Via LearnVest By Laura Shin ~
When it comes to our money, there is no shortage of ways we could spend it: food, rent, gifts, medicine, clothing, education, technology, gym membership, gas … you get the picture.
So when creating a budget, which you can do for free in the Money Center, it’s tempting to throw up your hands, say, “Forget it,” and hope for the best.
Well, we have a simple solution for you: the 50/20/30 Rule.
No matter whether you’re a mom with two kids or a recent college grad working your first job, this rule will help you not only figure out how much you should be spending in each area every month; it will also tell you in what order you should be spending your money.
The 50/20/30 Rule Broken Down
The 50/20/30 Rule is easy because instead of telling you how to break down your budget across 20 or more different categories (who could possibly keep track of that?), it splits everything into three main categories:
1. Essential Expenses
No more than 50% of your take-home pay should go toward Essential Expenses, which are the expenses you need in order to maintain the fundamentals of your life: shelter, food, heat, etc. Only four expenses go in this category: housing, transportation, utilities and groceries.
2. Financial Priorities
At least 20% of your take-home pay goes to Financial Priorities, which are the goals that are essential to a strong financial foundation. These include your retirement contributions, savings contributions and debt payments, if you have debt.
You should make these contributions and payments after you pay your Essential Expenses, but before you do any other spending.
3. Lifestyle Choices
No more than 30% of your take-home pay should go to Lifestyle Choices, which are personal, voluntary and often fun choices about how you spend your discretionary income. They often include cable, internet and phone plans, charitable giving, childcare, entertainment, gym fees, hobbies, pets, personal care, restaurants, bars, shopping and other miscellaneous expenses.
While Lifestyle Choices are the last things you should buy in your budget, you should never feel guilty about that expensive purse or ordering a nice bottle of wine at dinner … as long as you’ve taken care of your Essential Expenses and Financial Priorities first.
How the 50/20/30 Rule Works in Real Life
The flexibility of the 50/20/30 Rule makes it easily adaptable to real life. Let’s compare two budgets, one for Molly and one for a couple, Sarah and Tim.
Molly is a 22-year-old recent graduate with her first job, working in Chicago. She has student loans, but she is still able to meet her student loan payment every month and contribute to a Roth IRA, plus pay all her bills.
Her income: $36,000 a year
Her take-home pay after taxes: $2,250 a month (we’re assuming 25% of her salary goes toward a combination of taxes and her 401(k) contributions)
TOTAL: $1,100, which is 49% of her take-home pay
Student Loan: $225
Roth IRA contributions: $200
Travel savings fund: $50
TOTAL: $475, which is 21% of her take-home pay
Lifestyle Choices: $675, which is 30% of her take-home pay
Because Molly is on a tight budget, her Essential Expenses are very close to the 50% limit. Still, she is able to make her student loan payment and even put 9% of her take-home pay toward retirement, where the money will have a long time to grow.
Sarah and Tim
Sarah and Tim are in their mid-40s and have two children nearing college age.
Sarah and Tim’s household income: $150,000 a year
Their take-home pay after taxes: $6,767 a month (we’re assuming 30% of her salary and her husband’s go toward a combination of taxes and their 401(k) contributions)
Car payment and insurance: $600
TOTAL: $2,600, which is 38% of their income
Roth IRA contributions: $833
529 account contributions: $1,470
Vacation fund: $200
TOTAL: $2,503, which is 37% of their take-home pay
Lifestyle Choices: $1,664, which is 25% of their take-home pay
Sarah and Tim’s situation shows how flexible the 50/20/30 Rule can be. Essential Expenses are supposed to be “no more than” 50%, and Sarah and her husband have actually been able to keep them well below that threshold. They paid off one of their cars a while back and haven’t bought a house that stretched their budget.
What they’re doing with the money they’re saving on Essential Expenses is putting it into their kids’ 529 accounts. But they are still maxing out their Roth IRA contributions because saving for retirement is a higher financial priority than saving for their children’s college funds–not because their children’s education is less important, but because they could always take out a loan to make up any shortfall to pay for college tuition, but they can’t take out a loan to pay for their retirement.
In order to meet their 529 savings goals, they have decided to be as frugal as possible about their Lifestyle Choices, which is why they are allocating only 25% of their income to those.
One Note About Retirement
As you might have noticed, the 50/20/30 Rule applies only to take-home pay. Any contributions you make to retirement before your paycheck hits your bank account are not included. For that reason, you are actually contributing more toward your Financial Priorities than this breakdown would suggest. But we urge you to keep that retirement money out of sight, out of mind!
(If you are self-employed and don’t have your retirement contributions taken out of your paycheck before it hits your bank account, you’ll need to make sure you’re hitting your retirement goals, and that could mean contributing more than 20% of your income to Financial Priorities.)
How the 50/20/30 Rule Applies to Your Budget
Now that you see how the 50/20/30 Rule applies to two very different situations, it’s your turn to use it on your own budget. The LearnVest Smart Budget will analyze your current spending to see how it stacks up against the 50/20/30 Rule. If you don’t already have a budget with LearnVest, sign up here. The sign up process will ask you to enter your Essential costs and your Financial Priorities, and at the end, you can allocate money to your Lifestyle Choices. And setting up a budget that will save you money is absolutely free.
LearnVest is the leading lifestyle and personal finance website for women.