Monday, February 15, 2016

Giving Yourself a Financial Checkup Using All Your Worth's 50-30-20 Rule: A Worked Example


I'm a big fan of Elizabeth Warren and Amelia Tiyagi's book All Your Worth: The Ultimate Lifetime Money Strategy. Although it was written in 2005, the economic situations it describes are just as relevant and common today, if not more so. What I particularly like is that it acknowledged that most people don't struggle because of "affluenza" and luxury overspending (though following their plan would keep that in check if it were the problem), but because too much of their paycheck is eaten up with "must haves": locked-in fixed expenses like mortgages/rent, child care, car payments, student loans, and the like. In fact, this is even more dangerous and unstable than affluenza would be, since families are less able to recover from economic disaster; at least if you were wasting all your money on comic books and bubble gum, you could instantly stop if you lost your job. You can't instantly stop paying the mortgage.


Warren and Tiyagi suggest creating a budget of your monthly expenses and checking the percentages against their ideal formula, the 50/30/20 rule:


  • No more than 50% must-haves. This includes fixed expenses like rent and variable expenses like basic groceries: anything you need. It also includes anything you're legally locked into and couldn't get out of easily, like a phone contract. Monthly debt minimums are included here.
  • No more than 30% wants or discretionary spending on whatever it is you prefer to spend money on. One neat thing is that book goes out of its way not to judge what you spend your "wants" money on. It's cool as long as it's in balance. It's a refreshing change from latte-blaming.
  • At least 20% saving for tomorrow. This includes long-term savings, retirement plans, debt payments over the minimum--anything that increases your net worth (other than legal requirements which are must-haves).


What I like about this is that it's a good, reasonable check-up for anyone. The criticism I hear all the time from early retirement enthusiasts are that it's too lax on the spending percent, and yeah, you should be saving more if you have your eye on early retirement. But these aren't targets to hit exactly; the savings is a minimum and the must-haves and wants are maximums, so if your percents are more like 30/20/50 because you're a super-saver, you're still in balance!


I recently found an document from a few years ago where I worked through the Balanced Money Formula with my income and expenses at the time. Rather than toss it, I thought I'd step through it here as a worked example of the nuts and bolts of giving yourself a 50/30/20 financial checkup. The numbers are out of date, but I think this snapshot lets me show a relatively simple example, since it's pre-marriage. (Plus, it's mine to share--I feel less comfortable revealing the details of my joint finances with my wife, since they're not fully "my" numbers, if that makes sense.)

Step 1. Figure out your after-tax income

I used a pay stub to figure out my after-tax income. The book intends you to use your after-tax net income, not gross salary. The percentages are calibrated to disregard tax, and it makes more sense since you don't have control over that particular expense anyway. For all intents and purposes, your after-tax income is the money you have to work with. I consulted my most recent pay stub, in which the total deposited to my accounts was $1,806.74. Because I was paid every other week, this amounted to $1,806.74 * 26 = $46,975.24 a year.


Item
Per pay period
Annual
Income deposited into bank
$1,806.74
$46,975.24


Step 2. Add back in any voluntary paycheck deductions

But wait! Some of my paycheck was being automatically deducted for things which really should count toward my balanced money formula. For example, I was contributing to my 401(k). Also, I had a high-deductible health plan and was contributing the maximum to my HSA, figuring that even though I didn't have many health issues at the time, I could save up for future health issues (since HSAs, unlike FSAs, roll over).


Item
Category
Per pay period
Annual
Income deposited

$1,806.74
$46,975.24
Health insurance
Must-haves
$55.18
$1,434.68
HSA
Saving for tomorrow
$107.69
$2,800.00
401(k)
Saving for tomorrow
$247.50
$6,435.00
Total

$2,217.11
$57,644.92


I've arrived at my correct income--the denominator for my percentages. It also gives me some of my categorized line items. I'll have to do more work to figure out my totals in each category, but for now, I can:


Step 3. Figure out my targets

Category
Target percent
Target annual amount
Must-haves
<=50%
<=$28,822.46
Wants
<=30%
<=$17,293.48
Saving for tomorrow
>=20%
>=$11,528.98
Total
100%
$57,644.92


Step 4. List monthly fixed expenses (Must Haves)

We now turn our attention to monthly bills. Again, I multiplied by the number of periods (in this case, months) to get an annual total, so that I could compare apples to apples when finding percentages. Some expenses, like heat, were variable, but I made my best guess at an annual average.


Item
Monthly spend
Annual spend
Housing (mortgage + HOA + tax + insruance)
$1,214.00
$14,568.00
Home repair
$450.00
$5,400.00
Utilities (gas + electric + internet)
$225.00
$2,700.00
Basic food (based on USDA estimate for adult female--moderate cost plan)
$259.10
$3109.20
Health insurance
not monthly - see pay stub
$1,434.68
Total

$28,401.88


My must-have total was just under the target--coming in at 49.3%--so I was, just barely, on track with my must-haves!


Step 5. List planned savings

Savings and wants are both squishier categories than must-haves, so I went ahead and checked on my planned, automatic savings contributions next to find out if I was planning to save enough.


Item
Per pay period
Annual
HSA
$107.69
$2,800.00
401(k)
$247.50
$6,435.00
Roth IRA
not a paycheck deduction
$5,500.00
Total

$14,735.00


Great. I already planned to save 26.5% of my income, so that met the requirement of at least 20% for saving for tomorrow.


Step 6. Figure out what's left for wants

Between my must-haves and savings, I'd already accounted for $43,136.88 (74.8%) of my take-home income. That left $14,508.04 (25.2%) annually for my wants. That worked out to $1209.00 a month! A princely sum! All that was left was to decide how to spend it.


Item
Monthly Amount
Yearly Amount
Charity (5% of takehome)
$480.37
$5,764.49
Gifts (Xmas/birthdays)
$75
$900
Work-related
$50
$600
Personal care
$100
$1,200
Subscriptions
$15
$180
Eating out
$75
$900
Stuff
$200
$2,400
Total
$995.37
$11,944.44


I stopped there, with 20.7% of my income allocated to wants. I left unallocated $213.63 per month ($2563.56 per year, or 4.4% of my takehome income). I figured I'd probably forgotten some categories, gotten others wrong, and this would leave me a little wiggle room. If I spent it all on wants, I'd still be in balance, and if I didn't, I could throw it at savings.


I think I did a pretty good with this balance check, and I ended up with a decent monthly budget! (Though I'd have to spend some quality time with the spending register to see how well I did sticking to it).

As you can see, the steps for figuring out if you're in balance are a bit involved once you're dealing with real (not theoretical) numbers. But it's certainly not gruelling or impossible. I hope this worked example has helped if you were thinking of doing the same sort of check for your own finances.

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