By Jane Young, CFP, EA
A key factor impacting your ability to achieve financial security is living below your means. To live below your means, you need to understand your financial situation and live within a budget that includes an allocation for saving and investing. Regardless of your income level, a budget is essential to intentionally spend and save money based on your financial goals and priorities.
Everyone’s situation is unique, and you need to create a budget to meet your specific needs. However, budgeting guidelines or rules of thumb can provide some general thresholds and parameters to guide you in creating your budget.
Start by understanding your current situation. Calculate your after-tax income before voluntary deductions such as 401k contributions, vision plans or life insurance. Once you know how much income you have available, calculate your actual expenses and savings by reviewing credit card and bank statements along with other applicable documents. Obviously, if you are spending more than you earn, you need to devote considerable effort toward reducing expenses or increasing income.
Lump your spending into major categories and identify what items are discretionary and non-discretionary. Determine what percentage you are spending by major category. Calculating the percentage you spend in each category gives you a broader picture of your financial situation. It can also help you identify areas where you are overspending.
Below are some general guidelines on how much the typical household should spend in each category. Make adjustments for your situation. If you live in area with extremely high housing prices, have high child-care expenses, make large charitable donations, or have significant debt you may need to make some adjustments.
- Housing 25%
- Food 10-15%
- Savings 15-20%
- Insurance (life, medical, home and auto) 10-15%
- Transportation 10%
- Entertainment and Leisure 5-10%
- Health 5-10%
- Personal 5-10%
- Miscellaneous 5-10%
The 50/30/20 rule is another technique for budgeting your money. With this strategy 50% of your money is designated for absolute necessities. This includes housing, transportation, groceries, utilities, insurance, minimum payments on debt and child-care. Designate 30% for wants or discretionary items such as gifts, travel, entertainment and eating out. The remaining 20% is for saving, investing and debt repayment, in excess of minimum required payments.
This technique is simple because you identify and monitor broad categories of spending. However, it is difficult for households in areas with high housing costs or significant child-care expenses to stay within the 50% guideline for non-discretionary expenses. In this case you may need to increase your budget for necessary expenses and decrease spending on your wants. Additionally, this technique is not ideal for high-income individuals because the 30% for discretionary spending becomes too large.
Regardless of the budgeting technique you use, take the time to annually review and adjust your budget. A budget ensures you are making the best use of your money and you are spending and saving to support your financial goals.