The Right Way to Spend Your Paycheck
Although budgeting may seem to be a relatively simple task, it can feel daunting when using spreadsheets or other financial software to track expense categories, debt payments and transfers. Sometimes it may feel too technical and time consuming, and people will give up. If this sounds like you, here is a way to break down budgeting in simple, easy terms.
The 50/20/30 Guideline
When you get your paycheck, there are three main categories you should divide it into:
- Essential expenses. These are expenses you need in order to maintain your fundamental lifestyle, and they usually do not vary much from month to month. This category can be subdivided into five more categories: housing (including necessary repairs and other expenses), transportation, insurance, utilities and groceries. No more than 50% of your after-tax income should go toward these expenses. For example, someone who makes $120,000 annually ($10,000 per month gross) should spend no more than $3,600 per month on essential expenses (assuming a simple 28% tax bracket). If you live in the Bay Area, your housing costs may be extremely high relative to the rest of the country. It is therefore even more important that you pay careful attention to this part of your budget.
- Financial goals. At least 20% of your after-tax income (or 10-15% of your pre-tax income) should go toward savings for retirement, debt payments and other financial goals. For example, if you make $120,000 annually, consider saving $1,000 per month into your 401(k) and $440 per month to pay down student loans. (You will actually come out ahead tax-wise, since your 401(k) contribution will come out pre-tax, and you may even receive a deduction on student-loan interest depending on total MAGI.)
- Lifestyle spending. Up to 30% of your after-tax income should go to discretionary spending, which is all the non-essential stuff, or stuff you do for fun, such as your hobbies, gym membership, entertainment and dining-out expenses. So the person with the $120,000 salary should spend no more than $2,160 per month on lifestyle expenses.
Simple Tips to Make Your Budget Work
Here are some good rules of practice to take the 50/20/30 guideline and turn it into reality:
- Set up automatic withdrawals. A good technique is to set up a few different bank or investment accounts. Have your paycheck automatically deposited to your “fun” account. From this account, have an automatic withdrawal based on the amount of your essential expenses (the 50%) each month go to a different account designated to pay these expenses. If your 20% savings money is not automatically sent from your paycheck to your 401(k), have that amount taken from the deposit account and put into your savings and/or loan accounts. You can now feel free to spend the money leftover in the deposit account. (If you still have money left in there at the end of the month, transfer it to savings and you will be ahead of your goals.)
- Live on last month’s income. If you divide up your paycheck into different bank accounts, seeing your “essential” account near zero can be quite scary and stressful. I would recommend to always keep a buffer of one month of expenses in this account so that you know there will always be enough money for basic living. This amount can count toward your emergency reserves (NewFocus always recommends that three to six months of expenses be kept in safety cash of some sort).
- Use software. Once you get used to the 50/20/30 budget, I would suggest you use budgeting software to go even deeper into your budget. Mint.com is a good place to start; NewFocus clients also get budgeting tools through our client wealth management website. Using these tools, you can track more defined categories within your budget and figure out where to reallocate funds or where you might have more room to save.
Finding What’s Right for You
The 50/20/30 guideline is just that—a guideline—and not a hard and fast rule. Your goal should be to spend a maximum of 50% on essential expenses and 30% on lifestyle expenses. If you find that you can easily fall under that guideline, you shouldn’t be afraid to save more. Also, if you find that one month you overspent in one category, don’t beat yourself up. Figure out what happened and tighten that part of the budget for the next month.
Disclaimer: Consult your tax advisor before taking any action on topics discussed in the blog.