Managing your money can be confusing. Yet, getting on top of your cash flow is absolutely essential if you’re going to keep your head above water, let alone thrive, in these challenging times. So anything that simplifies your money management has got to be a good thing, right? Well, maybe. A popular budgeting guideline is the 50/30/20 rule. Let’s see how effective it is.
- What Is the 50/30/20 Rule?
- Budgeting Allocation
- Is 50/30/20 the Best Rule to Meet Your Financial Goals?
- Other Budgeting Rules
What Is the 50/30/20 Rule?
The 50/30/20 rule is a system to improve your financial health. The method has you allocate your after-tax income to cover your needs, wants, and savings requirements. Here’s how it works:
- 50% goes to cover your needs
- 30% goes to cover your wants
- 20% goes toward financial goals
Your needs are the things that you cannot do without. They include fixed costs, such as your rent and mortgage, car payment, and insurances. Also included in this category are food and utilities.
Your wants are the things that make your life more enjoyable but that you don’t actually need. They include such things as dining out, going to a concert, or having streaming services like Netflix.
Your financial goals include both savings and paying off debts like your credit card. You may find that some savings, such as retirement contributions, are automatically deducted from your pay before you receive it. This should be taken into account.
So, if your monthly after-tax payment is $5500 but $250 has already been taken out for your 401K contribution, then you should add that amount to your total income and to your 20% financial goal contribution. Here’s how that would look in terms of numbers:
- Total after-tax income = $5750
- 50% to needs = $2875
- 30% to wants = $1725
- 20% to financial goals = $1150 ($250 of which is already catered for)
You now plan your budget around these dollar amounts. Make adjustments as, and where, you can to make sure that each of these dollar caps are not exceeded.
Is 50/30/20 the Best Rule to Meet Your Financial Goals?
Many people have found the 50/30/20 rule to be very useful. Its greatest benefit is its simplicity. Money management can get very complicated, so having an easy-to-apply rule to guide you is very attractive. However, there are some problems with this plan.
The biggest problem with the 50/30/20 rule is the gray areas about what things fall into each category. For example, think of a car. Most of us would consider a car to be a need. But if you’re an inner-city apartment dweller in a big city, do you really need a car? You may well be able to do everything you need with public transport and Ubers. The same thing applies with food. How much of what goes into your shopping cart is “need” food, like meat and vegetables, as opposed to “want” food, like sodas and potato chips? You could even drill down deeper and question whether meat is a need or a want.
Another potential problem is that your fixed costs might not fit neatly into the “needs” money cap. If your rent, car payments, and insurances already spill you beyond 50% of your income, you’ve got nothing left to spend on food. That’s not very helpful.
Another gray area between “need” and “want” is religious tithing and donations to worthy causes and charities. You will need to decide for yourself where to place these expenses.
With research telling us that most people are struggling to meet their needs, putting aside 20% of their income for financial goals may be unrealistic for many people. It’s one thing to have a target to save money, but if you do not have the means to save money, it will only lead to frustration.
For others, the 20% financial goal may not be enough. If you are saving for a specific target, such as a house mortgage, you are going to need to up your savings game beyond 20% of your income. Depending on where you live in the world, you’re going to have to come up with between $100,000 and $300,000 for a deposit to get into your first home. If your goal is to reach that goal in 5 years, you’ll have to save as much as 30% of your income.
When it comes to the financial goals portion of your income allocation, there is more murkiness. The 20% includes both debt payment and savings, but there is no set division here. That means you’ll have to decide what percentage of that 20% goes toward paying off your credit card and how much goes to savings. You also need to decide whether things like paying off your car fit into debt management (“financial goals”) or whether they belong in the needs—or, even possibly, the wants—category.
It can all get very confusing!
Overall, the 50/30/20 rule is nothing more than a general guideline. Once you’ve set it, you then have to track your spending each month to assess how well you are doing in sticking to it. And because of the gray areas I mentioned earlier, it is easy to rationalize that some of your purchases are needs when they are really wants.
Other Budgeting Rules
The 50/30/20 rule is not the only percentage guideline floating round. Here are a couple of others that are quite popular:
- The 80/20 rule: This guideline is even simpler than the 50/30/20 rule. It requires that you put 20% aside for savings and do whatever you want with the rest. This may not be the most practical method for people who are struggling financially. After all, you need to meet your fixed costs every month, no matter how badly you want to save that 20%.
- The 70/20/10 rule: In this case, you allocate 70% of your after-tax income to living expenses (a combination of needs and wants), 20% to debt payments. and 10% to savings.
The 50/30/20 rule provides you with a simple budgeting guideline. The more you drill down on it, however, the more gray areas emerge. Use it as a general overview to take your financial pulse each month, and you will find it quite useful.