Budgeting 101: The 50/30/20 Rule
Most people cringe at the idea of creating a budget. However, budgeting 101 doesn’t have to be hard. It gives you the power to decide where your money goes each paycheck rather than watching it drain out of your bank account aimlessly.
One of the easiest budgets to get you started is the 50/30/20 rule. It was made popular by bankruptcy expert and U.S. Senator Elizabeth Warren in her book “All Your Worth: The Ultimate Lifetime Money Plan,” which she co-authored with Amelia Warren Tyagi. The idea behind the rule is to divide your after-tax income in three buckets: 50 percent to spend on needs, 30 percent to spend on wants, and 20 percent to put toward savings and debt repayment.
How do you build a 50/30/20 budget? Here’s a look at the basics to get you started.
Calculate Your After-Tax Income
Before you create your budget, make sure you’re using the right numbers.
Your after-tax income is your paycheck after taxes are taken out. This includes state and local taxes, income taxes, Social Security, and Medicare. If you have a full-time job, use your pay stubs to calculate your after-tax income. If you have deductions such as health care and retirement contributions taken out, add them back in.
For the self-employed, your after-tax income is your gross income minus taxes and business expenses. Self-employed individuals such as freelancers and business owners need to be cautious when calculating after-tax income. It’s easy to look at your bank account balance as all the money you have available to spend. Set aside your quarterly estimated tax payments in a separate account to ensure you don’t spend them.
Designated 50 Percent to Your Needs
Most of your income should go toward your needs. These are expenses such as housing, utilities, car payment, insurance, and so on.
According to the 50/30/20 rule, 50 percent of your income should go toward these expenses every month. One of the hardest things about budgeting is differentiating between needs and wants. A need is something such as your housing or car payment. A want is something you can forego with little impact, such as cancelling cable or not buying that new outfit.
Even within the “needs” category, there is a gray area as to what is truly necessary. For example, if you live in a four-bedroom house and you’re single, your housing payment is not just a need. By downsizing to a smaller one or two bedroom home, you can bring your monthly housing bill in line with the “needs” category.
What about debt such as credit cards? The minimum payment due on your credit card is a need, according to Warren and Tyagi. That’s because your credit score will take a hit if you forego the payment. If you put any extra money toward your debt, that doesn’t go in the “needs” category.
While food such as groceries makes it into the “needs” category, fancy ingredients, dining out and alcohol don’t make the cut. These are categorized as “wants” since you don’t need them to survive and lead a healthy life.
Limit Wants to 30 Percent
This category is where you get to have fun with your spending. Love going out to movies and drinks with friends? Go for it – just make sure you categorize it as a “want.”
Love splurging for cable and HBO rather than going with an antenna? Just add this to the “wants” category and you’re good to go. As you divide your expenses, you’ll notice that the “wants” category fills up pretty quickly. There are many things we categorize as “needs” when they’re a want. For example, having internet may be a need for you, but high-speed internet is a want. The rules can be tricky, but you can get hang of it as you use this budget for a few months.
One of the great things about this system is that it teaches you to look at expenses in a new light. For example, if you’re looking to buy a new car, anything beyond a basic four-wheel, four-door, fuel-efficient model is a want. Splurging for a big SUV or a truck will eat up a large chunk of your monthly “wants” budget with the higher payments. Think twice before opting to spend so much on your next set of wheels.
Put 20 Percent Toward Savings and Debt
As a final step, 20 percent of your budget should go toward savings and debt. Use this chunk to build an emergency fund of three to six months of expenses to help you pay for unexpected things that crop up.
This portion of your budget also includes retirement savings such as contributions to an IRA or an employer-sponsored plan such as a 401(k). If you’re saving for your kids’ college education using something like a 529 plan, include the contributions in this section as well. If you carry a credit card balance or have other debts, use part of this budget category to pay extra. The minimum payment on debts goes in the “needs” category, but additional payments are not a need and go in the “savings and debt repayment” category.
The 50/30/20 Budget in Action
Let’s do a quick example of the 50/30/20 budget so you can get an idea of how it may work for you. Let’s say you bring home $4,000 monthly after tax. This number is after taxes but with health care insurance premiums and retirement contributions added back in.
Using the 50/30/20 rule, you can’t spend more than $2,000 per month on your needs. This includes your housing, such as your mortgage payment, insurance, utilities, groceries, minimum credit card payments, car payment, and so on.
Wants should account for 30 percent of your budget or $1,200. This includes luxuries such as cable, getting your nails done, paying extra for a fancier vehicle, and so on. You can also set aside a portion of your “wants” budget to save for an upcoming vacation.
If you’re already locked into a lease or own your home, consider moving if the expense eats up most of your “wants” category. Same goes for your vehicle. If you drive a truck and you don’t haul wood and equipment regularly, consider selling or trading it for a smaller, more affordable option.
The balance of $800 is earmarked for savings and debt repayment. Use this to build out your emergency fund and save for retirement. Pay extra toward debt and plan for the future.
The Bottom Line
Budgeting doesn’t have to be scary or difficult. Using a guideline such as the 50/30/20 rule makes it easier to divide up your paycheck and make sure you prioritize your needs and pay down debt. This is a great option for people who don’t like to budget and just want an easy guideline for divvying up monthly income.
There are only three broad categories to track, which is less than most budgets out there. However, this rule may not work for everyone. If you live in a high cost of living area, you may need to adjust the 50/30/20 rule to fit your individual situation. The most important part of budgeting is doing what works for you and helps you meet your financial goals.