“I decided that a part of all I earned was mine to keep” ~ Richest Man in Babylon

The typical view of budgeting is to figure out how much money you “need” to spend, add some for wants, and save the rest.  This tends to result in ever more elaborate justifications for what qualifies as a “need”, and keeps the focus on maximizing spending, for good or for ill.  Surviving is really just about avoiding dying, and that can sometimes be had at a price of \$0, and sometimes it can’t be had at all.  Furthermore, correct estimations of the amount of money required to prevent your death are fortune-telling at best.  The best solution for your financial health is to set the percentage of money you will save first.

Focus on the percentage to save, rather than percentages to spend

What percentage of your income do you need to save?  The answer to that question can be determined by asking yourself what you are saving for?  The only sensible answer to that question is financial independence (you are financially independent once your investment earnings can fully cover your spending).  If you’re saving for anything else, like a fancy television, you’re simply deferring spending.  There’s nothing wrong with spending money on a fancy television, but that should be marked as an expense in your budget as well, money you save is money you keep.

Therefore, in order to determine how much money you should save you first need to know when you want to become financially independent.  Financial independence allows you to retire, so many choose a date at which they would like to retire.  My recommendation is to set this date as early as you can stand, keeping in mind that the following calculations assume your spending after financial independence and before financial independence will be the same adjusted for inflation:

Equations taken from Jacob Fisker’s nifty book: Early Retirement Extreme.

Keep in mind these are after inflation rates of return.  While stock market returns have been quite high over the last 5 years, I find it safest to assume a rate of return of 4%.  You’ll find that the difference between assumed rates of return become less important as your savings rate approaches 1 (100% that is).  Therefore if you’re 35 and want to be financially independent by 50 you have 15 years, this requires a savings rate of roughly 55%.  If you’re 20 and want to be financially independent by 50 then you only need a savings rate of 35%, as always starting early helps!  This plot assumes that invested capital equal to 28.5 times your annual expenses will sustain you indefinitely.  (Why 28.5? Well, that’s math for a later post, but for now it is an amount which has been safe for the vast majority of market scenarios over the last 100 years in the US).

Once you know the savings rate you need then you can worry about how to spend the rest of your money.  Suppose I make \$4,000 per month after taxes and I have determined that I want to be financially independent in 15.  My savings rate needs to be 55%, so I have the other 45% to allocate as I see fit, this works out to \$1,800.  You then need to split out your monthly bills and your other expenses.

Monthly Bills – Fixed Expenses

This is anything you have to pay every month to avoid a service interruption.  For example, your rent.  If you don’t pay rent, you will be kicked out of your house.  (Same for a mortgage).  These are characterized by little variability and are hard to avoid paying in the near-term.  It’s important to make sure that your income covers these expenses with plenty of room to spare. This isn’t complicated, usually you know the values of these in advance.  They’re also pretty important to pay, no one wants to be without health insurance.  As a rule of thumb I want to make sure that my income after taxes and savings covers my fixed expenses by a factor of two at least, most of which will be housing costs.  In our example the remaining 45% should cover the fixed expenses twice, therefore the percentage of your budget spent on fixed expenses ought to be roughly 20%.  If you make \$4,000 per month after tax that means \$800.  That’s not much when you consider it has to be split up among rent, utilities, health insurance and so on.  This likely means that you don’t want to be spending much more than \$500 for your housing.  That doesn’t get you a lot in some places in the country.  Hopefully a high cost of living area means you can pull more income in.  If not, get a roommate, or double your working life, doesn’t matter to me, if you intend on waiting 30 years to become financially independent then you can spend 30% of your income on fixed expenses, making \$800 for rent more reasonable…seems like not very much benefit when you consider it means working for twice as long.

Other Stuff – Variable Expenses

The stuff here is important too.  Food is in this category.  You want to be able to eat, it’s bad if you can’t.  Fortunately, it’s also a pretty flexible category.  Most people can save money on food simply by going out to eat less frequently.  The typical cost of eating out is 2 to 3 times greater than eating at home on a per person per meal basis, that creates a lot of wiggle room for most people.  Your automobile will probably account for half of the remainder of your budget, 12.5% from the remaining 25% of your after-tax income.  This means that you eat, entertain yourself, and cover everything else that comes up in life on \$500 for a person making \$4,000 per month, intending to be financially independent in 15 years.

Putting it together

You should keep in mind that savings or retirement accounts count as working years.  If you save \$25,000 per year and your net worth is currently \$75,000, you get to count that as an additional three years.  Thus, if you want to be financially independent in 12 years and have three years worth of savings you can use the savings rate of someone who desires to retire in 15 years.  Keep in mind however that you have to continue to live on the same amount of money post financial independence if you lose your original source of income.

Example Budget:

15 years to financial independence

After-tax income: \$4,000

• Savings \$2200 — 55%
• Fixed Expenses \$800 — 20%
• Housing \$500 — 12.5%
• Health Insurance \$150 — 3.75%
• Car insurance \$50 — 1.25%
• Utilities \$40 — 1%
• Internet \$30 — 0.75%
• Cell Phone \$30 — 0.75%
• Variable Expenses \$1200 — 25%
• Car \$500 — 12.5%
• Food \$300 — 7.5%
• Entertainment \$100 — 2.5%
• Books \$50 — 1.25%