Congratulations, you've created a budget. You're aware of how much money you spend on your home, your car and your retirement fund. But how does your financial allocation compare to the amount you ideally should spend and save?
Harvard bankruptcy expert Elizabeth Warren - named by TIME Magazine as one of the 100 Most Influential People in the World - and her daughter, Amelia Warren Tyagi, coined the 50/30/20 rule of thumb in the book they co-authored together, "All Your Worth: The Ultimate Lifetime Money Plan."
The 50/30/20 plan outlines the following four steps:
Step One: Calculate Your After-Tax Income.
Your after-tax income is the amount you collect after taxes are taken out of your paycheck, such as such as state tax, local tax, and Medicare and Social Security tax.
If you're an employee with a steady paycheck, your after-tax income is easy to figure out. If health care, retirement contributions or any other deductions are taken out of your paycheck, simply add them back in.
If you're self-employed, your after-tax income equals your gross income, minus your business expenses (such as the cost of your laptop or airfare to conferences), minus the amount you set aside for taxes.
Step Two: Limit Your Needs to 50 Percent.
Review your budget. Note how much you spend on "needs" such as groceries, housing, utilities, health insurance and car insurance. The amount that you spend on these "needs" should be no more than 50 percent of your total after-tax pay, according to the 50/30/20 rule of thumb.
What's a need and what's a want? That's the million-dollar question. Any payment that you can forgo with only minor inconvenience, like your cable bill or your back-to-school clothing, is a want. Any payment that would severely impact your quality of life, such as electricity and prescription medicines, is a need.
If you can't forgo a payment, such as a minimum repayment on a credit card, it is also considered a "need," according to the Warren and Tyagi. Why? Because your credit score will be negatively impacted if you don't pay the minimum.
Read More: Here's a worksheet that helps you calculate the cost of your "needs."
Step Three: Limit Your Wants to 30 Percent.
On the surface, Step Three sounds great. Thirty percent of my money can be put towards my wants? Hello, beautiful shoes, trip to Bali, salon haircuts and Italian restaurants.
Wait! Not so fast. Remember how strict we were with the definition of a "need"? Your "wants" include your unlimited text messaging plan, your home's cable bill, and cosmetic (non-mechanical) repairs to your car.
Sometimes you'll buy a "need" that upgrades to a "want." Bread is a need; Oreo cookies are a want. Yes, they're both classified as "groceries," but one is clearly discretionary.
You may spend more on "wants" than you think. A threadbare minimum of warm clothing is a need. Anything beyond that - such as shopping for clothes at the mall rather than the discount outlet - qualifies as a want.
Read More: Here's a worksheet that helps you calculate how much you spend on "wants."
Step Four: Spend at Least 20 Percent on Savings and Debt Repayments
If you carry a credit card balance, the minimum payment is a "need," which counts towards the 50 percent. Anything beyond that is an additional debt repayment, which qualifies towards this 20 percent. If you carry a mortgage or a car loan, the minimum payment is a "need" and any extra payments count toward your "savings and debt repayment."
Read More: Here's a worksheet to help you pay off debt and get closer to your savings goals.