Budgeting is the cornerstone of building wealth, and the 50/20/30 rule is an exceptional rule of budgeting. It was made popular by Harvard Bankrupt Expert and US Senator Elizabeth Warren in a book co-authored with her daughter titled “All Your Worth: The Ultimate Lifetime Money Plan.”
The 50/30/20 rule is ideal for individuals who don’t have the patience to track their every expense. Instead of having to write down every individual expense, you only need to divide your income into three parts; needs, wants, and savings. This way, you quickly determine how much is used up or left for each category.
Getting Started With a 50-20-30 Budget
First, you need to review your current financial status to know precisely how much you bring in every month. If you are an employee, you should calculate your after-tax income (which is what remains after taxes like local taxes have been taken out of your gross income). Add back any deductions that aren’t taxed like retirement and healthcare if they have been removed from your income at source.
If you are self-employed and have irregular income, then you‘ll have to review your earnings and pick an average monthly income for your computation. To compute your after-tax, you need to deduct business expenses from your gross income.
Proceeds from rent, dividends, and other earnings from investments should also be included as part of your income.
Next, you have to compute your expenses. List out every expense from bills to groceries and every item you spend a cent on, including the coffee you grab on your way to work.
Categorize Your Needs, Wants and Savings
After computing your after-tax income, you also need to calculate how much you can allocate to your needs, wants, and savings. So, for instance, if your monthly net income is $5,000, then you have to divide it into three parts.
1. Needs – 50%
You should be able to determine which expense are needs and those that aren’t. Needs are those expenses that are necessary for you to live comfortably. These expenses are unavoidable. Though you can control how much you spend on them, you definitely can’t get them off your budget. It includes the cost of buying groceries, money to purchase gas for your car or take the bus, healthcare expenses, money for utilities like electricity, water as well as supplies you need for your home. Then there’s clothing. While you may not buy one every month, clothing is a necessity.
You need to limit your needs to 50% of your after-tax income. That means the total cost of necessities like utilities groceries, gas, shouldn’t exceed 50% of your after-tax pay.
So if you earn a monthly income of $5,000, you can spend 50% of it ($2,500) on this expense category. If the expense amount exceeds what you allocate, then you’ll have to cut it down to half your income amount. To do this, you can reduce the amount spent on groceries, transportation, and other expenses.
2. Wants – 30%
Wants are those expenses that you can control. It’s up to you to decide whether you actually want to spend on them and how much you want to spend on them. The category of expense includes cable and TV subscriptions, shopping trips, internet, entertainment, gifts, gym membership, vacations, and others.
One way to determine whether an item is a need or want is to ask yourself whether you can live comfortably without it. If you can’t live without it, then it’s a “need,” otherwise it’s a “want.”
You should spend at most 30% of your income on wants. The thing is that human wants are endless, but it’s essential only to spend as much as you earn. So consider shelving your planned trip to Bali or eating out at an Italian restaurant till you earn enough.
3. Savings and debt repayment – 20%
Your debt and savings are stand-alone in parts of your budget. Your savings is money you set aside for your retirement, emergency fund, and other goals. For instance, you can save for down payment for a house, a new car, or start a business.
Then there’s your debt, which may include students loan, credit card debts, mortgage, auto loan, or personal loan. Allocate at least 20% of your income to your savings and debts.
Note, for your needs and wants, allocate 50% and 30% at most, but your savings shouldn’t be limited to only 20%. The more you save, the better. However, it should be at least 20% of your monthly after-tax income.
Illustrating the 50/30/20 Rule
To demonstrate the rule, let’s say you earn $4,000 monthly after-tax. The rule requires that you spend at most half or $2,000 (50%) of your income on needs like food, and others. This doesn’t necessarily mean you must spend all of it. Your goal should be to fit all needs related expenses into 50% or less.
For wants, you can spend a maximum of $1,200 (30%), while the last 20% should be shared for debt repayments and to save for your future.
Who’s the 50/30/20 Budget Rule Best For?
The rule is ideal for anyone struggling to control their finances. It keeps your finances very simple and gives you control of your money. If you find it difficult tracking where your money goes to, then by breaking your expenses into various categories, you will be able to determine how much you spend on each item easily. Additionally, it will allow you to weed out unnecessary expenses that take a huge cut in your budget. It will become easier to cut down the amount you spend on various items and save more towards your goals.
It eliminates uncertainty, so you can live comfortably and ultimately attain financial stability. The method also builds a consciousness about your finance. You will gradually see yourself questioning every purchase or payment, whether it’s worth it.
A person’s ability to create and stick to a budget can determine their financial success. While the 50/30/20 rule may not work for everyone, it provides a simplified approach to keeping your finance in check.