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Wouldn't it be nice if life came with step-by-step instructions? Now it does! We break down how to master pretty much any money-related task right here in our "How to Do Everything" series. Whatever the goal, we'll cover the steps to take and things to know to reach your next financial milestone, all in one place.
Today, financial planner Brian Frederick breaks down how to set up a budget using a budgeting method that can help simplify how you spend and save.
Most personal finance advice you hear typically starts this way: Create a budget.
Of course, that’s easier said than done, especially considering there’s no one-size-fits-all budget that works for everyone. But there is a simpler way to categorize your expenses and keep track of your spending. If you’re new to budgeting, we’ll help explain how it works, and how you can put it into practice.
How Does It Work?
In a nutshell, you categorize your spending into four basic buckets:
1. Fixed Costs: These are regular monthly bills that don’t fluctuate much. That might include your mortgage or rent, utilities, cell phone bill, minimum payments due on any credit cards or loans and regularly recurring subscriptions, like your gym membership or Netflix account.
2. Financial Goals: These are things you’re either saving up for or trying to pay down — think money you put toward emergency savings, a down payment for a home, vacations, a college fund and any extra money that you put toward paying down debt faster. It also includes post-paycheck retirement contributions (such as what you put into an IRA).
One thing that isn’t included here are your 401(k) contributions. That’s because your take-home pay is used as the baseline from which to create your budget, and 401(k) contributions are taken out before you receive your paycheck. That said, it’s important to figure out how much you can contribute to a 401(k) while still leaving you enough to cover your cost of living. Ideally, you’re contributing enough to meet any company matches.
3. Non-monthly Expenses: These are costs that you pay throughout the year, just not monthly. Quarterly taxes, annual insurance premiums or school tuition could fall into this category, but so could things like holiday gifts. Add up the total of these expenses over a year and divide by 12; that’s how much you should be putting aside each month in order to cover these costs when they come around.
4. Flexible Spending: This includes all your monthly costs that fluctuate, such as food, shopping, gas and entertainment. You’ll use the One-Number Strategy to determine how much of a flexible-spending budget you have each week.
How Do I Know How Much I Can Spend?
Start with your monthly take-home pay, then subtract your monthly fixed costs, financial goal contributions and non-monthly expense contributions. What’s left over is your flex spending number. Divide that by 4.3 (the average number of weeks in each month), and that’s how much you can spend each week without spending beyond your means. Here’s that formula in action:
- Monthly Take-home Pay: $4,000 a month
- Total Monthly Fixed Costs: $2,000 (e.g., $1,000 rent, $300 in utilities, $300 car payment, $200 in minimum debt payments, $100 cell phone bill, $100 gym membership)
- Total Monthly Goal Contributions: $500 (e.g., $200 to an emergency fund, $200 to a future house fund, $100 to a Roth IRA)
- Contribution to Non-monthly Expenses: $400 (e.g., $4,800 total over the course of a year for things like insurance premiums, taxes, and holiday travel, divided by 12)
$4,000 - $2,000 - $500 - $400 = $1,100
$1,100 / 4.3 = about $255
$1,100 / 4.3 = about $255
That means $255 is your weekly flex spending number, and the number you must stick to in order to make your whole budget work.
How Can I Set Up My Budget?
In theory, once you have your flex spending number figured out, your finances should be on near autopilot, save for the 15 or so minutes you take each month to review your bank transactions to catch any mistakes. Here are some tips to help you set up your budget successfully.
1. Set up two checking accounts. Create one checking account for your fixed monthly costs (your “fixed checking”) and one for the money you use to cover your flexible spending (your “flex checking”). That will help ensure that you don’t use up the money you’ve set aside for bills to pay for discretionary costs like concert tickets or takeout. If there is more than one adult in a household, each should have his/her own flex-spending account.
In a perfect world, none of your accounts would require minimum balances or monthly service fees — especially because you may draw them down to near zero on a regular basis (particularly with your flex spending).
2. Set up multiple savings accounts. For long-term goals like retirement and college, it makes sense to save using tax-advantaged savings accounts built specifically for those purposes, like IRAs and 529 college savings plans. But for shorter-term savings goals like the ones below, consider FDIC-insured, high-yield savings accounts.
- Emergency Fund: Your emergency savings should be set up at a different institution than where you normally bank so that you’re not tempted to dip into it for something besides an emergency (no, a last-minute flight deal to Cancun does not count).
- Non-monthly Expenses Savings: This is where you’ll funnel your monthly contributions so you can help cover these types of costs. Some people even subdivide their non-monthly savings into two categories — one for necessary expenses like property taxes or car registration fees, and one for fun expenses like gifts and holiday travel — either by creating subaccounts within one savings account, or by opening two separate savings accounts.
- Short-term Goals: By short-term, we mean goals that you’re trying to reach in five years or less. This could include saving for a dream vacation, a home renovation or buying a new car. (For goals more than five years out, you may be willing to take on market risk and save in a brokerage account so your money has more potential to grow.) Again, you can either set up subaccounts for each goal or separate accounts.
3. Set up direct deposit. For most people, using your fixed checking as your “main” checking account will feel the most natural. From here, you can set up weekly transfers into your flex checking, as well as the amounts you’d like to send over to your various savings accounts.
If you have the option to split up your direct deposit into multiple accounts, you could also split your paycheck between your various checking and savings accounts. Just remember that sticking to a bi-weekly or monthly flex-spending number (depending on how often you get paid) requires more discipline than sticking to a weekly one, so you may want to wait to do that until you’ve found it easier to stick to your spending amount.
4. Set up your auto payments and transfers. Once your fixed checking account has enough to cover at least a months’ worth of your bills and your flex spending, put as many payments as you can on autopay. This helps ensure that everything gets paid on time and you avoid late fees. Also, set up your weekly flex-spending transfer and any other transfers toward your other savings goals.
5. Prioritize your savings goals. If you have many savings goals and not enough take-home pay to cover them all, consider prioritizing your emergency fund first. At a minimum, you want enough to cover one months’ worth of expenses before you start working toward other debt or savings goals. (Eventually, you’ll want your emergency fund to grow to about six months’ worth of expenses.) Second, make sure that your necessary non-monthly costs are on schedule to being covered. For example, if you have a $3,000 property tax bill every December 31st, you’ll need $750 in that account by March 31st to be on track.
Set aside money for discretionary savings goals, like travel and gifts, based on their importance to you, how soon you want to reach them and how much actual cash you have left over to fund them.
How Do I Know If I'm Sticking to My Budget?
Ideally, your budget should help you make your payments on time, avoid overspending and regularly fund your goals. The more consistent your expenses and income are, the more you’ll be able to stick to your budget — but the beauty of this approach is that you still have some flexibility to make changes when you need to.
Did you overspend one week? Then simply adjust the following week’s flex spending. Are you facing a big annual expense for the first time this year? Time to adjust how much you send to your non-monthly savings account each month.
The more you work with your budget, the more you’ll be able to build a rhythm and strong habits around your spending, and the less likely you’ll be taken off guard by unexpected costs or changes to your situation. Then, as your goals change or your income grows, you can always recalibrate your spending.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, CFP® (with plaque design) and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.
No investment strategy can guarantee a profit or protect against loss. All investments carry some level of risk including the potential loss of principal invested. Taxpayers should seek advice based on their particular circumstances from an independent tax advisor.