By: Mike Curran
Wealth Manager, The Milwaukee Company
You finally realized what you’d been ignoring for years: not having a budget is a financial dead-end. Congratulations! You’ve made the first step towards achieving financial freedom.
After having that “a-ha” moment, you will need a game plan to accomplish your goal. The following steps can serve as your guide.
Step 1: Gather all your Financial Information
No matter how you receive them (e-delivery or through the mail), collect and organize your financial statements so that they are easily accessible. Items to collect include:
The more information you can gather, the better. The key to building a monthly budget is to organize your finances, and you can’t do that without a complete understanding of your current position.
Step 2: Calculate your Spendable Income
Next, you’ll have to identify the amount of money that is available for you to spend each month.
- If you receive a paycheck, that money most likely is after federal and any state taxes as well as other deductions, such as Social Security and Medicare. This is your after-tax income.
- Next you should deduct the amount of each paycheck that is deposited in your employer-sponsored retirement plan. (I’ll discuss how to determine how much to save for retirement in an upcoming article.) If your employer does not sponsor a retirement plan, you should set up an IRA account and make contributions to it as part of step 6, below.
- The dollar amount after the foregoing deductions is your take-home pay. This is the number you should be using for budgeting expenses.
Step 3: Create a List of Monthly Expenses
At this point, you will realize how much of each paycheck is left to cover your current living expenses (cue the frustration). After the small temper tantrum, get back to work and dive deep into your current spending habits. This can be categorized into two lists: Fixed and Variable. Your fixed expenses are consistent from month to month – rent, mortgage payments, utilities, etc.
Variable expenses are ones that change from month to month. The best place to find these expenses is on your bank and credit card statements. This will help you categorize each item and identify which category you spend the most on.
Variable expenses can be further broken down into “needs” and “wants”. A need is something you cannot live without, such as paying for gas for your car so that you are able to get to work or groceries. A want is a discretionary expense such as eating out and entertainment.
Step 4: Calculate the Difference
Now subtract your expenses from step 3 from your take-home pay from step 2. Which one is larger? If your income is greater than your expenses, you can proceed to step 6. On the other hand, if your expenses are greater than your income, proceed to step 5.
Step 5: Make Adjustments to Your Wants
If your take home pay is less than your expenses, look for ways to save a few dollars every day by scaling back on your wants. For example, making your coffee at home rather than going to your favorite coffee house on the way to work, or pack a lunch rather than going out to eat. These little changes will help you in the long run because that $5 cup of coffee from the coffee shop could grow to $150 over time due to the power of compounding (another topic I will be covering in the future).
Note that it’s also important not to make such drastic spending cuts that you are miserable. If that happens you are likely to abandon your budget and land back at step 1.
If the cuts you’ve identified to your wants are not enough to balance your budget, then look for ways to increase your income. Perhaps it’s time to ask your boss for that overdue raise, or to spread your wings at a higher paying position. You might also want to investigate a second job, preferably one where you work for yourself doing something you like, and that just might turn into a full-time gig down the road.
Step 6: Make a Plan
Hooray! You are at the point that you have generated more income than expenses. Now what?
At this point it is important to figure out how to utilize the extra cash you have worked so hard to create. That calls for a financial plan. I will be laying out how to develop a financial plan in an upcoming article, but a good starting point is the 50-30-20 rule. With this approach, 50% of your income goes towards your needs, such as rent, food, and utilities. 30% goes to your wants, such as entertainment and eating out, and 20% goes to savings, such as retirement accounts or to your emergency fund. An emergency fund is a savings account that you don’t touch except in time of financial crisis. Try to build the value to at least three months’ worth of expenses to replace lost income from losing your job or some other unexpected event.
If you already have an emergency fund, kudos to you! Move on to paying off your high-interest debt or contribute more to a retirement account (401k, IRA, Roth IRA, etc.). The more you are able to knock down the debt, the more you can switch to saving for retirement. Every little bit counts when it comes to retirement savings.
Step 7: Reassess and Adjust
Now that you have balanced your budget and have developed a sound financial plan, you can sit back and relax, right? Wrong! It is always a good idea to schedule some time to review and update your budget to keep it up-to date. Consider doing an annual review at tax time.
If the above sounds like hard work, that’s because it is. Then again, the reward for all that hard work is the peace of mind that comes from financial freedom. I’d say that’s worth the effort. Wouldn’t you?