Budgeting isn't easy. Most people get hung up on the details.
How do I plan for unpredictable major expenses, like home or car repairs? How can I plan for fluctuating expenses like gasoline or utility bills? How can I project varying medical expenses?
My simple answer: I don't.
The 5-minute budget
Cast your spreadsheets aside. Take your calculator and throw it in the trash. Here's how you budget in less than 5 minutes:
- Find out what you earned last year, or what you can reasonably expect to earn this year. (Example: $50,000)
- Multiply that amount by 2 (Example: $50,000 X 2 = $100,000)
- Divide by 10 by moving the decimal point one place to the left. (Example: $100,000/10 = $10,000)
The result is an amount equal to 20% of your annual earnings. This is what you're going to save next year.
How to allocate your savings
"Savings" is a word that often implies stocking money away in a bank account. It doesn't have to be that way. Savings can be anything from putting money in a savings account, to paying down debt, to investing in the stock market.
Of the savings amount you calculated, dedicate half to things like making extra payments on high-interest debt. Student loans and credit cards are a great place to start. If you don't have any high-interest debt, you can skip this step and begin building up cash for emergencies, or double down on retirement savings.
Automate your savings. This is key. If you don't see the money, you won't want to spend it. You can request that your bank automatically transfer money to another savings account on a bi-weekly basis. Alternatively, you can schedule 12 automatic extra payments on a big debt over the next year.
Dedicate the other half to a retirement account. If your employer offers a 401(k) plan, this couldn't be easier. You just need to tell your employer to automatically put 10% of your salary into your 401(k) plan.
Living on 80%
Now that you've automated your savings by paying down debt, building up emerging cash, and saving for retirement, you've done the hard part.
Now you just have to live on the 80% that remains. Every expense must fit within this amount. If it doesn't, then you don't need it. If an unforeseen emergency requires cash, you're building the savings to cover it.
Saving 20% of your salary by paying down debt or investing in a retirement account will do wonders for your financial life.
A 25-year old who earns $50,000 per year and invests 20% their salary would have $1.55 million at age 65, assuming a reasonable 6% rate of return. That's 31 times their salary at retirement, an incredible sum of money.
And sure, you could object to the rate of return (I think it's fairly conservative), or the fact I didn't include the hidden cost of inflation (I didn't forecast any increases in salary, either). But the simple fact is that someone who saves 20% of their income over the long haul should have more than enough to maintain a reasonable standard of living in retirement.
Besides, when you get the big stuff right (saving 20% of your income from the start), you have the luxury to ignore the minor details that only stand to get in the way of making progress toward a healthy financial future.