We have all at one point made it to the end of the month and wondered where our paycheck has gone. Even if you consider yourself a frugal person, chances are you do not have a complete picture of where all of your hard-earned money is going. Whether you spend a fortunate at restaurants or you cave in and impulse buy an expensive item, unless you make a concerted effort to track and monitor your monthly expenses, you probably are wasting thousands of dollars every year that could be avoided by simply understanding what you spend each month.
The first step to take on your financial journey is to lay out and stick to a reasonable budget based on your personal spending needs. Once you determine a budget based on your future goals, you will probably find hundreds or thousands of dollars that you can potentially save and invest to grow your net worth. Because we all have areas we can improve in our spending, simply by implementing a spending plan in your personal finances, you can give yourself a well-deserved pay raise this month.
What is a budget?
A budget is a financial allocation tool that provides guidelines on where you should be spending your income. By implementing a spending plan, a budget allows you to track all of your income and all of your monthly expenses in one place to make sure your money is going where you tell it to go.
Often, budgets get a bad reputation and have negative connotations. In virtually every context, people associate personal budgets with a restriction on the financial choices you can make each month. While we all have a finite amount of money that we have available to spend based on our respective incomes and savings, budgets are much more than a responsible tool to allocate your available resources. Budgets offer a “big picture” view of what is important in our lives. After all, since we all trade our time and lives for money through active work and productivity, our choices of where to spend that hard-earned money is an indication of what we value in our lives.
More than a restrictive tool, a well-planned budget is permission to spend on categories that have meaning and bring joy to your life. The great aspect of budgeting is that you can build in fun categories based on the relative importance in your own life. Since you are giving yourself permission to enjoy your money in certain categories, budgets eliminate any guilt or concern for “splurging” on certain items that you can afford and should be able to enjoy. Instead of impulse buying out of frustration, you can have a line item in your budget specifically for hobbies or wants.
How do you make a budget?
The budgeting process can be daunting for beginners. However, this is often because new budgeters are not organized. Therefore, the budgeting process gives you the opportunity to get a handle on your finances by organizing your income and monthly expenses.
Thanks to technology, many websites, downloadable apps on your smart phone, and an endless supply of tools will help you create, maintain, and monitor your budget on a monthly basis.
If you have experience with Microsoft Excel and enjoy diving into the details, you can also consider using spreadsheets to track your monthly income and outgo. However, if you prefer to use technology to automate the process and are willing to link your various banking and credit/debit cards, tools such as EveryDollar, Mint, and Personal Capital offer helpful tools that track your income and spending.
1. Determine your net income
The first step in your budgeting process should be to determine your net income after taxes. Since hefty fines and penalties are assessed for underpayments, there are plenty of headaches when dealing with the IRS if you do not pay your required taxes. If you have little experience with taxes, hiring a qualified professional to prepare your tax return and advise you on how much to withhold from your paycheck and pay quarterly may be the best option.
Determining your after-tax income
Your after-tax income is your gross income (or salary) minus any taxes such as federal, state, and Medicare taxes that are applied and withheld from your paycheck. After your paycheck processor deducts these tax expenses, you are left with your after-tax income.
While taxes can be a difficult and confusing subject for the general population, most employers have processes in place through their Human Resources departments and payroll providers that will automatically withhold the required taxes from their W-2 employees. If you are responsible for withholding your own taxes and paying quarterly estimates, consider hiring a tax professional to guide you in calculating how much you should withhold and pay. Then, subtract the amount of taxes from your gross income to determine the income to base your budget.
If you have consistently received a large federal income tax refund, you may want to consult with your tax professional or simply adjust the amount withheld from your paycheck in order to ensure all of your income is coming home each month for your budget. While everyone enjoys getting a tax refund, this is essentially money you are loaning to the government at 0% interest. Therefore, this is your money that could be used for a much better purpose in your budget.
Additionally, to get a more accurate picture of your income after taxes, you will need to add back any other payroll deductions such as insurance deductions and automated retirement contributions. After including all of these assumptions, you should not have an accurate starting point to base your budget.
2. Compile your budget based on your financial goals
While determining your own budget from scratch or based on historical norms is certainly helpful, several rules of thumb exist to help guide the budgeting process. While these general guidelines are helpful to make sure one category is not completely out of line and hindering other important parts of a balanced financial life, general budgeting guidelines do not consider your personal dreams and goals. For this reason, you can make modifications to these general rules by compiling a more detailed monthly budget.
The best budget is a personalized spending plan that accounts for your own financial goals. Additionally, your budget should be well-rounded and balanced. You have the ability to allocate your dollars in three basic ways: you can spend money, save cash and invest, or give away any extra to charity, family, or friends.
You do not want to save and invest to the point where you cannot be generous and enjoy your life. Alternatively, you do not want to consume all of your income through wasteful, frivolous spending habits and have nothing left to show for your hard work. Instead, you should implement a budget that encompasses all of these areas based on your future goals, causes that are important to you, and hobbies and purchases that bring you joy.
The 50/20/30 Rule
One of the most popular budgets today is the 50/20/30 rule. Under this general guidance, people should spend 50% of their after-tax income on necessities such as housing, utilities, required and necessary food, and clothing needs. Within the 50% category, you must understand that these are necessary, basic items and do not include luxuries such as dining out or purchasing high-end clothes.
According to this rule of thumb, an individual should save or invest a total of 20% of their income and spend the remaining 30% as they please. When saving 20%, some of this should be allocated to retirement through tax-advantaged accounts and some to unrestricted accounts that can be accessed in case of emergency or to fund other future expenses. Within the 30% of spending, any expenses for luxuries or discretionary items such as dining out in restaurants, vacations, quality clothing, or other non-essential expenses are included.
Downfalls of the 50/20/30 Rule
While this technique is good general guidance for individuals and households just getting started and who earn near the median income, for those that are on the low and high extremes of the income spectrum, the advice may be less suitable.
As an example, for individuals in certain high-cost areas of the country that make below the median income, they may find themselves spending a higher percentage on required expenses and less on savings and discretionary spending. Therefore, their personal budgets may not allow them to save and invest anything. High income-earners may be better off allocating a greater percentage of their monthly budget to savings, discretionary expenses, or generosity as “necessary” items will be a relatively small percentage of their financial world.
Another pitfall is that this advice does not consider a household’s personal goals and dreams. For many, building a substantial net worth through savings and investments in order to retire early or explore a different career path could be a very important pursuit in their lives. If they followed this budget, they would more than likely achieve “average” results rather than the extraordinary lifestyle they are striving to achieve. For individuals looking to achieve financial independence, they may need to save and invest 30-40% of their after-tax income which is nearly the double the recommended amount of this particular budget.
Additionally, most of the financial planning community and personal finance experts recommend individuals save 15% of their gross income in tax-advantaged accounts such as a Traditional or Roth 401(k)s or IRAs. Since the 50/20/30 rule of thumb only outlines savings of 20% of your take home pay, nearly every penny saved after tax would be locked up until 59 ½ when the retirement funds could be accessed without penalty in retirement accounts.
While saving for retirement is certainly an important goal, savers also have financial needs and wants beyond retirement. Therefore, accumulating savings outside of restricted retirement accounts to buy a home, purchase a new car, or pay for college is paramount to leading a well-rounded life. For this reason, there are other budgeting methods to consider when compiling your own budget.
Zero-Based Budget
A zero-based budget is a category of budgets where each dollar you earn from your paycheck has a specific assignment and purpose each month. Even though the 50/20/30 rule is in the same family of budgets, other zero-based budgets may allow for additional flexibility and customization to your particular goals.
For those looking to prioritize saving and investing above and beyond the 20% recommended in the 50/20/30 budget, a popular method is to “pay yourself first” in a line item in your budget. After you have paid yourself a desired savings rate, the remaining amount is virtually free game to spend as you please.
As an example, a household may have the goal of saving 30% of their after-tax income. In order to accomplish this, they may contribute 15% of their gross income into tax-advantaged retirement accounts with the remaining amount allocated to a high-interest money market fund, individual brokerage account, or other unrestricted savings vehicle.
With the remaining amount, they may decide lifestyle expenses such as dining out, vacationing, and driving new cars is relatively less important than owning a larger residence. In this case, they may decide to spend another 35% on their housing costs and use remaining amount on other living expenses.
After paying yourself first, the key in any budget is to maintain balance and leave room in your budget to splurge and enjoy life. If too much of your money is going to one category, you will probably feel financial stress or become burned out and give up budgeting all together. For this reason, you should continually assess and modify your budget based on your long-term game plan.
Dave Ramsey Budget
For those ardent Dave Ramsey fans, the advice you will hear from his show and books is definitely on the financially conservative end of the spectrum. For many Americans, this can be a welcome reprieve from societal pressures to own a big house, drive a fancy car, and live life leveraged to the maximum.
One major theme prevalent in his financial advice relates to becoming debt-free before investing or spending money beyond your basic required spending. Because of this philosophy, virtually all spending should be allocated to religious giving, required living expenses, and debt reduction until all liabilities have been eliminated.
Once becoming debt-free, there are only a few percentages his program recommends as general guidelines to ensure you are in balance.
Firstly, his program dictates that 10% of your gross income should be affiliated with giving and generosity. Secondly, 15% of your gross, household income should be invested in tax-advantaged retirement – specifically, Roth 401(k)s and Roth IRAs. Finally, your monthly housing payment on a 15 year, fixed-rate mortgage or rent should not exceed 25% of your after-tax pay. The surplus can be spent freely as desired.
The overall premise of his recommended plan is that you will have the most peace when you control 100% of your income by having no debt obligations and do all three categories in balance. You will not feel fulfilled if you invest and hoard all of your money. Similarly, you will feel intense financial pressure if you owe a lot of money or cannot be charitable.
Hybrid Budget Approach
Generally, you will probably not go wrong with including aspects from any of these plans in your personal budget. In my own budget, I adapt and combine the better elements of each plan into a hybrid budget based on what is more important to me.
While some financial planners recommend spending 33% on housing, investing 15% for retirement, and spending the remaining amount as you please, I spend no more than 25% on my housing, save and invest 15% into retirement accounts and max out my employer matching program. I also save an additional 10% of my gross income in unrestricted accounts, resulting in a total savings rate of 25% of my gross income.
For me, building a substantial nest egg and achieving financial independence prior to retirement is more important than living in a more expensive residence, dining out frequently, or buying stuff that I will eventually throw away.
To determine your initial budget, you should see how much you historically spend on housing and utilities, food, clothing, recurring expenses, and other non-essential spending. Once you have organized your expenses into these categories by thumbing through your bank and credit card statements, you should have a good basis to start tracking your budget. More than likely, you will see areas of one-off expenses or areas you can quickly downsize or eliminate altogether. In order to determine a sustainable budget going forward, you will probably have to monitor and update your budget the first few months as you determine what is a realistic expectation in your own situation.
3. Track your monthly expenses
Now that you have developed a preliminary budget based on the general rules of thumb we discussed, your personal spending and savings goals, and your historic spending needs, the next step is to monitor and track your budget each month.
For most people, monitoring and calculating your spending each month can be quite boring and may deter people from sticking to the budget. If you do not want to manually obtain your credit card statements and add up all of your food expenses and constantly track how much you spend on gas and car insurance, there are many apps that can automatically track your spending.
Use helpful apps such as Personal Capital and Mint to automate your budget
As previously mentioned, two of my favorite budgeting apps are Mint and Personal Capital. By linking your various accounts, all of your income and spending can be automatically tracked by category within the app. This offers a real time picture of how much you have spent and how much more you have left remaining in each category.
For instance, if you go to the grocery store and make a purchase, the software automatically places the spending in a “grocery” category. If you made a purchase that does not relate to that category, you can simply split the bill and manually allocate the amount to another category. Within both the Mint and Personal Capital applications, you can set up a budget for each spending category such as fast food, groceries, restaurants, gas, insurance, and housing payment. Each month, you can track how much you are spending relative to your budget and based on the prior months. Once you near the end of your budget, you can elect to receive alerts or emails notifying you how much you have left to spend before going over a particular category. This will help keep you accountable to your budget.
Monitoring and tracking your monthly expenses are quite possibly the most important aspects of the budgeting process. Even though you may not enjoy the tedious process, in order to get control of your finances, you must know where your money is going at all times. While tracking your budget, you are able to make a conscious effort to control your money rather than having your spending decisions control you. Additionally, by tracking all of your expenses, you will probably find areas of excess that you can cut back or eliminate. By leaning and trimming unnecessary expenses, you will quickly find more money in your budget, to save and invest or give away.
Once you implement a spending plan based on your financial goals and dreams and know where your money is going at all times, you will quickly gain control of your financial situation and identify areas that can be improved to save more money. Therefore, making a budget is a wonderful first step to achieving your personal finance goals.