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Investing basics: how to use the 50/30/20 rule for budgeting

Emma Rapaport  |  31 May 2019Text size  Decrease  Increase  |  
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Setting up a budget is no one’s idea of fun. After all, we'd all like to spend what we make.
But a good budget that quietly works in the background is an essential first step to saving and growing your wealth.

To make the task less painful, we've collected three popular budget strategies so you can pick a method best suited to your goals and personality.

Last week, we explored Christine Benz's 30-Minute Money Solutions budget.

Today we unpack the 50/30/20 budget.

The 50/30/20 Budget

The 50/30/20 budget was devised by current Democrat presidential candidate and Harvard academic Elizabeth Warren in a book she co-wrote in 2005 called All Your Worth: The Ultimate Lifetime Money Plan.

According to Warren, the 50/30/20 budget is a great way to put your spending and saving on autopilot. It's easy to follow, works quietly in the background, and is useful in shifting your focus to what you can spend money on. And best of all, you don't have to account for every single dollar you spend.

This basic budgeting rule gets you to split your after-tax income into three categories:

  • 50 per cent into spending on 'needs' – living expenses and the essentials
  • 30 per cent into spending on 'wants' – things you want but don't necessarily need
  • 20 per cent into 'savings' – working towards your financial goals

So, how does it work?

Step one: calculate your after-tax income

To begin, calculate the amount of income you've got coming in each month.

Your after-tax income is your employment income minus income tax minus and the Medicare levy (if you pay it). If you're on a higher income, you may also pay an additional Medicare Levy surcharge if you don't have private health insurance.

Your employer might also pay a portion (9.5 per cent) of your pre-tax income into a superannuation fund. To help calculate these amounts you might like to try PayCalculator.com.au.

Then divide this amount by how often you get paid. For example, if you make $50,000 a year in after tax income, and get paid every two weeks, you should be pulling in around $1,900 fortnightly.

Eg. $50,000 / 26 = $1923

Step two: make a list of your 'needs' and 'wants'

Distinguishing a “need” from a “want” in your spending is up to you.

A good rule of thumb is to think about needs as the things you must spend money on each month, things like rent, utilities, mortgage payments, health insurance, prescription medication, transport to work, groceries etc. It's a payment that would transform your life if you went without it. Warren says your needs should be no more than 50 per cent of your after-tax pay. If they're more, ask yourself if you can reduce your fixed costs.

Wants are the basic necessities that make you enjoy life. Things like new clothes, eating out with friends, a Netflix subscription. Remember, wants are not extravagances such overseas holidays, which is something you would save for. 

Savings can include money your putting aside to save for something big – a home, a car, big holiday – to invest, to contribute to retirement, or to pay down debt.

Step three: set-up three bank accounts

You probably already have an everyday transaction account and a savings account, but for this method to work you'll need a second transactions account (with a bank card) to receive your automatic transfers. To make things easier, Warren suggests labelling your accounts “Needs”, “Wants”, and “Savings” (or something that will help you remember which account to use).

As suggested by Scott Pape in his best-selling book Barefoot Investor, seek out a bank account which has no (or low) account keeping fees.

Step four: set up automatic transfers

The final step is to automate your Needs, Wants, and Savings system so you no longer need to visit your budget daily.

First, check your bank account to see which day your salary is deposited into your Needs account. Next, set up an automatic transfer service from this account – 20 per cent into your Savings account, 30 per cent into your Wants account – on the day your salary arrives.

For example, if you receive a fortnightly after-tax income of $2000 - $400 will be automatically transferred to your Savings account (20 per cent), and $600 to your Wants account (30 per cent). $1000 is left over for your Needs (50 per cent).

Some workplaces allow you register multiple bank accounts into which you direct your salary. Ask your payroll/accounts department if this is available.

Verdict

The 50/30/20 budget is an efficient method for anyone put off by transitional line-item budgets built in Excel. It's also a useful way to get you started thinking about your fixed-expenses, and not feel guilty about spending money for the fun things in life.
Automating your savings is also a way to ensure you are reaching your targets each pay cheque.

It's important to note that these ratios are a guideline. If you don't have a lot of fixed expenses and want to put more into savings, go for it. Or if you're struggling save 20 per cent of your income, make it a goal you can work towards.

This budget doesn't work for everyone, particularly for those with higher levels of income. For people trying to achieve an above-average savings level, blowing 30 per cent of their income seems counterproductive. It can also be difficult to stick to when money is tight, or for those saddled with a lot of debt. And finally, this budget works better for people with a singular source of income.

Next week, we’ll examine the pay-yourself-first budget.

is a reporter for Morningstar.com.au

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