What is the 50/30/20 Rule?

by William Sabin, CPA

Budgeting Insights

The 50/30/20 Rule helps you build a budget by using three spending categories:

• 50% of your income should go to living expenses and essentials (e.g. housing, health insurance, car insurance, car payment, rent, groceries, utilities, transportation)

• 30% of your income should be used for flexible spending – your ‘wants’ (e.g. movies and travel).

• 20% of your income should go to financial goals (e.g. savings, investments, reduction of debt)

Elizabeth Warren coined the "50/30/20 rule".  Keep in mind that the percentages above for the 50% and 30% categories are the maximum you should spend. 

How to start a 50-20-30 budget

After reading the other articles on the site, as well as,  using the excel file, you now know how much you are spending in each category. 

How do your financial allocations compare with the 50/30/20 rule?  The key is to consistently use a system that works for you.

I’ve seen this topic discussed, but it leaves me with more questions than answers.  The first question that I have is how is ‘income’ defined?

How is ‘income’ defined?

Income in this guideline is defined as really net income after tax.  So, the first step is to calculate your after tax income.  Take your gross pay and subtract out all taxes (federal, state, local), Medicare, social security, etc.  If self-employed, you need to ensure that you also deduct self-employment tax.

Now you have your ‘income’ number.  The next step is to apply this income into the 50/30/20 categories. 

Limit Your Needs to 50 Percent of Your After-Tax Income

This is where the rubber meets the road and also where my second question generally starts – determining what is a ‘need’ and what is a ‘want’.  It’s akin to raising kids, they want everything (but brussel sprouts – who can blame them), but don’t need as much.

It would appear to me that anything that would affect your life in a hugely negative way could be considered a need.  Things like a required mortgage payment, rent, utilities, medicine, and food.  I would tend to also add giving to charities in this category.

Things like if to have you heat / air condition on a ‘perfect’ temperature might be more of a want.  Having cable TV, lots of new clothes, a new iPhone are wants.  I’m mixed if having a smart phone is a need or a want – they are so integral to daily life for more now.  However, the key is to get the major things in the right buckets and to maximize the 20% bucket.

Limit Your Wants to 30 Percent of Your After-Tax Income

While this sounds like a lot.  You will quickly find that this bucket is used up fast even before you really have any extravagant purchases.  The key here is don’t cheat or take from the 20% bucket. -

Maximize Your Financial Goals  - the Best Part

This is the place that you can really shine and get to the financial freedoms that you should strive for.  Repay debt (especially those credit card balances), build an emergency fund, save for the future, fund retirement accounts, etc.  If you pay more than your required mortgage each month, it is a form of savings.  This is the category for the extra payments. 

An Example of the 50/30/20 Plan 

Assume you make $5,000 a month and after taxes and other items as define above, your take home pay is $3,500.  Using the 50-30-20 rule, you have $1,750 in the 50% needs category; $1,050 for the 30% needs category and $700 for the 20% bucket.

You might quickly find that your 50% bucket is full and is spilling over into wants bucket.  What to do?  Don’t stress.  You might just have to cut back on more of our wants.  In the longer term, you might have to figure out a way to reduce your ‘wants’ bucket – move to a smaller place, cut back on the car that you drive, increase your insurance deductibles (possibly), save on utility bills ,etc.  More on these thoughts in future articles.

The best bucket of all is the 20% savings bucket.  Fill it up.