How Much of Your Income Should Go Toward Living Expenses?

By Markets Fool.com

Some people are better at saving money than others. Those who are good savers generally know how to live within their means, and they tend to keep their living expenses low compared to their earnings. Those who aren't natural savers, by contrast, tend to fall into the trap of spending most, if not all, of their income on their basic needs. And then there are those who truly go overboard, spending more money than they bring home and racking up debt in the process.

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No matter your age, it's important to start saving money for things like retirement, emergencies, and major life goals such as buying a home. Creating a budget can help you manage and keep track of your living expenses so there's money left over to help you meet your savings targets.

Taxes
The first rule of establishing a budget is figuring out your take-home pay. Remember, your salary is notthe amount you take home. If your job pays you $60,000 a year and you're in the 25% tax bracket, then you'll pay about $10,800 in taxes on that income, leaving you with $49,200. That's about $4,100 a month that you can put toward living expenses and savings. (Note that your tax bracket, also known as your marginal tax rate, is not the rate you pay on all your income. Your effective tax rate is generally much lower. See this article for more details.)

Housing
Housing is generally the average person's greatest monthly expense. It's best to keep your housing costs as low as possible, but under no circumstances should you allow more than 30% of your take-home pay to go toward housing. If you're a homeowner, that 30% includes not only your mortgage payment, but also your monthly property tax and homeowners' insurance payments as well.

The 50/20/30 rule
When creating a budget, you can list each and every monthly expense you incur as its own line item, or you can combine some of your expenses and follow what's known as the 50/20/30 rule. The benefit of the 50/20/30 rule is that it groups certain expenses together to make your budget easier to track. The 50/20/30 rule splits your living expenses into three main categories:

  1. Fixed costs that stay the same month after month, such as your rent or mortgage, car payment, and cable bill. Fixed costs should take up 50% of your income.
  2. Variable costs that can change from month to month, such as entertainment, groceries, and clothing. Variable costs should take up 30% of your income.
  3. Savings, which should take up 20% of your income

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The 50/20/30 rule allows you to retain some flexibility in your budget while saving a nice percentage of your income. While you can always adjust these percentages to accommodate your circumstances, limiting your fixed costs to 50% of your income should leave you with enough money left over to save and cover your variable expenses. Along these lines, allocating 30% of your income to variable costs means you'll have a decent amount of wiggle room within that category alone.

Identifying essential costs
A big part of saving money is learning to distinguish between essential and non-essential living expenses. Essential living expenses are non-negotiable; you simply can't function without them. Examples include housing costs, auto insurance, and food. Non-essential living expenses include restaurant meals and fancy electronics, which may be nice to have but aren't necessary. Limiting your non-essential living expenses can help free up more of your income for more important things, like savings.

Growing your savings
Once you distinguish between your essential costs and those that are "wants" more than "needs," you can work on making changes that allow you to build your savings. While the majority of your income will probably go toward your living expenses, make sure your budget leaves you enough room to save money as well. Your first savings goal should be to put together an emergency fund with enough money to cover three to six months' worth of expenses. From there, you should work on saving for retirement. Many financial experts recommend saving at least 10% of your income for retirement, and the sooner you begin, the more time you'll have for that money to grow. You may start off by saving a small sum each month and increasing that amount gradually, but the key is to make saving a priority regardless of how much money you earn.

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