You’ve reviewed your spending and created a budget, and now you know exactly how much you spend on your home, your car, discretionary spending, and how much you divert to your retirement accounts. That’s all good, but what about other savings, such as for an emergency? How does your financial allocation compare to the amount you should ideally spend and save?
Harvard bankruptcy expert Elizabeth Warren- U.S. Senator from Massachusetts and named by Time Magazine as one of the 100 most Influential People In The World coined the “50/30/20 rule” for spending and savings with her daughter, Amelia Warren Tyagi. They co-authored a book in 2005. “All Your Worth: The Ultimate Lifetime Money Plan.”
So how does the 50/30/20 plan work? Here’s how Warren and Tyagi recommend you organize your budget.
Step One: Calculate Your After-Tax Income.
Your after-tax income is what remains of your paycheck after taxes are taken out, such as state tax, local tax, income tax, Medicare, and social security.
If you are an employee with a steady paycheck, your after-tax income should be easy to figure out by checking your pay stubs. If health care, retirement contributions, or any other deductions are taken out of your paycheck, add them back in. If you are self-employed, your after-tax income equals your gross income less your business expenses such as the cost of your laptop or airfare to conferences, as well as the amount you set aside for taxes. You’re responsible for remitting your own quarterly estimated tax payment to the government because you do not have an employer to take care of it for you.
Just remember that being self-employed means that you must also pay the self-employment tax, so include this in your calculations. The self-employment tax is double what you would pay in Medicare and social security taxes if you were employed.
Step Two: Limit Your Needs to 50 Percent of Your After-Tax Income
Now go back to your budget. How much do you spend on “needs” each month, things like groceries, housing, utilities, health insurance, car payment, and car insurance? According to Warren and Tyagi and their 50/30/20 rule, the amount that you spend on these things should total no more than 50 percent of your after-tax pay.
Of course, now you must differentiate between which expenses are “needs” and which are “wants.” Basically, any payment that you can forgo with only minor inconveniences such as your cable bill or back-to-school clothing is a want. Any payment that would severely impact your quality of life such as electricity and prescription medicine is a need.
If you cannot forgo any payment such as a minimum payment on a credit card, it can be considered a “need,” according to Warren and Tyagi. Why? Because your credit score will be negatively impacted if you do not pay the minimum. By the same token, if the minimum payment required is $25 and you regularly pay $100 a month to keep a manageable balance, that additional $75 isn’t a need.
Step three: Limit Your “wants” to 30 percent
This may sound great on the surface. Can you put 30 percent of your money towards your wants? Hello, beautiful shoes, a trip to Bali, salon haircuts, and Italian restaurants.
Not so fast. Remember how strict we were with the definition of a “need”? Your “wants” do not include extravagances. They include basic niceties of life that you enjoy like the unlimited text messaging plan, your home’s cable bill, and cosmetic (not mechanical) repairs to your car.
You might spend more on “wants” than you think. A threadbare minimum of warm clothing is a need. Anything beyond that, such as shopping for clothes at the mall rather than at a discount outlet, qualifies as a want.
Step Four: Spend 20 Percent on Savings and Debt Repayment
Now about the extra $75 you pay on that credit card each month. That’s neither a want nor a need. It’s the “20” in the 50/30/20 rule. It is in a class of its own.
You should spend at least 20 percent of your after-tax income repaying debts and saving money in your emergency fund and your retirement accounts. If you carry a credit card balance, the minimum payment is a “need” and it counts towards 50 percent. Anything extra is an additional debt repayment, which goes towards this 20 percent category. If you carry a mortgage or a car loan, the minimum payment is a “need” and any extra payment counts toward “savings and debt repayment.”
An Example of the 50/30/20 Plan:
Let’s say your total take-home pay each month is $3,500. Using the 50-30-20 rule, you can spend no more than $1,700 on your needs per month. You probably can’t afford a $1,500 a month rent or mortgage payment, at least not unless your utilities, car payment, minimum credit card payments, insurance premiums, and other necessities of life do not exceed $250 a month.
If you already own a home or you’re locked into a lease, you’re pretty much stuck with that $1,500 payment. Consider relocating when your lease expires to make your budget more manageable or take a look at your other needs to see if there’s a way that you can reduce any of them. Maybe shop for more affordable insurance or transfer the balance on that credit card to one with a lower interest rate so your minimum payment drops a bit.
Your goal is to be able to fit all these expenses into 50 percent of your take-home after-tax income.
You can spend $1,050 a month on your “wants” based on that $3,500 you’re bringing home each month. You may consider doing away with a few things and shifting some of this money to your “needs” column if you are coming up short there-not necessarily indefinitely but until you can get your needs down to a more manageable level. Remember, you still need 20 percent left over so you can save and pay down your debts according to the 50/30/20 plan.
Now you have $700 left. That last 20 percent. You know what to do with it. Pay down on debt, save for an emergency, and plan for your future.