Creating a Spending Plan, Part 2

In the last article, we introduced the concept of a spending plan. And we used what’s typically called a zero-based budget as our template. A zero-based budget accounts for every dollar of income and allocates each to a spending, saving, or investing category.

But using a zero-based budget is not the only way to create a spending plan. In this article, we’ll explore three alternatives to a zero-based budget.

50/30/20

The first method we’ll explore is the 50/30/20 budget. Simple and intuitive, the 50/30/20 budget can be implemented quickly. It was popularized by Elizabeth Warren. Take your after-tax income and divide it up in the following way: 50% to necessities, 30% to wants, and the final 20% to savings.

While it sounds good in theory (who wouldn’t want to spend 30% of your income on anything you want?) and it’s easy to get going, it does have significant flaws.

What if 50% isn’t enough for your necessities? And just what is considered a necessity? Is internet a want or a need? How about cable TV? Is buying a more expensive car a want, or should that be in the 50% classified as a necessity? And what do you do with any extra if you don’t spend the entire 50% - does it go into the savings bucket or into spending on wants?

And for higher-income earners, 30% on wants might be extravagant. Think about the family that brings home $10,000 per month. It’s a good problem to have, but $3,000 each month on whatever you want to buy could encourage higher earners to over-spend.

And 20% in savings might not be enough to achieve your goals. Think of someone that’s trying to save for a down-payment on a house, retirement, an emergency fund, and, perhaps to purchase a car. In that case, they may need to be more frugal and save more aggressively.

While it may be a good budget to get you started, I would suggest you graduate to one of the budgeting methods more tailored to your specific situation.

The envelope system

This method of creating a spending plan is old-school. Basically, you’re dividing your income into different spending categories, such as: groceries, gas, clothing, dining out, etc. Once you’ve created all your categories (and don’t forget irregular expenses such as taxes, insurance, or holiday spending), then you decide how much should be allocated to each category. Now take that amount of cash and put it in an envelope labeled with that category. When you’ve spent everything in the envelope, you’ll have to wait until the next paycheck to replenish the envelope.

This system works because in a typical household, there’s nothing telling us when we’ve reached our spending limit. One of the reasons people overspend is that they don’t know they’re doing it.

But the envelope system works best when you do most of your spending in-person. When you go online, it’s difficult, if not impossible, to use cash. It does steer you away from using credit cards to a great degree (which is the cause of much of our overspending), it has plenty of drawbacks. If you’ve ever tried to go on vacation without a credit card you know it makes renting a car or buying airline tickets much more complicated. And cash isn’t very conducive to today’s finance apps or software.

You’ll also have to lookout for the tendency to raid another budget envelope when one runs dry. If you’ve used up all the grocery cash, but still need milk, it’s tempting to grab the gas envelope.

What if you have an emergency mid-month? The car breaks down and there’s not enough in the car repair envelope (you do have a car repair envelope, don’t you?)? For all of these faults, I wouldn’t recommend the budget envelope system anymore. It worked 30 years ago, but has too many flaws in today’s financial world.

Paying yourself first

This is less of a systematic process than it is a philosophy. Instead of allocating all your spending, then saving whatever is left, you instead put your savings in a separate account, then spend what’s left. This is similar to how it works when you have a retirement plan at work. Your employer deducts whatever percentage of your salary you’ve determined, and direct deposits the rest into your bank account.

But if you don’t have any kind of retirement account at work, you can simulate this procedure. Simply sign up for automatic deduction into an investment account at Fidelity or Vanguard. Or have an automatic transfer in place from your checking to your savings account. Whichever you choose, make the deduction or transfer happen on payday – and if you get paid more than once a month, make sure to set them up to happen at each pay date.

This is easy to setup, maybe easier to setup than it is to live with. But the simplicity is appealing. And it will get you to your savings goals, forcing you to work with whatever’s left after your deductions.

The disadvantage is that it doesn’t deal much with whatever’s left. You’ll still have to implement some type of way of allocating that excess, otherwise, you’ll constantly be raiding your savings to make up the difference. But in combination with one of the other systems we’ve outlined, this might be a good option.

For example, the 50/30/20 dictates that 20% of your take-home pay goes to savings. That’s a great goal, but for your specific situation, you might need more or less than that amount. Paying yourself first would dictate that you determine how much you’ll need in retirement. Then put that amount each month into savings before you’ve done any spending. You could then allocate the remainder into the “50” and the “30.”

So, there are your three spending plan ideas: 50/30/20, the envelope system, and paying yourself first. My preference is the system I outlined in the previous article – budget accounts. If you’re unfamiliar with that idea, review the first spending plan article.

Use whichever method seems most appropriate to you and your particular situation. You should be in control of your spending, rather than a passive observer of it. And there’s nothing wrong with trying one system, and switching to another if it doesn’t suit your needs. But get going – start your spending plan today. The longer you wait, the harder it is to get things under control. Good luck!