Creating Your Budget

A budget is one of two critical personal financial statements for your household (the other being your net worth statement). Creating your budget allows you to see where your money is going and be more intentional in your spending and saving.

The Value of a Budget

“Budgeting” is often a dreaded exercise that scares off many from even beginning to take a look at their personal finances, but it is a critical financial statement. The good news is budgeting doesn't just mean rationing your resources, saving more, and cutting back on the fun stuff. Budgeting is a combination of being intentional with your money, ensuring your spending and your values align, and taking care of your future self too.

Steps to Create Your Budget

Below are a few steps to create your household's budget. But before starting, it's important to acknowledge that no budget is "perfect" and your budget will inevitably change and be refined over time.

1. After-tax Income
   • Take your most recent paycheck and deduct taxes from your gross income to determine your after-tax income. Multiply this by the number of paychecks you receive in a year for an annual figure. You can also add in reliable bonuses (less taxes) for a more accurate picture of your annual after-tax income. Or ignore bonuses for a more conservative estimate of your regular income.
   • Importantly, we are looking for "after-tax" income, as opposed to your "take-home" income. Take-home income is what's left after deducting taxes and payroll deductions like health insurance premiums, retirement contributions, and other benefits. We will take these deductions into account later in your budget, so keep your paycheck handy as we continue creating your budget.
2. Planned Savings
   • Planned savings is dedicated or, even better, automated savings into accounts like your 401(k), IRA, 529, HSA, taxable brokerage, or savings account. Planned savings is not what is leftover after your expenses. This is planned, pay-yourself-first savings. We'll get to what is leftover (your free cash flow) later.
3. Monthly Expenses
   • Review your last one to three months of bank and credit card statements to estimate your expenses. You can also use an app like Monarch Money, YNAB, Mint, or others to streamline this process. Your expenses will generally fall into two broad categories: fixed and variable.
     • Fixed monthly expenses will be the same each month and include bills like mortgage or rent, debt payments, cell phone, TV/internet, insurance premiums, gym memberships, subscriptions (Spotify, Netflix, etc.).
     • Variable monthly expenses will include things like groceries, gas, utilities, dining out, shopping, gifts, and miscellaneous expenses. In general, try to categorize as much as possible to avoid having big and less meaningful categories. For example, break your shopping category down into line items like clothing, household goods, and even Amazon purchases. Also, be sure to budget for the expenses you enjoy as well as the day-to-day living expenses. If your budget only allows for rent, groceries, and utilities, it’s unrealistic, no fun, and likely to be short-lived.
4. Significant, non-recurring Expenses
   • Identify big expenses that are not monthly but you know are coming. These expenses include travel, gifts for the holidays, new vehicles, home projects, and more. Planning for these items will give you a more realistic sense of your budget and allow you to more freely spend this money when the time comes. This will mitigate the risk of feeling like you are going backwards when these big expenses arrive.
5. Split Expenses into Needs and Wants
   • Review your expenses and categorize each line item as either a "need" or a "want." This will be a valuable tool later as you evaluate your overall budget and set general targets. 
6. Free Cash Flow
   • Calculate your free cash flow by subtracting your planned savings and expenses from your after-tax income. Hopefully you have some money leftover! If so, evaluate the size of your free cash flow relative to your income. Target 5% remaining after savings and expenses as free cash flow.
   • We want to put a name on most of our income, but also don’t want to run our budget too tight. For example, if you earn $100,000, aim to have $5,000 remaining after steps 1-5 as free cash flow. This allows a little wiggle room for life and can also be allocated in the future if your emergency fund ends up growing too large.

That's it. You've created your household budget. If this is your first effort, revisit your budget over the next several months and make changes as appropriate. Next we will discuss evaluating your budget and additional steps you can take now that you have this personal financial statement.

Evaluating your Budget

As a type-A, quantitative person, I want to know exactly what my budget should look like. What's the optimal ratio for each of these broad categories? What's the correct housing payment? What's the optimal savings target? What's an acceptable debt payment? And so on.

Unfortunately, there are no hard and fast rules as each household's situation is unique. But I like to reference the 50/30/20 rule as a general rule of thumb, with a personal tweak. (My personal adjustment is to make the 20% target for savings alone, not savings and debt payments.) The numbers in the 50/30/20 rule of thumb correspond to:

1. Keeping Needs below 50% of After-tax Income
2. Keeping Wants below 30% of After-tax Income
3. And Saving at least 20% of After-tax Income

Again, this is just a rule of thumb and a starting point for evaluating your budget. Your situation and goals must be taken into account. If you are just out of college in an entry-level position, your rent and student loan payments may make it very challenging to hit these figures. The same goes for if you have two to three kids in daycare for the next couple of years. On the flipside, if you are aiming for retiring in your early 50's, a 20% savings target is highly unlikely to get your there.

What Else Can You Do with Your Budget?

1. Establish an Emergency Fund Target
   • Now that you know your spending you can set an emergency fund target of at least 3-6 months of expenses.
2. Make Sure You’re in Alignment
   • This a good time revisit your core values or Statement of Financial Purpose and ensure your budget aligns with your values.
3. Reassess Your Wants
   • Evaluate the Wants in your budget and consider where you like spending and where you don’t. Are there any areas you are spending more than you realized and would be happy to cut back? Are there any trades in your budget you would like to make? Would you happily swap $100 in your clothing budget for another $100 hosting family and friends? 
4. Plan for Your Next Raise or Bonus
   • Identify now where you would like to allocate your next raise or bonus. Are you a little short on your savings target? Tell yourself now that you will take half your next raise to put towards Savings and the rest towards a Want category you highly value.
5. Revisit your budget as life changes
   • As income and expenses change, or as you are evaluating big life events, come back to your budget to better evaluate the impact.

Creating a household budget is an incredible step for your personal finances and unlocks so many tools for your financial future.  You may have shied away from sitting down to create a budget for years for any number of (very understandable!) reasons. But now is exactly the right time to make it happen.

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