If you’re like most people, creating a budget tends to fall to the bottom of your to-do list. And it’s no wonder! There’s something about a budget that feels so restrictive. Between careers and personal obligations, our lives have enough structure. Who wants to pile on even more rules?
The thing is, the right kind of budget should empower rather than confine you. It should allow you to spend money on the things that make you happy and still meet your financial goals.
I’ve finally found a budget that works for me, and I’m so excited to share it. Scroll down for five simple steps to start building yours.
#1: Calculate your monthly after-tax income.
First, you need to understand what you’re working with. The key is knowing how much money you actually take home each month after taxes and retirement contributions. If you don’t know this number off the top of your head, review your last paycheck. If your salary fluctuates month to month, consider averaging your take-home pay over the last few months to get a better idea.
#2: Tally your monthly living expenses.
Next, make a list of your living expenses. These can be bills you’re locked into or essentials you need to survive. If you took a pay cut at work, it would be very difficult to slash these items from your budget. Rent, mortgage, car payment, insurance, utilities, groceries, and phone bill are all fair game.
photo via natalie off duty
#3: Determine your discretionary spending.
Here comes the best part. This category represents anything you spend money on for fun. Think date nights, Netflix, fitness classes, travel, and Kindle books. (Or is that just my credit card statement?) These are discretionary purchases you could eliminate or delay if things got tight. Estimating this number can be difficult because it varies month to month. I like to use Personal Capital, a free online budgeting tool, to track my spending by category. For better or worse, it divulges exactly how much I (over)spend on cappuccinos.
#4: Write down your financial goals.
After subtracting your living and discretionary expenses from your monthly income, how much is left? Ideally, this is cash you will put toward your financial goals, which might include:
Paying down debt — If you have credit card or student debt, paying it off is a priority. My definitive guide to paying down debt will help you get started.
Setting up an emergency fund — I recommend keeping three to six months of living expenses in a safe savings account. If your car breaks down or you’re between jobs, this will save you from dipping into retirement funds or taking out a loan. Everything you need to know is in my complete guide to an emergency fund.
Contributing to a retirement fund — If your employer deducts 401(k) or IRA contributions from your paycheck, this is where you’ll categorize them. As part of your benefits package, many employers will match 3-6% of your retirement contributions. Take advantage of this free money by contributing at least what your employer will match.
Starting an investment account — If you’re debt-free, have an emergency fund, and contribute to a retirement plan, bravo! Consider opening an investment account to take things to the next level. Interest rates on basic savings accounts are 1% or less, but you can boost your returns by investing long-term in the stock market. I personally don’t have the time or desire to pick stocks and manage a portfolio, so I use Wealthfront to do it for me. Plus, they manage your first $15,000 for free.
#5: Download and set up your 50/20/30 budget.
Now that you’ve laid out your monthly finances, how do you know if you’re on the right track? This is where the 50/20/30 budget comes in. The 50/20/30 budget is a guide for managing your income in a way that allows for both saving and spending. Here’s how it works:
- 50% of your monthly after-tax income should go toward the living expenses we tallied in step 2 (rent, utilities, transportation, etc).
- 20% is allocated to financial goals like paying down debt, saving, and investing. We discussed this in step 4.
- 30% can be spent on discretionary purchases from step 3 (cable, gym memberships, shopping, travel, etc).
I want to emphasize that the 50/20/30 budget is a guide, not a rule. Someone in an expensive city may pay more than 50% in living expenses. Someone with heavy student loan debt may allocate more than 20% to financial goals. The budget is just a proportional guide to keep you in check. And it doesn’t have to be intimidating, either! The bottom line is that a successful budget is a flexible one. It should give you space to spend money on the things you value and still grow your net worth.