you have paid your necessary expenses and before you make any other spending.
For your lifestyle options, you can use the remaining 30% of your take-home pay. This includes personal, deliberate, and even fun options in spending your discretionary income. Some examples of these expenses include telephone, cable, internet, shopping, restaurants, hobbies, entertainment, charity, gym fees, etc.
In your budget, lifestyle options are the last things that you will pay. However, you should not feel guilty about this since you have already taken care of your necessary expenses and financial priorities.
How To Start The 50/20/30 Rule?
First, you need to determine what is the current situation of your finances. First of all, examine your pay stubs to figure out how much money you actually earn every month. This is your income and you will use this amount as the basis for your 50-20-30 split. If you are self-employed, then you have to keep track of your earnings carefully. Be sure to compute your average income per month so you will be able to make an efficient budget.
The next thing to do is to monitor your spending. This means that you have to record everything down to the last centavo. Regardless if it is a big amount such as the rent or small stuff such as the coffee that you buy on your way to your work.
Afterward, divide them into three categories, necessary expenses, financial priorities, and lifestyle options. You have to ensure that your spending will fall into the 50/20/30 budget. If not, then you have to make some adjustments. If you think that you are overspending on some unnecessary things, then you have to cut back on your spending.
Warren and Tyagi recommend that you should try to manage your budget effectively. Here are the steps on how to do it.
Step One: Determine Your After-Tax Income
The after-tax income is the amount left after taxes were deducted from your paycheck. These deductions include Social Security, Medicare, income tax, state tax, etc. If you are working and you have a steady income, then it will be easier for you to figure out your after-tax income. All you have to do is look at your paystubs. If there are retirement contributions, health care payments and other types of deductions that were deducted from your paycheck, then you have to add them back to your after-tax income.
If you are self-employed, then you can compute your after-tax income by adding your gross income and deducting your business expenses including your transportation expenses, cost of your devices, tax payments, etc. Since you don’t have an employer, then you will be the one who will remit your tax payments to the government.
Step Two: Restrict Your Essentials to 50%
When it comes to your needs, it should not go beyond 50% of your after-tax pay. These needs will include your groceries, utilities, insurance payments, housing, etc. Try to figure out which of these expenses are considered as needs and which ones are wants.
Needs include electricity, prescription medicines, and other essential things that can severely affect your quality of life. On the other hand, wants are the things that you can simply do without since it can only provide minor inconveniences.
Step Three: Allocate 20% on Savings and Debts
20% of your after-tax income should be allocated for savings and additional debt repayments. It is important that you should save some money for your retirement and emergency funds. This category is not considered as a need or a want. If you have a current balance on your credit card, then paying the minimum amount is considered as a need. Hence, it will be part of the 50%. Any additional credit card repayment belongs to the 20% category.
Step Four: Restrict Your Wants to 30%
This may sound awesome on the surface. Perhaps you are thinking that you will spend this 30% on beautiful clothes, Italian restaurants, vacation trips, etc. However, this is not the case, since this does not include extravagances. what it includes are the basic things that can help us enjoy life. For instance, cable, phone plans, internet, etc.
If you have a mortgage or a car loan, then its minimum payment belongs to the 50% category while the additional repayments belong to the 20% category.
How Does The 50/20/30 Rule Work?
Since this 50/20/30 Rule is very flexible, then it is very easy to apply it in real life. Here we are going to make a comparison of two budgets. One is from Molly who recently graduated from college and got his first job. While the second one is for the couple, Sarah and Tim.
Molly is 22 years old and she recently graduated from college. Luckily, she got her first job and she is now working in Chicago. Although she has student loans, yet she can still afford to pay them each month. At the same time, she also made some contributions to a Roth IRA and made payments to all her bills.
Molly’s income is $36,000 a year. This means that her monthly income is $3,000 and after taxes, she will only receive $2,250 a month. Here, we assume that 25% of her salary is allocated for taxes and 401(k) contributions.
For her necessary expenses, she spent $200 for groceries, $75 for transportation, $75 for utilities, and $750 for rent. If we add everything, then it will give us a total of $1,100. Essentially, this is equivalent to 49% of her salary.
For her financial priorities, she made Roth IRA contributions of $200, she allocated $50 for her travel savings fund, and made a payment of $225 for his student loan. All in all, it has a total of $475 which is 21% of her salary.
For her lifestyle options, Molly spent 30% of her income or $675. Since Molly has a tight budget, her necessary expenses are almost 50% of her salary. Despite this, she is still able to make payments for her student loan. Eventually, she will have no more worries, when she retires since she allocated 9% of her salary for her savings. These savings can grow tremendously in a long time.
Sarah and Tim’s Budget
Sarah and Tim have two children who are about to go to college. This couple is in their mid-40s and is earning $150,000 a year. Approximately, they will obtain $6,767 a month after taxes and 401(k) contributions. This is assuming that 30% of their salary will be allocated for these deductions.
For the couple’s necessary expenses, they’ve allocated 38% of their income or $2,600. In this amount, $400 is for groceries, $1,200 is for mortgage payments, $250 for gas, $150 for utilities, and $600 for car payment and insurance.
For Sarah and Tim’s financial priorities, they’ve made 529 account contributions $1,470, Roth IRA contributions of $833, and made a savings of $200 for their vacation fund. The overall total is $2,503 or 37% of their total income.
The couple decided to spend $1,664 or 25% of their salary for their lifestyle options.
In this situation, it clearly shows that the 50/20/30 Rule works for the couple since it is very flexible. Supposedly, the necessary expenses are only 50% of their salary, yet the couple successfully keeps it below this threshold. They have finished paying one of their cars and they’ve decided that they won’t purchase a house yet. Because of this, the couple was able to stretch their budget.
So, how are they going to spend the money that they have saved from the necessary spending? What they can do is to put them on their children’s 529 accounts. However, both of them are still paying for their Roth IRA contributions which is a higher priority than saving funds for the college education of their children.
However, this does not mean that their children’s college education is less important. The reason behind this is that they can always get a loan for their children’s college education in case they fell short in paying for their tuition. On the contrary, they can’t get any loan to pay for their retirement. Sarah and Tim wanted to meet their 529 savings goals. In order to do this, they agree that they should be frugal as possible most especially when it comes to their lifestyle options. This is why they are only putting 25% of their salary on these.
A Reminder About Your Retirement
As you can see, the 50/20/30 Rule can only be applied for the take-home pay. How about the retirement contributions that you’ve made before your paycheck reaches your bank account? Obviously, they are not included. Because of this, it seems that you’ve made more contributions to your financial priorities than what this breakdown actually shows. However, we recommend that you should keep this retirement money out of your mind.
But if you are self-employed and you have not made any retirement contributions before your paycheck reaches your bank account, then you have to ensure that you meet your retirement goals. This means that you have to allocate more than 20% of your income to financial priorities.
How Can You Apply The 50/20/30 Rule On Your Budget?
After learning how the 50/20/30 Rule can be used in two very different situations, it’s time for you to use it to your own situation. The LearnVest Smart Budget can help you in analysing your current spending so it can be applied to the 50/20/30 Rule. All you have to do is sign up with LearnVest so you can obtain an effective budget. You will be asked to enter your necessary expenses and financial priorities. In the end, you can assign some money for your lifestyle options. The best thing about this is that this is absolutely free. Hence, you can easily create an efficient budget that can help you in saving more money.