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, youâll have more to spend across your categories.
One approach is the 50/30/20 rule. This budgeting method was popularized in âAll Your Worth: The Ultimate Lifetime Money Plan,â 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 youâve determined your monthly income, youâll 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.
âThe most successful clients have separate banks for these accounts to limit the tendency to talk themselves into making âexceptionsâ on their spending,â Murphy said.
An important note: If youâre 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, letâs consider a hypothetical example. Miguelâs 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 Miguelâs 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 â 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.
Miguelâs 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. Letâs 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 youâre 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.
âContribute up to the percentage your employer matches into your 401(k) or 403(b),â Murphy said. Youâll 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 youâre 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.
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 isnât feasible right now, donât give up. Maybe your categories look more like 60/30/10 right now. Thatâs 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 itâs 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.
âGreater savings allows for more flexibility,â Murphy said. âIf you live on less than half of your income, you are likely to never have a personal recession, regardless of the economy.â