Budget Planning 101

I often get asked what type of budgetary structure someone should have from a tax perspective.  As a big believer in the ownership society, I tend to look at the world through the prism of retirement savings accounts.  That being said, there's more to life than retirement savings.  Below is one tax guy's idea of how to answer the question, "what should I be doing with my money?"...

The first thing to keep in mind is the overall budget level.  I've always believed that your household budget should be broken down into four quadrants, each equaling about 25%.  The denominator of this budget is total household income, which for most people is wages and a little investment income.  Here is what the chart should look like:

To break down each of the constituent parts:

1. Housing.  This includes mortgage payments, homeowners association and condo fees, private mortgage insurance, homeowners insurance, and rent paid.
2. Taxes.  Includes FICA, federal income taxes, state and local income taxes, and state and local personal and real property taxes.
3. Bills, Etc.  A catch-all for everything else.  This includes monthly bills (student loans, cell phone, utilities, etc.), leisure, lunch, travel, gifts, furniture, etc.
4. Savings.  The heart of the budget.  All parts of the budget should try to get this metric up to its full 25%.  Of this, 15 percentage points should be for retirement, and 10 percentage points for non-retirement savings.

This is a model budget.  No household in the world has a precisely-calibrated 25 x 4 pie like this, nor should they.  An Alaskan may have to spend more on food, and a New Yorker more on housing.  The point is that this rough goal should be aspired toward, and the savings goal paramount among them.

So step one is to take a look at your own budget.  If your savings rate is not up to 25% (as most people's aren't), then the other three quadrants are taking more than their fair share.  Do what you can to pare back.  For instance, you may want to downsize your housing, go out to eat less, save in a more tax-efficient manner, or downgrade your cell phone plan.  Another option is to "grow the denominator"--that is, earn more income through a second job.  Something's got to give.

I've Gotten Some Savings In--Now What?

Congratulations on solving step one--taking a look at your budget and getting it under control.  Now that the bleeding has stopped (or the wound has been prevented from forming, if you're young enough), it's time to allocate your savings.

Liquidity and High Interest Debt

Before you do anything else, you need a foundation.  Think of analyzing and correcting your budget as clearing the rocks and underbrush from your dream home's land parcel.  Now, it's time to lay the concrete.  Without this foundation, you'll be building your house again and again, without it ever getting completed.

I first asked you to take a look at your budget.  In business, this would be called a cash flow statement.  Any MBA student will tell you this is only half of a business' financial picture.  The other side of the coin is the balance sheet.  This latter measurement simply lists all of your assets (home equity, cash, investments, retirement accounts, etc.) on one side, and your liabilities (credit card debt, student loans, mortgages, etc.) on the other.  The difference between the two is your net worth (negative, for many people).

Go ahead and do this.  For your liabilities, check to see what interest rate your are paying on your debt.  If any debt has an interest rate of 10 percent or greater (usually just credit cards), this is priority number one for your savings.  Everything should be directed at this like the Beaches of Normandy on D-Day.

Already done with this or not in credit card debt?  Congratulations.  The next step is to build up a minimal level of liquidity.  This should be equal to a minimum of 3 and a maximum of 6 months worth of emergency expenses.  An "emergency expense" amount is equal to the amount you would spend in a month if you had no income coming in.  For most people, about $10,000 per person in the household ought to do it.  This money can at first sit in a savings account, but is best used in a money market account, laddered CD, or ultra-short bond mutual fund so that it grows with your lifestyle.

The First 15 Percent: Retirement

In my opinion, the first 15 percentage points of savings after the essential savings steps listed above should go toward retirement.  That means that if you're only up to a 17 percent savings rate so far, you're only saving 2 percent for everything else.

Even better, I've developed a priority list of saving for retirement.  If one of these does not apply to you or you don't qualify for it, just keep going down the list until you've used up the full 15 percent:

1. Workplace retirement plan up to the match.  If your employer offers a 401(k), 403(b), Thrift Savings Plan, or SIMPLE plan, contribute so that you can get the match.  This match level is often about 3%, and you are often required to contribute about 6% of your salary to get full advantage of it.  Don't count the percentage points your employer contributes until you are vested in them, which normally takes about a percentage point per year.  If you have a choice between a tax-deductible deferral option and an after-tax "Roth" deferral option, go with the former if you are in the 28% federal bracket or above, and the latter if you are in the 25% federal bracket or below. 
2. Roth IRA up to the max.  There are pretty strict income limits to this (see limit list to the left), but you may be eligible.  If so, you can contribute up to $4000 to a Roth IRA in 2007.  If you have enough earned income, you can also make a contribution for a non-working spouse.
3. Go back to your workplace plan and max it out.  You can contribute up to $15,500 into these accounts (plus your employer contribution) in 2007.  See the limit chart to the left for full details.
4. Still not up to 15 percent of gross income?  My next step would be saving in a taxable brokerage account.  Your underlying investment should be the same as in any of the above accounts--a low-cost index fund with a proper amount of equity exposure for your age.  This will be very tax-efficient, as churn in these accounts is kept to a minimum (as is cost).

I often get asked what to invest retirement savings in.  I am not a series-licensed broker or financial advisor.  However, I can tell you what I do.

I save every penny of my retirement savings in low-tax, low-fee, no-load index funds that are passively-managed.  They simply track the broad stock (or bond, as the case may be) market, and leave it at that.  Over time, you should get an historical rate of return, which beats the hell out of what an actively-managed fund can give you (when fees and taxes are taken into consideration).  For more on this, see the Common Sense on Mutual Funds by Jack Bogle link below.

What should your stock-to-bond ratio be?  I think the old rule of thumb about your age being the percentage of your portfolio that should be in bonds or bond funds is way too conservative.  This is the method I am employing for myself:

Age

0-50: 100% stock/0% bond
51-60: slowly shift over time to 60% stock/40% bonds
60 (retirement age): 60% stock/40% bonds
60-death: every year, shift another percentage point over to bonds

Shifting can usually just take place by re-investing dividends and capital gains into bonds--no actual selling usually needs to happen.  You don't need to be obsessive about this, either: once a year after age 50 should do just fine.

The Other 10 Percent: Now It's Your Turn

The other 10 percentage points of savings is up to you.  Do you want to save for a home?  Pay for college for your infant son?  Go back to school yourself?  Save for retirement health care costs? 

It's up to you.  This is the "insert goal here" part of savings. 

Whatever you want your savings to be, keep in mind that you don't want to get too aggressive or too conservative with your savings.  You need to know what the time horizon is of your goal.  For instance, savings for a house you will purchase in 6 months will be invested differently than money in your child's 529 college savings plan.

Here is what I use to determine the appropriate savings vehicle, based on time horizon:

<1 Year: Money Market Fund, Laddered CDs, General Savings Account
1 Year-3 Years: Ultra-Short Term Bond Mutual Fund (index)
3 Years to 7 Years: Intermediate-Term Bond Mutual Fund (index)
7 Years to 10 Years: Long-Term Bond Mutual Fund (index)
10 Years and More: Total Stock Index Fund

Wrapping It Up

If you've hit all of these things--budget sanity, a good foundation, enough for retirement, and your other personal goals--you're in great shape.  Suppose you have even more to save?  It's really up to you.  You can save more for retirement and retire a little earlier, or start up a small business, or get a bigger house, or anything you want.

Best of all, you'll be free.  You'll never have to worry about bills, or outliving your savings, or being caught flat-footed.  If you're a woman, you never have to rely on some man to take care of you (too many girls I know fall into this stupid trap).  Ownership and wealth are great piece of mind as you go about building the life you've always wanted.

That's my two cents, anyway.  Hope this helps.  Keep reading to learn about all the tax topics to make you a wiser consumer of information.

Comments

[J Rankin]

When calculating the ratios of your income that go toward the different goals, do you use before or after tax numbers?

For example, you can send 10 percent of your income to an IRA or TSP. But that ratio uses your pre-tax income as a denominator; it would be a lot higher if it used your post-tax income as the denominator.

So, when you're looking at where your money goes and see that some is taken out pre-tax and some is taken out post-tax, how do you create ratios that are as close to apples-to-apples comparisons as possible?

[Ryan Ellis]

The denominator is total income before any deductions for anything. So, if your entire income is your salary, and you get paid $50,000, that is your denominator.

A person in this case should be saving $7500 for retirement (including vested employer contributions) and $5000 for other savings.

[Hamed Elbarki]

Great information and very useful! Thanks for sharing...