When you are starting out in life, establishing a savings plan can be very difficult – there are so many things that you need, and limited income with which to buy it. Savings can get squeezed or ignored entirely, especially if you are starting a family, and debt can pile up quickly. If you are not careful, you can be caught in a vicious cycle of overspending and then correcting the overspending by delaying important bills.
Elizabeth Warren, the Harvard Professor turned U.S. Senator, helped to establish one of the more useful guides to balance your financial life – the 50-20-30 rule. It is a method of apportioning your after-tax income into segments to be dealt with in order of importance.
To apply this to your situation, start by calculating your after-tax income. This figure is not always your take-home pay, because your employer may withhold other non-tax expenses from your check, such as your 401(k) contribution and health insurance premiums. Make sure these employer withholds are added back to the total.
After that, divide your pay into three different sections:
- 50% for Necessities – These are basic expenses that must be paid each month, without fail. They include food, housing, insurance premiums, utilities, child-care, the minimum payment on any loan (mortgage, car, credit card, etc.), and any contractual obligations such as child support. The operative concept here is basic. If you are having trouble coming up with the 50%, reconsider your definitions. For example, milk and bread are necessities; ice cream and Pop-Tarts are not.
- 20% for Financial Priorities – Savings, payment of debt above the minimums listed above, and retirement fund contributions fall into this category. How you divide them within this category is up to you, but these payments must be dealt with before discretionary purchases begin.
- 30% for Discretionary Purchases –Otherwise known as "wants". These are your funds for dining out, shopping, vacations/entertainment, and other fun purchases (such as the aforementioned ice cream and Pop-Tarts).
The real genius of this plan is it forces you to define your needs and wants precisely in order to place them into categories. Many people find needs really are wants – but by leaving a significant amount of money for wants, it empowers people to prioritize between those wants.
For example, cable/satellite TV and phone/Internet access are often difficult for people to define. If you have a contractual obligation, it's a necessity in the short term – but what you really do need to get by? If we are honest, minimal communication requirements are needs and the rest are wants.
When deciding to renew, switch, or cancel a contract, figure the basic amount that you really need and consider the overage as a want. Classified as a want, it is easy to determine economic tradeoffs – e.g. would you rather have a particular communications plan, or eat out three more times per month?
The 50-20-30 rule does not break new ground – it is another way of balancing needs and wants, or the classic "bucket" approach for expenses – but it does leave a higher amount for discretionary purposes, helping people to avoid rationalizing more wants as needs.
It is also a goal that may be less attainable in the early years, but it makes a useful target. If you start with this mindset when you are younger and have limited income, you are more likely to stick with it when you are older and have more income to distribute.
If you need help with your budgeting, give this approach a try.