Updated: 1/18/2011 11:41 AM ET|
The 50/30/20 budget fix
How much should you spend on housing? Groceries? The frustrating answer is 'it depends.' Now there's a way to figure it out, and it works regardless of your income.
For years, I struggled to help people answer a fundamental budgeting question: "How much should I be spending?"
Most who asked were looking for specific answers about what they should devote to various categories such as housing, food, transportation, utilities and so on.
The answer I used to give -- that there's no one-size-fits-all solution -- was really unsatisfying. It's true, of course, because people's circumstances vary so widely. But it wasn't very helpful to people trying to create a workable budget.
Then Harvard bankruptcy professor Elizabeth Warren (now on loan to the Obama administration) and her daughter Amelia Warren Tyagi wrote a terrific book called "All Your Worth: The Ultimate Lifetime Money Plan," and I finally have an answer that works.
It's simple, if not easy. It's designed to work for any income. Its purpose is to help you live your life while building financial security and minimizing the chances a setback will send you over the edge.
It's the 50/30/20 budget. Here's how it works:
You start with your after-tax income. That's your gross pay minus any wage-based taxes, such as withheld income tax, Social Security and Medicare taxes, and disability taxes. If your employer deducts other expenses from your paycheck, such as 401k contributions, health insurance premiums and union dues, add those back into your net pay to get your after-tax income.
You aim to limit your "must-have" expenses to 50% of that after-tax figure. "Must-haves" include all the basic expenditures you really need to make each month: outlays for housing, utilities, transportation, food, insurance, child care, tuition and minimum loan payments. If you can delay a purchase for a few months with no serious consequences -- for example, clothing or dining out -- it's not a must-have. If you're contractually obligated to pay something (a credit card minimum, child support or a cell phone bill), it's a must-have, at least for now.
Your "wants" can consume 30% of your after-tax pay. Vacations, gifts, entertainment, clothes, eating out and other expenses are all "wants." Some bills you pay might overlap the two categories. For example, basic phone service is a must-have. But features such as call waiting or unlimited long distance are wants. Internet access and pay television are two other expenditures that can feel like must-haves but usually are wants, unless you're on some kind of long-term contract.
Savings and debt repayment make up the final 20% of your budget. Warren's a bankruptcy expert, remember, and she knows the devastation that results from too much debt and too little savings. To achieve financial independence and minimize the chances of disaster, you need to get rid of consumer debt, save for retirement and build your emergency fund. Any loan payments you make above the minimum belong in this category, as do contributions to your retirement and emergency funds.
(If you pay your credit cards in full every month, by the way, your credit card bills aren't debt. You don't assign the credit card payments themselves to categories; instead, you allocate each individual expenditure on the bill to its appropriate category, that's it.)
I said earlier that this budget plan isn't easy, and it's not. Limiting your must-haves to 50%, especially, is flat tough for most of us.
My husband and I make a generous income, and we have affordable mortgage payments and no other debt. But the first time I did this exercise, our must-haves consumed more than 60% of our after-tax income. It took a year of trimming, and some more income, to get us to the 50% mark.
We were lucky. I've heard from other people whose must-haves consumed 75%, 80% or even more of their after-tax pay. Fixing that can take a while.
You may be discouraged by how far you are from the ideal. But running the numbers can help you understand why your money isn't working for you. If basic overhead consumes so much of your paycheck, it's no wonder you have trouble saving, paying off debt and living the rest of your life.
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Then when I use my medical insurance (to take my kid to the hospital), I'm hit with over $1000 worth of bills. I thought I had premium insurance I was paying such a high premium for and then a simple 3 hour visit to the ER costs me $1000!! Why am I spending $498/month on health insurance if it's not going to cover anything?
My wife had 3 tests done, all they did was draw blood. That cost over $600 because they sent it to a lab outside of my network. WTF???
Ok, off my soap box now. Good night Cleveland!
Thanks you, Liz, for this well written article. I printed it out to share with my husband and intend to make it work for us. I'm glad you explained that it can take some time to really trim the expenses. Thinking back, our inability to do this trimming as quickly as I expected, caused a lot of stress to the relationship. Now we'll have a more realistic goal. Many thanks.
Before I retired my mortgage was about 25% of my take home amount, but after after retirement it takes 100% of my pension, but am fortunate that I was able to keep medical insurance which will cost $185.00 a month. I also will receive a supplement check until I turn 62 and then will apply for social security which will be used for my living expenses. I have a 401K which I hope not to have to touch until I am in my mid 60's, I am 58 years old. Yes, I hope to be able to sell my house within 2-3 years depending on the housing market and if not... will live in it until such time that I can sell and not have to lose $50,000.00.
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