Ask anyone who scrambles from paycheck to paycheck, and they’ll admit that it’s easier to make money than to figure out how best to use it, regardless of how much they earn. Some people struggle with detailed budgets; others have trouble figuring out how to save. If you’re looking for a simple plan that can help you get your finances on track, the 50/30/20 budget rule might be your ideal option.
How it works
Popularized by bankruptcy expert and former presidential candidate Sen. Elizabeth Warren in the 2005 book All Your Worth: The Ultimate Lifetime Money Plan, the 50/30/20 budget rule takes its name from the formula it uses to determine how you allocate your money. And regardless of how you feel about her politics, the 50/30/20 plan makes a whole lot of financial sense.
The plan splits your after-tax income into three categories: Needs, which get 50% of the funds; wants, which get 30%; and savings, to which you dedicate 20%. It seems simple. But unless you understand the specific definitions of those three terms, you may wind up misclassifying wants as needs – and even if the formula makes perfect sense, you still may need to adjust what you spend to make the plan work for you.
Defining after-tax income
If you’re an employee on a typical payroll, your employer deducts federal, state, and local taxes from your pay. To figure out your after-tax income, add back any employer-deducted health-insurance premiums and savings-plan deductions.
If you’re a self-employed independent contractor, you’re responsible for all those taxes yourself, along with the self-employment tax that equals twice the Medicare and Social Security taxes you’d pay as an employee. Once you’ve calculated your real after-tax income, you can start the budgeting process.
Needs are just that: Costs that are essential to your survival and your credit rating, including food, rent or mortgage, utilities, car payment, insurance, and minimum payments on other debts such as credit cards and student loans. Unless you live in an area with sky-high housing costs, you should be able to fit all these must-pay expenses into 50% of your after-tax income.
Wants get 30% of your budget, and here’s where the formula gets tricky for some people, because the difference between needs and wants can be more subtle than you think. Movie theater tickets, streaming entertainment services, gym memberships, and travel are obvious wants.
Additionally, if you spend more than the basic amount to upgrade an expense to something more luxurious, that upgrade fits into the want category as well. For example, you have to make your car payment, but the amount may not represent pure need. Leasing a luxury SUV or sports car instead of an economical sedan propels most of your car payment out of the need category and onto the list of wants.
Likewise, if you constantly eat out instead of cooking at home, your restaurant costs don’t count toward your needs. Wants may add fun to your life, but because you can live without them, they’re not needs.
Plan to set aside 20% of your after-tax income for savings, which includes an emergency fund, mutual-fund contributions, stock and bond investments, and payments above the minimum amount due on necessary debts. If your employer automatically deducts your IRA or 401(k) contributions, they belong in the savings category.
Like any budget framework, the 50/30/20 plan isn’t intended as a do-or-die mandate that forces you to squeeze every expense into these categories. Instead, it’s really meant to force you to reexamine how you spend and where you can save. How much you make plays a big role in how you use this budgeting plan to shape your expenses.
If you make a big six-figure salary but can’t manage to make the plan work for you, you may be spending too much on wants that upgrade your needs beyond your real means. If you’re on the lower end of the income range, you may need to allocate more bucks to needs, especially if you have high housing or health costs.
For most people who fit in the average-income category, however, the 50/30/20 plan can make it much easier to get a handle on expenses, advance your savings, and help you reach your long-term financial goals. Let us know how it works for you!