A budget is one of the most straightforward ways we keep ourselves on track, especially when it’s a roadmap toward growth. It keeps us informed, it keeps us on task, and most importantly, it keeps us honest. Just about everyone who’s accumulated wealth by slowly and steadily winning the race (not discovering buried treasure) has followed one principle: Tell your money where to go so you don’t wonder where it all went. When you’re ready to stop the guesswork, move on to budgeting and start working smart.
Just hearing the word “budget” can prompt a visceral reaction. Most of us imagine heavily restricting ourselves to sad desk lunches and passing on happy hour. But really? A budget is just the architecture of delayed gratification. It’s using your money in a way that aligns with your goals. Cut a little here, move a little there, and before you know it you’re on that vacation. There are dozens of ways to budget and one of them is the 50/30/20 Rule.
Some rules are made to be broken, and some rules are really just guidelines masquerading as commands. The 50/30/20 Rule is the latter.
What is the 50/30/20 Rule
Senator (and Harvard bankruptcy expert) Elizabeth Warren popularized the 50/20/30 Rule in her book All Your Worth: The Ultimate Lifetime Money Plan. In it, she advises us to divide up our after-tax income and allocate it to spending 50 percent on needs, 30 percent on wants, and 20 percent on saving and investing.
Part of the reason that this rule is so popular is because of its simplicity. It’s not a down and dirty spreadsheeting bonanza or a completely amorphous approach to our money. It’s a balanced approach to budgeting that is open to interpretation and able to be riffed onto suit specific cases.
How do you apply the 50/30/20 Rule?
Calculate your after-tax income. If you work a traditional job and have your taxes removed from each paycheck, this one is simple. Add up what’s deposited into your bank each month. If you are freelancing, take a cool 30 percent off the top of what you earn each month to account for your tax bill come April. If your income is unpredictable (we’ve all been there), review the last six months of your earnings, add them up, and divide by six to estimate your average monthly income.
Define your needs. This one is highly subjective and will be different for each person. Needs are those bills that you unquestionably, absolutely must pay. These are the things that are necessary for your survival and are mostly fixed costs. Refer back to the basic needs of Maslow’s hierarchy and list the payments associated with your food, water, warmth, shelter, and rest. These include rent or mortgage payments, groceries, health care, minimum debt payments, and utilities. For some, these bills may include child care, car payments, prescription medicines, or HOA fees.
Ideally, half of your after-tax income should be all that’s needed to cover your necessities. If you are spending more than that on your obligations, you might need to do a survey of your lifestyle and make some changes.
Total your wants. What counts as a want? Well, it’s anything you don’t need. This is the number one area where most people overspend and it’s so easy to do it. Anything in the “wants” category is optional when you boil it down. For example, you love your gym. But really you can workout at home just the same. Trimming your wants is typically an exercise in preparation and planning. All it takes is a few hours of meal-prepping lunches to halt that Postmates order. Using apps like Mint, or even good old fashioned paper and pencil, are great ways to track your spending in an effort to get a clear picture of where all your money is actually going. No one ever went poor buying cookies from a vending machine, but there are better and less expensive ways to get that afternoon sugar rush.
You should spend no more than 30 percent of your after-tax income on unnecessary spending.
Allocate the rest. The final 20 percent of your after-tax income is dedicated to savings and investments. Funding your emergency accounts, investing in the stock market or mutual funds, and contributing to your IRA all count here. Emergency savings accounts should either be in place or in progress before you begin investing.
Starting a mini-emergency fund of around $500 to $1,500 is the first step in establishing a fully stocked emergency fund. This smaller goal will bolster your confidence and go a long way in protecting you from life’s little problems. Because you have this safety net in place, a flat tire won’t cause you to whip out your credit card and go into debt. It’s not just peace of mind, it’s good business.
Your big emergency fund will cover you for three to eight months. The experts all suggest a different number of months to cover, but they all agree on one thing: Get one. To determine your goal amount for your big emergency fun, multiply your needs by whichever amount of months makes you comfortable. It will take time to get that amount of money stocked away; slow and steady wins the race.
The best place to stash both of these accounts is in a high-yield savings account that allows your money to earn interest—but it doesn’t stop there, eventually, the interest will compound. Compound interest is a magical thing. That’s when the interest you’ve earned on your money starts earning interest itself and then that new interest also starts earning interest and it goes on and on. Welcome to the world of your money making money for you.
Next up, target your retirement investments. If you’re just starting your career, then you’ve most likely have got a long way to go before you’re going to access your retirement investments. Because of that, you should inherently have a pretty high tolerance for risk. With time on your side, even a drastic dip in the stock market won’t hurt you because you’ve got decades to recover.
Investing your money in stocks means that you carry the highest risk, but also could reap the greatest rewards. Maximizing your market exposure is a solid move to make while you’ve got a long way to go to retirement. As you get older, a mix of stocks and bonds is recommended to even out some of the risks. And finally, when you close in on the last few years before you access your retirement funds, you’ll want to play it super safe and stick to bonds and other, traditionally less risky investments.
Long-term investing is essentially investing for growth. The average returns of investing in the stock market are much higher than with other types of investing. With this type of investing, consider dollar-cost averaging as your purchasing method. By making regular investments with the same amount of money each time, you will buy more of an investment when its price is low and less of the investment when its price is high. This is an especially smart move when you follow the 50/30/20 Rule because you’re able to automate your investments based on your budget.
If picking stocks seems cumbersome, you’re not alone. Financial advisors get paid lots and lots of money to choose the best individual stocks for their clients, and they even get it wrong more often than not. So if you’re not comfortable picking individual winning stocks, consider investing your money in low-cost index funds, mutual funds, or ETFs. These are all a good way to get significant exposure to the stock market at a minimal cost.
Index funds are a lot like a mutual fund, in that they are both bundles of investments. Mutual funds are managed by analysts (and therefore cost a premium), whereas index funds are not (and therefore are more affordable). An index fund will invest in companies that belong to particular indexes.
ETFs, or exchange-traded funds, are collections of securities that you can buy or sell through a brokerage firm on a stock exchange. You can invest in ETFs through Public, either by purchasing full shares or by purchases slices of ETFs; buying and selling are totally commission-free to maximize your purchase power.
A diverse portfolio is one that is spread out across many different asset classes.
Getting started with the 50/30/20 Rule
If this high-level and highly flexible approach is attractive to you, then good news: it’s super easy to get started. You just need a few simple tools to set you on the path to 50/30/20 success.
Personal Capital is a totally free tool to track your investments. You can link all of your 401k, IRA, and taxable accounts and Personal Capital will track your investments in real-time, with visual displays of everything from performance to asset allocation to the fees you’re paying.
Mint tracks your cashflow the same way Personal Capital tracks your investments. All you need to do is link your card and let the app works its magic. Mint automatically updates and categorizes your information as it happens so you always have an up-to-the-minute picture of your money.
Credit Karma keeps an eye on your FICO scores for free and makes you aware of credit cards that you’re most likely to qualify for based on your scores. Part of creating a solid financial foundation requires solid credit, so it’s best to keep an eye on your scores.
The bottom line
Even a loose framework like the 50/30/20 Rule can go a long way in keeping you on track. Discerning your needs from your wants may be an eye-opening experience.