Ever heard of the “50/30/20 rule?”
This type of spending plan has been around a while, although maybe you’re not familiar with it. But if you find most financial management plans too complex to be helpful, the simple budgeting strategy within the 50/30/20 could be the key that finally unlocks your ability to get on top – and stay on top – of your financial goals.
What Is the 50/30/20 Rule?
In its simplest terms, the 50/30/20 rule is a budgeting technique that divides your after-tax (net) income into three basic categories: needs, wants, and savings or debt repayment.
Rather than using a complicated spreadsheet to sort through line after line of your spending habits, the 50/30/20 budget sorts every dollar into one of these three buckets. By limiting your spending in each area to its allocated percentage (50% for needs, 30% for wants, and 20% for savings), this rule may help those new to using a budget or people who have found traditional budgeting methods confusing or difficult to maintain.
How Does it Work?
The first step to implementing the 50/30/20 rule is to calculate your after-tax income. If you are an employee who receives a W-2 at the end of the year, this may be as easy as looking at your paystub. If you have deductions such as health insurance and retirement savings automatically taken out of your check, those should be added back to the total because those items will ultimately fall into one of the three categories.
If you are self-employed, calculating after-tax income may take a little more time. If your income is steady from year to year, you could look at your taxable income from the previous year’s tax return; otherwise you will need to estimate your net income by subtracting business expenses and tax estimates from your gross income.
Once you’ve determined your after-tax income, you’ll need to figure out how much money you currently spend in each of the three categories. This is where the hard work begins – it will require a deep dive into your spending habits in order to get a full accounting of where your money is going.
Distinguishing between wants and needs might be difficult at first, so let’s go over the differences.
- Needs – 50%
The largest of the three categories, the goal is for basic needs to account for no more than 50% of your net income. This category is reserved for things such as rent/mortgage, food and utilities, car payments or public transportation, and clothing – all things you must have to work and live. But you should also include minimum payments on credit cards in this category because those payments must be made each month. Health insurance and health care expenses are needs, as well.
The point becomes sticky when discussing items like a cell phone or cable service. For the purposes of the 50/30/20 rule, your basic phone plan should be considered a need, but add-ons like extra data usage are a lifestyle choice and should be considered a want. Similarly, basic clothing is a need, but an expensive pair of boots or a luxury handbag are both a want.
- Wants – 30%
Speaking of wants, they are the second-largest of the budget categories. But they still should account for no more than 30% of your net income. The category is all about lifestyle choices. If you pay for a gym membership or golf club membership, those are wants. If you buy sports tickets or indulge in coffee shop lattes, those are wants, as well. So is dining out in restaurants, all forms of entertainment, vacations, and, as we discussed above, any clothing above and beyond basic needs.
In short, here’s where you lump in all the things you choose to buy but could get by without. If you are needing to trim some fat from your budget, this is the obvious first place to look.
- Savings or Debt Repayment – 20%
Finally, the 20% category is reserved for savings and/or debt repayment. While the goal is to get to the point where you are saving at least 20% of your after-tax income, we understand if you may need to pay off some debt first to get there. Remember, minimum payments are considered needs, but anything extra you pay per month toward unsecured debt belongs in this final bucket.
Most financial experts agree that saving 20% of your net income is a great place to start, but there is no rule against going above that number. If you’ve successfully paid off all your debt, and you are putting aside 20% every month toward savings and retirement, try raising your savings goal to 25% or even 30% or more.
The 50/30/20 Rule in Real Numbers
If talking about all of this in the abstract is confusing, let’s take a look at the rule in real life. Let’s say your monthly after-tax income is $4,000. Based on the 50/30/20 rule, you should spend no more than $2,000 a month on needs. This would leave $1,200 for wants or lifestyle choices and $800 for savings and debt repayment.
Like any budget strategy, the 50/30/20 rule should help you achieve your financial goals. If you’ve run the numbers on your own budget and find that your needs or wants currently exceed the limits of the rule, it might be time to make some lifestyle changes to lower your expenses. This could mean downsizing your house or apartment, getting a less expensive car, or dropping your gym membership for a time.
If you’ve tried several strategies, and your financial goals still seem out of reach, it might be time to call for some outside advice. At DebtGuru.com, we have a team of trained experts ready to help people just like you learn how to get from where you are to where you want to be. Call one of our friendly staff today, and get back on the road to financial health.