My second rule of budgeting: Don’t budget your entire take home!

by Nick on July 29, 2010

This one seems pretty self explanatory.  If you take home $3,000.00 per month set your budget lower than that.  How much lower?  This is where it gets a little complicated.  The answer is that it depends – on a lot of things.  It depends on your goals, where you are now, how risk adverse you are, how you want to live later, when you will need the money and a whole bunch of other things.  This is the personal in personal finance.

One way to decide is to figure out how much you want to save, by when and how much interest you are likely to earn on your path there.  For example, if you are 30 years old, single and make $50,000.00 per year, you’re probably somewhere in the ballpark of $3,000.00 per month after taxes (see here for an estimate). 

If you have $25,000.00 saved, think you can earn 5% interest on your money, are in the 25% federal tax bracket, have an 8% state tax rate, and want to hit $100,000.00 by the time you’re 40, you’re going to have to save about $475.00 per month in order to reach your goal. 

But if history is any guide, inflation may cause your $100,000.00 to feel more like $75,000.00 when you get there.  In order to feel like $100,000.00 ten years from now (and assuming a 3.1% inflation rate, which is the long-term average from 1925 though 2009 according to Dinkytown), you’re going to have to save at least $700.00 per month (you can run your own numbers here).

If you’re saving for retirement the calculations change because of tax-favored savings vehicles that we’ll talk about later, but with a fairly short-term savings goal on which you’ll have to pay taxes and want to use before retirement age, this is one way to calculate how much to budget for spending and saving. 

Another way is to simply pick a percentage of your income you want to save.  This percentage ended up being almost 25%.  What’s a good percentage for you?  Even experts disagree.  Here is one article talking about saving 40%.  Seems aggressive, right?  That’s a great goal, in my opinion.  That’s the percentage my wife and I use for our budget.  It’s a tough budget, I’ll admit – especially because we live in a very expensive part of the country.  But we work very hard to do it.

(Incidentally, if you take the same interest rate, taxes and other assumptions in our example, but save 40% – or $1,200 per month – you would have over $200,000.00 that feels like over $150,000.00 in ten years.  Pretty nice.)

So what to do now?  Pick your percentage – pick a percentage.  And don’t pick zero!  You can do it!

Set a direct deposit for that amount to be segregated from your take home for savings/investment.  Set up a separate account for that amount!  Then, before each month write your remaining take home amount at the top of a sheet of paper (or use budgeting software or other technology to help) and work through your budget.  Feel free to spend the rest of the money (wisely!) and, assuming you stick with it, earn your interest, pay your taxes, and spend no more than the remaining amount, you’ll reach your goal.  Earn and save more and you can get there faster.

This may seem complicated, but it doesn’t have to be.  Set a goal and work the numbers.  If you’re not sure where you want to put your money yet, set up a savings account and buy CDs with low- or no-early withdrawal options as you save. Based on my research I like Ally’s five-year CD the best. Because there is only a two-month early withdrawal penalty, you are likely to end up ahead of the game after a few months even if you withdraw early. It’s only 2.94% APY currently (lower than the 5% assumed), but it’s better than earning nothing if you’re not ready to put it in an investment. Later on we’ll talk about different investments you could consider.

If you’re wondering, change the 5% to 2.94% rate in the Dinkytown calculator and you still end up with over $120,000.00 after taxes that feels like over $90,000.00 with the $700.00 per month option and over $90,000.00 after taxes that feels like almost $70,000.00. Not too shabby for very little relative risk. I’m going to set one up for my student loan payoff account (remember my goal is 17 months away – less than the 5 years for the CD, but I’m willing to spend the 2 months of interest for the great rate and will end up ahead of other short term CDs). I’ll have to buy a bunch of CDs as I go, but that’s OK.  This Ally CD can actually be a great alternative to a CD ladder in my opinion because of the low early-withdrawal penalty. More on CD ladders later. 

So what’s the lesson?  Budget to spend less than you earn.  If you have a hard time, put it on autopilot with direct deposit.  Put the credit card away and slowly step away from the mall.

What do you think?  Does this seem aggressive to you?  How do you set your budget?  What percent do you save and why?  And let me know who sets up their savings on autopilot.  I haven’t done that, but am going to set up an account and do it.  How am I going to do the

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