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Budgeting is tough. Not having enough money to cover your monthly expenses can leave you scrambling to dip into your emergency fund or relying on a credit card.
If you are looking for another way to manage your finances, you could consider percentage-based budgeting, which relies on a percentage of your income to determine your spending limitations. In a month where you earn more, you’ll have more to spend across your categories.
One approach is the 50/30/20 rule. This budgeting method was popularized in “All Your Worth: The Ultimate Lifetime Money Plan,” the 2006 book by U.S. Sen. (and current presidential candidate) Elizabeth Warren and her daughter Amelia Warren Tyagi.
Read on to learn more about the 50/30/20 rule, how to use it and why it might be the key to helping you save more.
The 50/30/20 rule states that you should budget your income in three categories: needs, wants and savings. It starts with your after-tax income. This is the amount you have available to spend each month after taxes have been withheld by your employer or set aside for quarterly estimated payments if you are self-employed.
If you receive a paycheck and your employer withholds retirement contributions or insurance premiums, add them back in to get to your after-tax income. Once you’ve determined your monthly income, you’ll budget it as follows:
Todd Murphy, a financial advisor with Prime Financial Services in Wilton, Conn., recommended direct depositing your paychecks into multiple bank accounts: 50% to checking for needs, 30% to a different account for wants and the remaining 20% to retirement and savings accounts.
“The most successful clients have separate banks for these accounts to limit the tendency to talk themselves into making ‘exceptions’ on their spending,” Murphy said.
An important note: If you’re working to pay off non-mortgage debts, such as student loans and credit card payments, you might wonder where those fit. Payments towards these debts fall into two categories:
To show you how the 50/30/20 rule works in the real world, let’s consider a hypothetical example. Miguel’s take-home pay from his full-time job after taxes is $3,900 a month, and his employer withholds $200 a month for health insurance. Here is how Miguel might budget using the 50/30/20 rule.
Since Miguel’s employer withholds $200 a month for health insurance, Miguel adds that amount back to his take-home pay to determine his income of $4,100.
Now that Miguel knows his monthly after-tax income, he needs to think about his needs — what he spends each month on housing, utilities, insurance, groceries and the car that gets him to and from work.
According to the 50/30/20 rule, these costs should take up no more than 50% of his $4,100 income, or $2,050.
Miguel’s costs in this category are as follows:
According to the 50/30/20 rule, Miguel has $1,230 to put toward his wants. That number may seem like a lot to some people, but limiting wants to 30% of income can be difficult.
Miguel has a Netflix subscription, stops for coffee every morning and likes to meet up with friends once a week for drinks. He also likes to take his girlfriend out to nice dinners a couple of times a week and tinker on his vintage motorcycle. Spending on all of those interests adds up.
The rest of your income should be set aside for emergency savings, putting money toward retirement, saving for future goals and getting out of debt.
According to the 50/30/20 rule, Miguel has $820 for the saving category. Let’s assume that Miguel already has an emergency fund, so he wants to prioritize retirement, paying off debt and saving for an engagement ring. His spending in this category might look like this:
The great thing about the 50/30/20 rule is it gives you a guideline for living within your means so you can save more.
The 50/30/20 rule could open your eyes to changes you need to make. For example, if you run the numbers and realize housing takes up nearly 50% of your income, leaving little room for other necessities, you might decide to relocate to a less expensive neighborhood. Or you could look for other ways to reduce spending in the needs categories by shopping for new insurance or clipping coupons when you go grocery shopping.
If you’re overspending in the wants category, you may need to change up your daily habits: make coffee at home instead of buying it, cook at home more often or reconsider expensive hobbies. Small changes can add up to big savings over time.
If you have access to an employer-sponsored retirement plan, you may be able to get a boost to your savings without touching the other categories.
“Contribute up to the percentage your employer matches into your 401(k) or 403(b),” Murphy said. You’ll receive an automatic bonus when your employer matches your contribution.
Savings is an essential part of any budget because, without it, unforeseen expenses can leave you struggling to pay necessary costs of living or get you into debt. If you run the numbers and realize you’re not saving enough, look for ways to trim expenses in the needs and wants categories.
Knowing you have 20% of your income to dedicate toward savings and paying off debt can motivate you to pay more than the monthly minimum and make a bigger dent in your balance.
After setting up your emergency fund, prioritize paying off debts. The sooner you pay off any credit cards, student loans and car loans, the more you’ll have to invest and save for retirement.
As long as you have income left over after covering your needs, the 50/30/20 rule can work for you. However, if you run the numbers and realize a 50/30/20 split just isn’t feasible right now, don’t give up. Maybe your categories look more like 60/30/10 right now. That’s OK. Start where you are and look for changes you can make to reduce your cost of living, change your spending habits and get closer to a balanced budget.
The 50/30/20 rule is far from the only way to budget, but it’s a simple formula that allows you to meet your wants and needs and save money without strict dollar amounts and inflexible budget categories.
Murphy acknowledged this method might not work if you are experiencing financial difficulties, such as being laid off from your job. In that case, you may need to work on increasing your monthly income to cover your needs before allocating money to wants.
“Greater savings allows for more flexibility,” Murphy said. “If you live on less than half of your income, you are likely to never have a personal recession, regardless of the economy.”