Housing? Groceries? The truthful, frustrating answer is 'it depends.' Now there's a simple -- but not easy -- way to figure it out, and it works regardless of your income.
For years, I struggled to help people answer a fundamental budgeting question: "How much should I be spending?"
Most who asked were looking for specific answers about what they should devote to various categories such as housing, food, transportation, utilities and so on.
The answer I used to give -- that there's no one-size-fits-all solution -- was really unsatisfying. It's true, of course, because people's circumstances vary so widely. But it wasn't very helpful to people trying to create a workable budget.
Then Harvard bankruptcy professor Elizabeth Warren and her daughter Amelia Warren Tyagi wrote a terrific book called "All Your Worth: The Ultimate Lifetime Money Plan," and I finally have an answer that works.
It's simple, if not easy. It's designed to work for any income. Its purpose is to help you live your life while building financial security and minimizing the chances a setback will send you over the edge.
It's the 50/30/20 budget. Here's how it works:
You start with your after-tax income. That's your gross pay minus any wage-based taxes, such as withheld income tax, Social Security and Medicare taxes, and disability taxes. If your employer deducts other expenses from your paycheck, such as 401k contributions, health insurance premiums and union dues, add those back into your net pay to get your after-tax income.
You aim to limit your "must-have" expenses to 50% of that after-tax figure. "Must-haves" include all the basic expenditures you really need to make each month: outlays for housing, utilities, transportation, food, insurance, child care, tuition and minimum loan payments. If you can delay a purchase for a few months with no serious consequences -- for example, clothing or dining out -- it's not a must-have. If you're contractually obligated to pay something (a credit card minimum, child support or a cell phone bill), it's a must-have, at least for now.
Your "wants" can consume 30% of your after-tax pay. Vacations, gifts, entertainment, clothes, eating out and other expenses are all "wants." Some bills you pay might overlap the two categories. For example, basic phone service is a must-have. But features such as call waiting or unlimited long distance are wants. Internet access and pay television are two other expenditures that can feel like must-haves but usually are wants, unless you're on some kind of long-term contract.
Savings and debt repayment make up the final 20% of your budget. Warren's a bankruptcy expert, remember, and she knows the devastation that results from too much debt and too little savings. To achieve financial independence and minimize the chances of disaster, you need to get rid of consumer debt, save for retirement and build your emergency fund. Any loan payments you make above the minimum belong in this category, as do contributions to your retirement and emergency funds.
I said earlier that this budget plan isn't easy, and it's not. Limiting your must-haves to 50%, especially, is flat tough for most of us.
My husband and I make a generous income, and we have affordable mortgage payments and no other debt. But the first time I did this exercise, our must-haves consumed more than 60% of our after-tax income. It took a year of trimming, and some more income, to get us to the 50% mark.
We were lucky. I've heard from other people whose must-haves consumed 75%, 80% or even more of their after-tax pay. Fixing that can take a while.
You may be discouraged by how far you are from the ideal. But running the numbers can help you understand why your money isn't working for you. If basic overhead consumes so much of your paycheck, it's no wonder you have trouble saving, paying off debt and living the rest of your life.
If it's so hard to keep to the 50% limit, why do it? Several good reasons:
- It gives you flexibility. Your income could drop by half and you'd still be able to pay your essential bills. When your must-haves eat up more of your income, you have less ability to cope with setbacks such as layoffs, reduced work hours or unexpected expenses.
- It helps you figure out what you can and can't afford. If you're considering adding a loan payment or other contractual obligation to your overhead, you simply check to see if it would push you over the 50% mark. If not, you can consider adding the payment; if so, you don't.
- It gives you balance. Limiting your overhead allows you to have money for the pleasures in life, such as dinners out and vacations, without stress. It also allows you to get out of debt and save for your future.
So what should you do if your numbers are out of whack? Remember that the 50/30/20 plan is a goal to work toward, not something you'll necessarily achieve overnight. And if you're already in financial crisis -- you're unemployed, for example, or suffering through a disability -- true balance may have to wait until the crisis has passed.
But here are some places most people can tweak:
- Food. You've got to eat, but most of us could trim our grocery bills, often substantially, without too much effort. Plan your meals, cook from scratch, use up leftovers, clip coupons -- you know the drill.
- Utilities. You want the lights to stay on, but the air conditioner doesn't have to blast 24/7.
- Transportation. More carpooling and public transportation, less time alone in your car. If it's your car payment that's killing you, read "The real reason you're broke."
- Insurance. Higher deductibles can help reduce your premiums, as can shopping around and taking advantage of all available discounts. Ditch insurance you don't need, such as life insurance if you don't have financial dependents, or collision and comprehensive coverage on a clunker.
- Ditch the contracts. Early termination fees might make canceling your cell service too expensive, for example, but once your contract is up, consider switching to prepaid or pay-as-you-go service. Unless you're a real gym rat, gym contracts are another expense to shed as soon as you can. Consider paying by the visit or signing up at the local Y, which offers monthly billing without long-term contracts.
Other costs are tough to winnow but may be worth the effort. If you're paying too much for housing, you may need to consider a roommate or a move to cheaper quarters. If your child care expenses are eating you alive, brainstorm other alternatives. Several posters on the Your Money message board have found solutions, from sharing nannies to less-expensive day care (that turned out to be better) to changing their work hours so that one parent could always be at home.
You may think it's your income, rather than your expenses, that's the problem. That could be true, and if you can boost your income, go for it. But people can balance their budgets and save money on virtually any income, as MSN Money columnist Donna Freedman wrote in "Surviving -- and thriving -- on $12,000 a year."
If it's your debt that's unmanageable, you may need to consider some more drastic solutions -- credit counseling, debt settlement, bankruptcy or foreclosure. Some bills are simply impossible to pay, despite your best efforts, and you may need help or a fresh start.
Once you get back on your feet, though, the 50/30/20 plan can help you stay there.