How much you contribute towards your goals (your saving rate) is a key determinant of financial success, more so than your investment returns. However, disciplined saving is hard to implement, particularly with many competing needs and wants, and a busy life. One tool to help you get started is the 50/20/30 rule. 

The rule states that you should devote 50% of your after tax income to your necessities, 20% to saving for your financial goals, and 30% to your wants. The rule is a powerful starting point if you are trying to take control of your financial life. It starts with computing reasonable spending and saving targets, a good starting point to help you align your savings and spending habits with your goals. Notice there is a reason we write it 50/20/30 rule, and not 50/30/20: saving for your goals has priority over your wants! Let’s break the rule down.

The 50% to Needs

Your needs category includes all the essential expenses, like food and shelter. They include rent or mortgage payments, utilities like electric power, water, and gas, telephone bills, groceries, and basic clothing needs (including work clothes). Basic spending on transportation needs is also included in your needs. Minimum car or other loan payments are included as part of your needs. However, keep in mind that some of these costs may be above strict needs. For example, minimum payments on a luxury car are at least partially a want.

The 20% to Saving for Goals

The first saving goal should be to fund or replenish a safety net. Next is your retirement goal. Most people should start saving about 10% of their income for retirement. Higher earners should make this a starting point, and increase it over time to about 20%. You may also have other goals, including family goals (e.g. college) and lifestyle goals. Because you can fund some lifestyle goals by borrowing, debt repayment above your minimum monthly payments is considered part of this saving bucket. Take a look at our goal setting process.

The 30% to Wants

Notice the 50% needs does not include spending on extras, like subscriptions to streaming services, cable or even wifi. That is part of entertainment, which is a want. Clothing beyond your basic needs and what’s required for work is not a need. There is nothing wrong with wanting to spend more on clothing if that’s important to you. This additional spending is part of your wants. Your wants include spending on entertainment, like eating out, movies, etc., and shopping on things you like, including electronics, hobbies, vacations, etc. It also includes spending more than strictly needed for a good or service. For example, a first class upgrade when a coach seat might do, a new phone every two years, or a luxury car instead of a basic model. This type of spending is called discretionary spending, because you have some discretion over it and you can adjust it.

How to Get to Your Targets 

Start with your paystub, take your gross income, and subtract your tax withholdings. ADP has a calculator that does it for you. If you are not sure if your withholdings are right, and make a determination using the IRS calculator.  Suppose you are married and make a combined $140,000 per year, and your taxes amount to $25,000 including federal taxes, Social Security and Medicare contributions.  Your after tax income is $115,000 annually, or roughly $9,600 a month.

Calculate your percentages

The 50/20/30 rule is useful because it lets you set reasonable targets that can help you get started with your goals. Most budgeting tools help you categorize your expenses, but don’t help you understand or set useful targets. 

Using the example above, from the we have:

• 50% to Needs: $4,800 a month.
• 20% to Saving for Your Goals: $1,920 a month.
• 30% to Wants: $2,880 a month.

Once targets are set, you can use your actual expenses to see how you can adjust spending to align with your targets, particularly your savings goal. In this example, we should have a total savings capacity of almost $3K a month.

Allocate Your Actual Spending

With your percentages set, it is now time to compare them with your actual spending. It should be relatively easy to come up with your monthly spending on Needs and Savings. Use at least three months of data and average the expenses out, to eliminate some month-to-month variation. Wants may be a bit more erratic, so you may need to use at least 6 months or preferably a year, and then calculate a monthly average. Once you get a handle on your spending, you can also use the momentum to create a budget.

Grain of salt

The goal of the 50/20/30 method is to help you take control of your finances, and help you focus on saving for your goals. Since it’s a very simple process, you should think of these percentages as your starting point. It may work well for someone in the early stages of a working career in areas with average housing costs. However, it may require adjustments. 

• In high cost of living areas, the Needs bucket may be higher than 50%. If you are renting and are much above the 50%, consider options to reduce your monthly rent. Consider moving into a smaller place or a less expensive neighborhood might work for you.  If you are making mortgage payments, you can consider part of the equity you are building on your house as part of your savings. This can help you adjust the percentages to Needs and Savings, somewhat, particularly, if you plan to retire in a less expensive area.
• If you are a high earner, the spending percentages on Needs and Wants should come down, and the Goals should go up. For example, while a 10% saving rate applied to retirement is a good starting point, high earners should consider saving 20% just on retirement. As your income grows, your Goals bucket should be greater than 20%. You may want to consider a full financial plan.
• Having set a savings target, and having checked its feasibility based on actual spending, the next step is to automate your savings. You do that with your 401(k) plan, do it with your other savings or investment accounts as well.
• After some work on your budget, what if you still find the targets to be unfeasible. Save as much as you can, and consider the allocations to Needs, Savings, and Wants as targets to work towards. Commit to saving more as you earn more or experience life changes.

Until Next Time!

Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC.  DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives.  As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.