If you are part of that 40 percent of Americans who are not saving anything—or are not saving enough, think about these rules of thumb as a foundation of any savings plan:
- 50% of your income should be the maximum amount you spend on necessities—What you need
- 30% of your income should be dedicated to discretionary spending—What you want
- 20% of your income should go towards savings—including an emergency fund to meet three to six months expenses
Obviously, to see where you fall within that 50/30/20 spectrum, you need to write down what you spend, put the expense item in a column and make some hard choices. Let’s look at each in reverse order:
20% Savings—If you are going to allocate the recommended 20% of your income to savings and investments, you must first set aside the aforementioned emergency fund in an easily accessible bank savings account. Then figure out what percentages IRA, mutual fund, and employer contributed 401(k) savings plans. If all of those items aggregate to 20% of your income, you are doing fine. If not, you need to proceed to the next tier.
30% Discretionary spending—Be honest — you probably spend a lot pampering yourself with purchases and expenses you could do without. Your morning drive through at Starbucks for that yummy $6 fancy coffee concoction would be an example. Multiply $30 a week times 52 weeks, and you’re spending over $1,500 on a totally discretionary item.
The thing about discretionary spending is that one person’s wants could be another’s needs. So, writing down discretionary spending will take some honest soul searching. Add up those discretionary items and do some reductions or cutting, and you can send them to savings to set up your emergency fund and 20% savings level.
If those cuts in discretionary spending are placing you on the path to your savings goals, again, you’re doing just fine. If not, go to the next step and see how your necessities might be busting your budget.
50% necessities— Those expenses are the bills and payments necessary for survival. They include rent/mortgage, auto loan, insurance, health care, and essential groceries. Again, you need to be honest here. The foregoing are the things you must cover, and should not include cable television, dining out, movies, and other extras.
So, one-half of your income after tax should cover everything you need to pay your bills and meet your needs and obligations—which gets us to some difficult downsizing choices if your actual expenses exceed that 50% maximum.
The difficulty arises from the extra time it will take if you want save more at the expense of having to downsize your home or trade in that SUV for a smaller, more economic model. The ancillary benefit of downsizing is that supporting expenses like insurance and maintenances go down as well.
The bottom line is that the 50/30/20 percent rule is a great budget template. It can be as incremental as first concentrating on paydown of debt, building up your emergency fund, and then replacing that Starbucks brew with your own cheaper treat. The common denominator is that in order to have money left over at the end of the month — rather than month left over at the end of the money — you must live below your means.
You don’t have to live like an ascetic hermit, but if you want to have savings that will serve you through your retirement years, you need a flexible and adjustable strategy.