It’s not just about how much money you make, it’s more about how you manage that money that truly matters. In other words, it’s very possible to be ballin’ on a budget. Lack of budgeting skills is probably the #1 reason why financial illiteracy is such a huge problem in not only the U.S., but in the entire world today. This article will provide you some of the tools and tips you need to know in order to master the skill of budgeting.
There are six major steps in the budgeting process which includes: planning, figuring out your income, determining your expenses, subtracting your taxes, coming up with a take home pay amount, and finally, continuously following up on the budget.
Step 1: Planning
A failure to plan is simply a plan to fail. With that being said, the first step to successful budgeting is developing a plan. I would recommend setting up an annual budget before the budget/current year begins to provide a full picture of how you can manage your money. The components of the annual budget will be described below in the following steps. Another type of budget to use is a monthly budget that you can easily keep track of and adjust your budget goals/targets as you see fit.
To properly set up the budget(s), there are three different approaches you can use. The first approach is a website known as mint.com which is a free tool that you can use to set up a budget. The site is 100% free and all you have to do is create an account and input as much information as you can about the different accounts you have. These accounts include bank accounts, retirement accounts, investment accounts, etc. Once you input all of the necessary information, you will be provided with a pretty accurate budget of how much you’re bringing in vs. how much you spend. Mint.com is excellent for a monthly budget and is extremely user-friendly. It provides you a breakdown of what you spend in certain categories, how you can make improvements to your budget, whether or not you’re reaching your budget goals, and even provides you with your net worth. Great site to use to keep track of your finances and the numbers are updated automatically.
The next approach is to use a manual budgeting template (i.e. Excel template) where you update the amounts yourself as time goes on. This can be good to use for an annual or monthly budget. The details of the template are in the next steps below, but basically you take how much money you make, subtract your expenses and taxes, and finally come up with how much you ultimately keep/take home.
The third and final approach, which is an approach I use very often, is a personal financial statement. This is on a much higher level than a budgeting template, but is an excellent way to set up an annual budget. Also, some loans require a personal financial statement so it is good to have in general if you can prepare one or have someone do it for you. The purpose of this statement is to provide you with an overview of how much you ultimately keep (i.e. net income/disposable income/take home pay) and what you’re worth (net worth).
Step 2: Know What You Make
The next step to developing a budget is knowing how much money you make. This can apply to both an annual budget and a monthly budget. Things such as your paycheck, investment income, and anything that puts money in your pocket all gets added up as “income.” This is normally the very first line of any budget. One important thing to note is to not add any loan amounts (money you owe) to this section. For example, you borrow $5,000 from a friend and agree to pay them back in three months. Adding this $5,000 to the income section will only throw off your budget because it’s ultimately not your money and you have to pay it back (making it a liability). Income items should be money that you receive on a fairly consistent basis. The best way to set up an annual budget is to estimate how much money you’ll make in the budget/current year based on how much money you made in the previous year. Be sure to take into account any changes that you know for sure will happen (i.e. a new job with a much higher salary) to get a more accurate annual budget. For a monthly budget, simply divide your annual budget by 12. Once the month is complete, compare your budget to how much you actually made that month to see if you were correct. If you were wrong, adjust next month’s budget to reflect what you actually made in the current month unless something extraordinary happened. For example, if you receive a $10,000 one-time bonus in the current month, adding that amount to next month’s budget will throw off your budget since it’s a one-time thing.
Step 3: Know What You Spend
This is the part of the budget that changes very often. Expenses include rent, utilities, cable, parking, transportation, medical, insurance, food, and anything that forces you to pay out money. This is the very next section of the budget and is the most critical to keep updated. For an annual budget, it’s basically the same exact approach as the income section. Estimate all of your expenses based on the previous year’s amounts in order to come up with the budget for the current year. Always make sure the numbers aren’t skewed if you know an event either happened in the previous year that most likely won’t happen again or you’re expecting a large expense in the current year. For a monthly budget, it is best to first set goals of how much money you want to keep (i.e. take home or net pay) each month, then set numbers around those. If you know the numbers for fixed expenses such as rent and cable, they automatically stay the same each month. Setting goals should be focused around expenses that can change (i.e. variable expenses) from month to month such as food, gas, utilities, etc. The ultimate goal should be to lower these expenses as much as possible. The lower you set the expense amounts, the more likely you’ll aim to achieve them and ultimately, the more take home pay you have in your pocket.
Step 4: Taxes
For some this is a huge “expense” incurred each month. It is best practice to subtract this amount from your income to get a more accurate representation of how much you take home each month. Luckily, your paycheck automatically calculates the tax expense for you so that should save you a major headache. So all you have to do is use the "net pay" amount at the bottom of the paycheck and put that in the income section to make your life easier and not have to worry about taxes messing up your budget. If you want to reduce this tax amount, this is where a health savings account and/or a traditional 401(k) comes in handy. To learn more about how to reduce your taxes, check out my article “IRS. vs. You. vs. Charity: Tax Saving Strategies.” This tax amount applies to both an annual and monthly budget and the same rules stated above in steps 2 and 3 apply.
Step 5: The Infamous Take Home Pay
What exactly is take home pay? Simply put, it’s how much you get to keep in your pocket. The simple formula is income minus expenses minus taxes. The lower you can keep your expenses, the higher your take home pay will be. If you don’t like your take home pay, try to set goals to either increase your income, reduce your expenses, or pay lower taxes. If your take home pay is “too much,” then it might be time to look into some investments or potentially, increase your savings. You should always save a portion of your take home pay, but in today’s society, the more you can save, the better. And if your take home pay is negative, it might be time to completely eliminate some expenses or find some other way to get back in the green zone.
Step 6: Continuous Follow-Up
The final and extremely critical step to budgeting is continuous follow up. A budget doesn’t just sit there and come up with numbers on its own. You have to be proactive in adjusting your numbers and checking to see if you’re meeting your goals. Always remember that the current budget should reflect both past outcomes and future expectations. The budget changes pretty often and is something that should be adjusted frequently as circumstances change. Since an annual budget is an estimate, it normally stays the same throughout the year unless something extraordinary happens. The annual budget should be updated each year based on what happened last year and what you expect to happen in the year under budget. A monthly budget changes much more often since information becomes available to you sooner, allowing you to quickly adjust the numbers.
As previously stated, budgeting is a critical skill to have in life. Failing to come up with a budget can make you unaware of where your money is going. Also, if something major is coming up such as buying a home, a budget will prove to serve you well by helping you develop goals of how much you can save per month based on your take home pay. And remember, budgeting doesn’t just happen once, it’s a continuous process that can last a lifetime, even throughout retirement.
If you have any questions regarding the budgeting process, financial management in general, how to create a personal financial statement, or how to use some of the tools described in this article, please feel free to contact me.