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- Your expenses generally fall into two categories: Your needs and your wants.
- It’s important to prioritize your wants – these generally include food, housing, health care, transportation, and insurance.
- Depending on how much you earn, you may spend a larger (or smaller) percentage of your income on necessities.
- After you have established an emergency fund, you can start saving and investing.
When was the last time you ate a marshmallow? Were you sitting around a campfire roasting smores, perhaps? Did you eat one or two marshmallows, or did you leave the bag half empty?
Marshmallows are a tasty treat – they’ve also been found to reveal a person’s ability to delay reward. In a famous experiment from the 1970s, Stanford psychologist Walter Mischel studied whether children had the willpower not to eat a marshmallow placed in front of them. If the children resisted temptation for 15 minutes, they were rewarded with a second marshmallow. The kids who gave in only got one. (You may have come across YouTube videos of these cute little ones struggling to hold back.) While it may be tempting to gobble up the marshmallows right away (i.e., live for the moment), a long-term approach may prove more rewarding, especially when money is involved. By weighing your needs and wants, you can build a life of marshmallows for the future.
Here are some ways you can think about spending, saving and investing with your after-tax income.
The 50/30/20 rule
TL; DR: Spend 50% on needs, 30% on wants, and set aside 20% for savings.
There’s no perfect rule when it comes to budgeting, but the 50/30/20 rule is a solid starting point. The basic idea is this: take your net income (i.e., what you’ve left over after taxes) and divide your spending into different areas.
Let’s say you earn $50,000 after taxes each year. Under the 50/30/20 rule, you’d spend 50%, or $25,000, on necessities – that’s, housing, utilities, groceries, clothing, perhaps car or student loan payments, and insurance. It depends on what you consider “necessities” (e.g., keeping a car in town or using public transportation).
Here’s how you can calculate that: Amount that can be spent on necessities = after-tax income x 0.50
The next 30% of your income, or $15,000, can be spent on entertainment and luxuries. Think movie nights with friends, buying a guitar, or new camping gear. (Those marshmallows aren’t going to roast themselves!).
Here’s the math: amount you can spend on luxuries = after-tax income x 0.30
The last 20%, or $10,000, you can use for savings and investments. Again, this probably looks different from person to person – it could depend on whether you want to build an emergency fund, save to buy a car or house, or invest in the stock market.
The numbers: Amount to save or invest = after-tax income x 0.20
These percentages are rough guidelines. What applies to one person may not necessarily apply to another, and the exact amounts may not stay the same from year to year. In addition, your needs, desires, and ability to save or invest will likely change as you age.
Still, this approach has the endorsement of Senator Elizabeth Warren. (She founded the Consumer Financial Protection Bureau and co-wrote a book with her daughter, Amelia Warren Tyagi, about this approach to budgeting.)
Note that the 50-30-20 rule works best for people with average incomes for where they live. It’s less useful for low-income people who live in expensive areas where it might be impossible to spend only 50% of your income on essentials. It’s also not ideal if you’ve a high income – in that case, you probably wouldn’t want to spend 50% of your income on necessities.
The 50-15-5 rule
TL; DR: Spend 50% on necessities and paying off debt. This time, however, save 15% for retirement and set aside 5% for emergencies.
Here’s a similar variation: the 50-15-5 rule. This rule states that you should spend 50% of your income on living expenses and paying off debt. You can use the next 15% to save and invest for retirement, and you can set aside 5% of your money for an emergency fund.
But wait. 50 + 15 + 5? That only adds up to 70%. You’re right!
How you spend (or save, or invest) the remaining 30% is up to you. You may notice that this guideline isn’t so different from Warren’s 50-30-20 rule – it just divides the 20% into different purposes: retirement and emergency fund.
The 30% rule for housing
Another popular budgeting tip is to spend no more than 30% of your income on housing (i.e. rent or mortgage). However, this rule is somewhat outdated – it dates back to the 1960s and was part of the public housing requirements and hasn’t been updated since. Especially since housing prices have risen and wages have stagnated, the 30% rule may no longer work.
For your own purposes, you can get an idea of housing costs or find out if you’re getting a good deal by comparing prices online. If you’re making comparisons for smaller purchases, why not do the same for housing?
Many Millennials now spend a large portion of their income on rent. So if you can find a way to optimize your rent (or mortgage), you may be able to put more money aside.
Create a budget
Managing your money boils down to one question: do you’ve more money coming in than you’re spending? That’s the basic principle that determines whether you can save and build your wealth over time. Let’s take a closer look.
When we talk about “income,” we mean two types: gross income (before taxes) and net income (after taxes).
Gross income is your total income, before taxes and deductions. This includes the wages you earn, the money you make from your part-time jobs, and even the income from some savings or investment accounts.
Net income is what you can take home after taxes are deducted. When budgeting, it’s helpful to consider your net income because that’s the money you can actually use.
Your expenses can generally be divided into two areas: Your fixed costs (things you often have to pay for each month) and your variable costs (things you want but aren’t 100% necessary). For most people, the biggest fixed cost is their home. Other fixed costs include debts like student loans or car payments, as well as everyday necessities like groceries and clothing. Your variable costs might include designer clothes or 4K Ultra HD TV.
Take a piece of paper and try it. What’s on your list might be a little different. But it’s good to get a feel for your living expenses. Put it all together and that’s your monthly expenses.
My living expenses = My fixed expenses + My variable expenses.
To find your annual expenses, you can multiply your monthly expenses by 12. Then, dividing your annual expenses by your annual net income will give you the percentage of your money you spend each year.
My annual expenses = Monthly living expenses x 12
Percentage of income = Annual expenses / Net income.
If you can, try to build this into a routine. Have a drink once a month and calculate how much money you take in (i.e. your paycheck) and how much money you spend (using card statements, etc.). It’s fun to play detective and try to remember what you bought. If you end up with more money than you spent, you have built wealth that month. Then track your progress over time.
You may even notice a few questionable expenses (e.g., subscriptions you no longer use). If you find ways to save, you can keep the money. Also keep in mind that your exact expenses will likely fluctuate from month to month, and it’s easy to overlook expensive, one-time purchases, like buying a new microwave or fixing the dishwasher. (When budgeting, you can spread these costs out over twelve months.) Unexpected costs are also why many people set up an emergency fund.
Saving for your emergency fund
An emergency fund is a pool of money that you don’t touch under normal circumstances. It’s available when something unexpected happens. You’re in a car accident and need to pay medical bills, or you lose your job and still need to pay rent. While setting up an emergency fund can be difficult when you’re living paycheck to paycheck, the idea is to have something saved.
Some financial advisors recommend saving at least enough money to cover three months of essential living expenses. Others recommend setting aside enough for six months or more. You’ll have to decide for yourself what’s right for you.
Investing for the future
When it comes to investing for the future, you probably have competing priorities. Do you want to buy a home? Do you want to retire? Some of your goals may be closer than others.
It’s difficult to set an exact percentage for saving or investing because your goals are individual. The American Association of Retired Persons (AARP) indicates that you should expect to spend 70 to 80 percent of your annual income in retirement. Remember, starting early can make a big difference, especially when returns are compounded.
Ultimately, budgeting is about figuring out what works for you and adjusting your approach to meet your goals. You might consider these next steps:
Write down your net income
List your expenses (your needs and your wants)
Subtract your expenses from your net income.
If you get a positive number, you’re probably increasing your net worth. If a negative number remains, you may be accumulating debt.
Wherever you stand today, it’s good to start measuring your money. This can help you manage your spending, saving and investing habits and create a sound financial plan.