The 50/30/20 Plan
As a whole, our budgeting and saving habits could use some serious improvement.
A 2017 study by the Federal Reserve found that only 44% of U.S. households could cover a $400 expense with their personal savings. Whether it’s a visit to the emergency room, a necessary car repair, or even a hefty speeding ticket, more than half of American households would need to pay for these predictable expenses by accruing more debt.
There are a number of factors that have led to this widespread financial unpreparedness. Real income for wage-earners has stagnated since the 1980s, while average household student loan debt and credit card debt have dramatically increased. However, perhaps the primary cause of our poor saving habits is the lack of education surrounding personal financial management.
When done properly and consistently, budgeting can be the single most effective way to build your financial security. While most people understand the importance of sticking with a budget, the concept of “proper” budgeting can be hard to pinpoint. How much should you be spending and saving? Where do you even start?
Here is a simple yet effective tool to help you get on the right track: the 50/30/20 plan. In order to get started, track all of your living expenses for the previous month so you can get a feel for your “natural” spending and saving habits (contact your CAS advisor for our Monthly Spending Tracker to simplify this process).
With this foundation, you can start to put the 50/30/20 plan into action going forward.
Step One: Calculate Your After-Tax Income
Knowing your after-tax income – or take-home pay – is essential for determining your monthly budget.
If you are an employee with a steady paycheck, your after-tax income should be fairly easy to determine. Assuming you claimed the proper withholdings on your W4, most of your federal income tax is automatically deducted. In most cases, state and local taxes – as well as Social Security and Medicare – are deducted as well.
Look at your paystubs to confirm which of these taxes are automatically withheld. If health insurance, retirement contributions, or any deductions other than taxes are taken out of your paycheck, add them back to calculate your after-tax income.
If you are self-employed, your after-tax income equals your gross income less your business expenses (i.e. the cost of your laptop or transportation costs) and less the amount you set aside for taxes. You are responsible for remitting your own quarterly estimated tax payments to the government.
Note: Being self-employed means that you must also pay the self-employment payroll tax of 15.3%, which is double what you would pay in Medicare and Social Security taxes in comparison to an employee.
Step Two: Limit Your Needs to 50 Percent of After-Tax Income
Take a look at your Monthly Spending Tracker. How much do you spend on “needs” each month?
The basic necessities are more restrictive than many people realize. When we say “needs”, we mean any payment for a good or service that would severely impact your quality of life, such as:
Groceries
Housing
Utilities
Student loan payments
Health insurance
Car insurance
Car maintenance
Prescriptions
Personal supplies
The amount that you spend on these things should total no more than 50 percent of your after-tax pay.
In addition to the above list, some expenses can be considered needs to an extent. For instance, spending a bare minimum of clothing is necessary; but a $400 shopping spree is a want. Gas to travel to/from work is a need; the fuel used on a cross-country road trip is a want. The same is true of auto repairs: mechanical repairs are a need, but cosmetic fixes or enhancements are a want.
If you can’t forgo a payment such as a minimum payment on a credit card, it can be considered a “need as your credit score will be negatively impacted if you fail to pay. By the same token, if the minimum payment is $25 and you regularly pay $100 a month to keep a manageable balance, the $75 difference is not a need.
Step Three: Limit Your Wants to 30 Percent
Putting 30 percent of your money toward your wants sounds great on the surface. Say hello to beautiful shoes, a trip to Italy and swanky restaurants! Well, not quite.
The reality is that “wants” are not the same as luxuries. A want is considered to be any payment that you can forgo with minor inconvenience, including:
Cable/phone/Internet
Vacation/non-business travel
Pet expenses
Eating out
Entertainment/hobbies
Salon/spa services
Gym memberships
Home services (not utilities)
Personal gifts
Charitable giving
If you think you might be spending more than 30% of your income on wants, you are not alone. The 2017 Federal Reserve study also found that the average household spends nearly 50% of their annual income on goods and services that are beyond the basic necessities. Although there is a time and place for spending your “fun money” on the things you enjoy, the key is to keep it below that 30% threshold.
Step Four: Spend 20 Percent on Savings and Debt Repayments
You should spend at least 20 percent of your after-tax income repaying debts and saving money in your emergency fund and your retirement accounts.
If you carry a credit card balance, the minimum payment is a need and it counts toward the 50 percent. Anything extra is an additional debt repayment, which goes toward this 20 percent category. If you carry a mortgage or a car loan, the minimum payment is a need and any extra payments count toward savings and debt repayment.
Note: Find out if your employer offers a 401(k) plan. Most employers do, and some offer a substantial match for all of your contributions. This is a great way to build strong retirement savings, especially if you start early. Your CAS advisor would be happy to discuss the breakdown of where your assets are invested.
The 50/30/20 Plan in Action
As an example, say your total take-home pay for each month is $3,500.
Using the 50/30/20 rule, you can spend no more than $1,750 on your needs per month. You probably cannot afford a $1,500-a-month rent or mortgage payment – not unless your utilities, car payment, minimum credit card payments, insurance premiums, and other necessities of life combined are less $250 a month.
If you already own your home or you are locked into a lease, you’re pretty much stuck with that $1,500 payment. Consider relocating when your lease expires to make your budget more manageable or take a look at your other needs to see if there’s a way that you can reduce any of them.
How might you get back on needs costs? Consider shopping around for more affordable insurance, or transfer the balance on your credit card to a different card with a lower interest rate. Your goal is to be able to fit all these expenses into 50 percent of your take-home after-tax income.
Now you can spend up to 30% of your income – $1,050 per month – on your wants. You might consider doing without a few things and shifting some of this money to your needs column if you’re coming up short there. This would not necessarily be an indefinite shift, but a temporary means of getting your needs expenses down to a more manageable level.
After needs and wants are under control, you have $700 left (the last 20 percent). You know what to do with it. Save for an emergency, pay down debt, and plan for your future.
Special thanks to Harvard bankruptcy lawyer Elizabeth Warren and her daughter, Amelia Warren Tyagi, who coined the 50/30/20 plan in their 2005 book “All Your Worth: The Ultimate Lifetime Money Plan.”
Material discussed herewith is meant for general illustration and/or informational purposes only, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice.
