The 50/30/20 Budget is a way of allocating your money each month. The idea is to take your after tax income and allocate 50% towards needs and obligations, 30% towards wants, and 20% towards savings.
The 50/30/20 budget is a simple and easy way to allocate your funds in a sustainable, long-term way. This type of budget works best for those that do not like to spend time categorizing expenses and figure out how much to spend in each category. Both the categories and spending are predetermined (and explained in detail below).
Needs and Obligations 50%
Needs and obligations include things like food, housing, transportation, childcare, and debt pay-off. According to the 50/30/20 rule, needs and obligation should make up approximately 50% of your after tax income.
However, not all housing expenses constitute a need. For instance, living in a $1 million house is not a need. If you have a mortgage on a $1 million house, then you have an obligation, but no one needs to live in a $1 million house.
If you need a car to get to work each day, then you need for a car. However, you do not need to be driving around in a Cadillac Escalade. What you need is an inexpensive, dependable, and safe mode of transportation. Purchasing used car from brand known for reliability is what you need.
Food in this category does not mean eating lobster dinners at home. No one needs a $40 lobster for dinner, even if you bought it at a grocery store. Needs are reasonably priced nutrient dense foods such as fresh vegetables and fruits. Do not confuse junk food and luxury food as a need. You do not need Oreos and lobster to survive.
There is no way around it, childcare is expensive and you do not want to be dropping your child off at a budget daycare. When you need some sort of childcare so you can get to work each day, then you have a need.
Obligations is a nice way of saying debt. Debt includes your mortgage, credit cards, car loans, and student loans.
Approximately 30% of your after tax income in your monthly budget include wants. Wants are things like eating at restaurants, buying luxury purses, fancy shoes, and TV subscriptions. Wants are upgrades to your life.
A lot of times we try to justify our purchases as needs and obligations when in reality they are wants.
Think about it this way – when you build your emergency fund, what do you need to save? Your emergency fund only includes the basic expenses, what you will need to get buy in the short-term. Anything beyond your emergency fund is a want.
When defining your wants, be honest with yourself. If you are honest with yourself, then you are going to be much more successful.
Savings includes funds for retirement, to build an emergency fund, and put towards other investments.
It’s unfortunate that the savings category is 10% lower than the want’s category even though savings is more important. However, according to the 50/30/20 budget, savings should be 20% of your after tax income.
How Can you Find Your After Tax Income?
The 2020 Federal Tax Rates have 7 tiers. Based on the chart below, the lowest tier is 10% and the highest tier is 37%. The United States has a marginal tax system. The definition of marginal tax can get a little harry so I am going to provide you with an example of how it works below.
If you are single and make $100,000 per year at a w-2 job, what is your taxable income at the federal level?
Based on the chart, a person making $100,000 at a w-2 job looks like they are going to pay into the 24% tax bracket. However, this person is not going to be paying $24,000 in taxes.
The first $9,875 of income is going to be taxed at 10%. This equals $988 ($9,875 * 10%). The remaining amount of income available to tax is now $90,125 ($100,000 – $9,875).
Moving on and up, this person is going to pay 12% income tax on income below $40,124. This equals $4,815 ($40,125 * 12%). The remaining amount of income available to tax is $50,000 ($90,125 – $40,124).
We still have $50,000 that needs to be taxed. According to the chart, the remaining $50,000 is taxed at the 22% marginal tax rate. This equals $11,000 ($50,000 * 22%).
So how much is a person making $100,000 paying in federal taxes? $988 + $4,815 + $11,000 = $16,803.
What is the effective federal tax rate of a person making $100,000 a year? Approximately 17% ($16,803 / $100,000).
Below is a chart to summarize the example above:
Calculating State Taxes is more difficult because there are 50 different ways to calculate state taxes. If you are interested in finding out your State’s tax rate, a quick google search will provide you the answer you need.
At the end of the day, the easiest way to figure out your after tax income is to look at your most recent pay stub.
For this example, we will assume this person lives in New Hampshire. State income taxes in New Hampshire are 0.00%.
How to Use the 50/30/20 Budget
Now that we know what the 50/30/20 Budget is and our after tax income, we need to figure out how to use it.
Using our example of the person earning a gross income of $100,000, we calculated our tax liability at $16,803 which brings our after tax income to $83,197.
Based on the table above, this person’s monthly basic cost of living spending limit is $3,467. If this is a true representation of their financial situation, their emergency fund is fully funded if they have $20,802 in a savings account ($3,467 * 6 months).
This person can spend roughly $2,000 per month on wants such as going out to eat, lifestyle upgrades, vacations, etc.
This person should be saving approximately $1,400 per month towards retirement, HSA contributions, 529 Plan, and other investments.
How to Pay-Off Debt Using 50/30/20
In the 50/30/20 Budget, the best way to pay off debt is to reduce the cost of your needs and increase your debt pay-off spending.
Are you willing to move to a less expensive area?
Can you use public transportation?
Can you drive a less expensive vehicle?
Is it possible to cut back on your grocery spending?
Remember, 50% of your monthly after tax income goes towards needs and obligations. So the way you are going to reduce debt is to reduce your needs.
You can also decide to spend less than 30% of your after tax income on wants. If you spend less on wants, you can allocate more money towards, saving/investing or paying off debt.
Are you willing to give up Netflix and Amazon Prime so you can get out of debt? Can you live without that YSL purse? Do you need those latest Jordan’s?