Developing a budget may seem a near perfect manifestation of drudgery, which in turn may help explain why so few people expend their time and energy creating one. While budgeting is not an especially creative endeavor (after all, who wants a creative budget?), the effort can pay dividends by placing you more firmly in control of how your money is being allocated. A budget serves as the foundation of a good financial plan. It helps you make informed decisions related to savings, investments, and the trade-off between current and future consumption. Done right, it can help those saving for retirement to establish realistic and attainable savings goals, track their progress and make adjustments to their investments, their rate of savings, target retirement date or retirement lifestyle. For retirees, the information contained in their budget helps them to identify expenses that may be curtailed, if necessary, along with opportunities to increase their consumption or to transfer wealth to loved ones or charity.
The process begins by reviewing your pre-tax income and deductions. Look at your deductions with a special focus on federal, state and local tax withholdings. Following the passage of the Tax Cuts and Jobs Act of 2017, the Internal Revenue Service revised its withholding calculator to account for the law’s changes to marginal tax brackets. More than a simple worksheet, the software accounts for multiple income sources and deductions and will estimate your federal tax obligation and whether your withholdings should be adjusted. If the answer is yes, file an updated form W-4 with your employer as early in the year as possible.
Deductions for employee benefits, including insurance plans and retirement plan deferrals are also worth a look. Pay particular attention to health insurance premiums, as many employers pass on a portion of the premiums to their employees. Be certain that you understand the cost sharing arrangement (i.e., a 75% to 25% split between employer and employee), as the termination of your employment could result in the need for extended coverage through COBRA at as much as 102% of the total premium. This total premium cost should be accounted for in your emergency fund.
Finally, make note of your current retirement plan deferrals and your firm’s retirement plan matching formula. This is the amount that your employer contributes to the plan on your behalf and is often a percentage of the amount that you contribute. At the very least, you should contribute enough to the plan to capture your employer’s full matching contribution; to do otherwise is foregoing what amounts to free money. Employees may contribute as much as $19,500 in 2020, with an additional $6,500 catch-up contribution for those that are age 50 and older.
Capture, categorize and calculate
Now the fun begins. But you don’t have to experience the joys of budgeting all at once. In fact, this is a good time to pause. Accurately capturing expenses is far and beyond the most challenging part of budgeting, and it’s the part that virtually no one does well. Resign yourself to completing this exercise in stages, with this critical stage spent identifying all of your expenses, and where to locate the information that will help you to quantify them. A good way to do this is to select a sufficiently long period of time, often a month or more, which is representative of how you spend your time and money. Don’t select January if the pain of holiday bills or well-intentioned New Year’s resolutions causes you to temporarily forego your status as a social butterfly in favor of a teetotaling hermit. During this period, use a credit or debit card to pay for expenses that might otherwise be paid with cash. Make note of the amount and timing of insurance premiums, vacations and other costs that might otherwise be overlooked. In the end, you should have a very good sense of how you spend your money and will have the data you need for your budget. Combined with your check registry or a summary of bills paid using online banking, you’re ready to categorize your expenses.
When categorizing your expenses, it may be helpful to use a sample budget for reference. You can use any category titles that you like, but most people opt for standard categories. These might include things like housing, utilities, household expenses, taxes, transportation, insurance, leisure, and entertainment, etc. Categories are helpful in identifying where your money is allocated, but the really critical thing to consider is the degree of control that you have over the expense in question. A mortgage payment cannot be easily avoided, vacations or discretionary clothing purchases can. Identifying the exact expenses that can be reduced or eliminated if times get tough is one of the key outputs of a good budget.
Armed with your expenses and categories, it’s time to build your budget. Mint, Nerdwallet, Quicken and other technology solutions can make quick work of categorizing and sorting the data, but if you actually want to learn how to make a budget, Microsoft Excel is hard to beat. An additional benefit of this do-it-yourself approach is that you can customize the categories and easily update the data. Begin with gross income and the adjustments that will yield your net income. Make note of bonus or incentive compensation income and whether the timing of their payments is predictable. Move on to each category of expense, making note of discretionary expenses, irregularly-timed expenses and any large month-to-month deviations. Total each category by month and in aggregate. When complete, your budget might look something like the sample version posted on our website.
A case study
Your budget contains a lot of information that can be used to facilitate better decision making. To begin, review the monthly and aggregate totals to determine if your household operates at a net surplus or deficit, and note any months with large deviations in income or expenses. Returning to our sample budget, it’s apparent that January is a tough month for this hypothetical client, with expenses exceeding income. The following two months, however, show large surpluses. In this case, the deficit can be easily remedied by simply changing the premium mode on this individual’s insurance policies (i.e., monthly, quarterly or semi-annual). In a similar vein, April appears to be a lean month due in large part to an annual automobile insurance premium. This despite additional bonus income paid in that month. If this bonus payment is considered a reliable inflow, matching a large expense to a large inflow can be a sensible budgeting technique. If, however, the payment does not reliably occur, a net deficit may occur. To avoid this, consider spreading the premiums across several months by switching to a different premium mode.
Staying with our sample budget, we can easily see that there is a meaningful surplus of income that could be allocated to savings, and it’s apparent when those surpluses occur. Depending on the individual’s specific savings goals, additional retirement plan deferrals could be made, especially if their expenses were spread more evenly throughout the year, or those deferrals could be scheduled during specific months. Likewise, saving for a major purchase could be accomplished by identifying months with an anticipated surplus and directing that to savings.
Using their budget, our sample client can identify a sustainable level of savings that is supported by their income and can estimate whether these savings are sufficient to support their desired standard of living in retirement. If not, they can return to their budget to determine whether and how to make any necessary adjustments to their current spending in support of their future goals. When identified early, these changes may be barely noticeable. And for those that are further behind in their retirement savings, this exercise can serve as a reality check and may prompt consideration of other options such as deferring Social Security retirement benefits, working longer, or working on a part-time basis in retirement. When it comes to retirement planning, knowledge is power.
And what if you are already retired? Not only can you sleep in late and have wine with lunch, but you also play by a different set of rules when it comes to budgeting. Instead of beginning with income and deducting expenses, retirees use their anticipated expenses to determine the amount of income they must generate from their assets. For those with Social Security and pension income that is sufficient to cover a large portion of their expenses, the reliance on their assets is minimal. In most cases, however, retirees will have only a modest portion of their expenses covered by guaranteed-income sources and will depend on their assets to generate the rest. Maintaining an up-to-date budget can help retirees to identify specific expenses that can be reduced or eliminated when asset values decline. A budget can help retirees determine whether their portfolio withdrawals are sustainable by matching the percentage of the withdrawals to the value of the asset. In a similar way, your budget may identify opportunities to increase consumption when asset values rise or if you are fortunate enough to have a substantial amount of excess assets that are not needed to support current or future spending.
Although asset allocation and investing tend to attract the time, attention and focus of financial advisors and their clients, the humble budget is both the backbone and the Achilles heel of financial planning. Developing a budget does not require any special knowledge or skill, and the results can be incredibly useful in planning for retirement or maintaining your retirement lifestyle.