Updated: Aug 15
In the previous post What are Your Priorities? Where does Your Cash Go?, I guided you through creating a timeline of important goals. I suggested an inspirational photograph to put on your wall to keep you focused on balancing future goals with current lifestyle needs. This will motivate you to track your spending habits regularly and manage a budget.
You were also assigned the task of collecting information on where your money is going. This data is essential for creating a budget. In today’s exercise you will be categorizing your spending to formulate your budget.
Categorize your spending.
Now that you have collected your statements or run a report on your last twelve month’s spending, it is time to group your spending into categories. The three categories are:
1. Essentials: Shelter, Food, Health, Transportation
Essentials are items you cannot do without. The cost of maintaining a roof over your head, food, transportation, insurances to protect your family, and items or services needed to support your professional identity are all essential items.
Make a list of your recurring monthly expenses. From this you can pinpoint the majority of essential spending. For essential bills that are paid once a year, such as property taxes, simply divide that expense by twelve to lessen the pressure of a large but anticipated expense.
How to decide what is Essential? If you ran out of money tomorrow, you would probably find a way to pay your mortgage, car payment, and cell phone before your country club bill. But to go a layer deeper, think about when you purchased your car. Did you opt for a higher monthly car payment to pay it off quicker? Even if you went with a $1,000 a month payment, you can count it as essential as long as your income still leaves room for Fun and Future spending. But, if that $1,000 a month car payment prevents you from saving for retirement, it may be necessary to reconsider your priorities.
2. Fun or Discretionary Spending
We each have different definitions of what is essential and what is discretionary. In my view, discretionary spending is what makes life more enjoyable.
It includes shopping online for the latest technology, going out to eat, traveling, buying gifts for friends and family, purchasing music or video games, or having a hobby such as restoring cars, playing golf, or collecting wine. They are not necessary to have a roof over your head. However, most folks place a high value on these discretionary items. Making charitable donations would go in the discretionary category too.
3. Saving and Investing for the Future
During your prime working years, typically age 35 to 55, it is essential to place money aside to invest for the future. Depending on your goals, allocate 20-30% of your monthly income for the saving and investing for the future.
For each individual, the amount and goals will vary. You may be saving up to purchase an investment property, fund a child’s education, or socking away money for your retirement. Perhaps you worked with your financial advisor to identify how much you need to save to hit each goal in your desired time frame. For example, fund in-state college tuition in 12 years. Or, take a less stressful job at age 60.
How do you view the items in each category above? Are your hobbies essential or fun? Do you consider emergency savings contributions to be essential? You should aim to have at least six months of your take home pay set aside in savings.
If you are unsure you are on pace, once you’ve worked out your monthly budget and documented where your money is going, you will be in a good position to have a discussion with a financial advisor.
Formulate Your Budget
The most important piece of advice you need to always remember is your income must be equal to or greater than your expenses.
If your annual income from all sources is $350,000 (post tax) and annual expenses are $400,000. You are negative by $50,000 each year, which means you are taking on debt to meet essential and fun expenses. You may need to revisit spending habits if this is the case. Sometimes difficult choices such as down-sizing your home, selling a vacation property, or driving less fancy cars should be considered. However, understand that you will be happier in the long run if you have control over your spending and are investing for the future rather than winging it and hoping everything will work out for your family.
For many folks essentials will range from 40% to 60% of your monthly income. Keep in mind, the higher your essential spending, the less flexibility you have for Fun and less investment for your Future. Fun may range from 20% to 30% and Future may range from 20% to 30%.
There are no hard and fast rules, these are guidelines to consider.
If you are older, perhaps in your late fifties and have already saved a substantial nest egg, then your Future budget may require only 10-15% of your income and you’ll be able to increase your Fun or Essential spending. If you are in your prime earning years, between age 35 and age 55, I strongly suggest your future expenses should be 30% of your income to make sure you have a substantial amount of savings for kids’ college, retirement, and can maintain sufficient flexibility for the ups and downs of life.
Your Next Step.
Now that you know your average monthly essential, fun, and future spending you can ponder whether where your money goes balances your current desired lifestyle with what is near and dear to your heart in the future.
Have a discussion with your spouse, partner or financial advisor.
Does your Essential and Fun spending truly make you happy? Are there items you could be content without? Do you feel good about the money you are investing in your future?
A friend of mine generously shared her monthly budget so I may share it with you. You’ll see how she prioritizes essential, fun, and future spending as well as the percentage distribution of her total monthly income. Her monthly income is right around $11,000 a month, so her spending pretty much matches her income.
As you complete today’s exercise, ask yourself: Does your spending align with your income?
Do you have fluctuating income?
Some folks have a fluctuating monthly income if they own a business and take occasional draws or they receive periodic bonuses or commission checks. Next week’s post will discuss how to budget when your income fluctuates.
If you’ve a budgeting question you’d like answered, the Peak Wealth Planning team can assist.
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About the Author
Peter Newman is a Chartered Financial Advisor (CFA) and president of Peak Wealth Planning. He works with individuals nationwide that have accumulated wealth through company stock, ESOP shares, real estate, or running a business. Peter applies his unique background to help clients achieve their specific goals and enjoy peace of mind.
Peak Wealth Planning provides concierge services to meet your wealth management needs. Services include: financial planning, investment management, esop diversification, retirement income, insurance, and estate planning advice. Peak Wealth Planning is a fee-based financial advisor based in Champaign, Illinois, and Fraser, Colorado.