Why the 50/30/20 Rule Doesn't Go Far Enough

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Most people find budgeting to be a drag, and the idea of meticulously measuring out all your spending on every last detailed category is enough to make some would-be savers give up on the exercise entirely.

To make things easier, some people like to follow simple strategies like the 50/30/20 rule. Yet even though the 50/30/20 rule is easy to understand, it has some flaws that make it less than ideal in many key ways. By looking at some enhancements to the rule, you can use the 50/30/20 guideline as a starting point while finding a solution that will work better for you.

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What is the 50/30/20 rule?

The 50/30/20 rule appeared in a book by Sen. Elizabeth Warren, D-Mass., written before she became a legislator. As a Harvard professor specializing in bankruptcy law, Warren knew how easy it is to get into trouble with poor budgeting and extensive debt. Yet rather than espousing a complicated budgeting system that would track every single expense to the penny, Warren chose to include a much simpler approach.

The idea of the rule is to allocate 50% of your after-tax earnings to necessities like food, shelter, clothing, and transportation. Another 20% goes toward paying down debt or building up long-term savings. That leaves the remaining 30% for discretionary spending on things you want but don't absolutely need, such as entertainment, vacations, and eating out.

The benefit of the rule is that it's simple to understand. If you make $2,500 a month, then you can spend up to $1,250 on needs and $750 on wants, and set aside $500 toward longer-term financial goals. Yet there are some shortcomings to the rule that make it less than ideal in many situations.

What the rule gets wrong

Most criticism of the rule attacks the 20% savings side of the equation. With many financial advisers suggesting savings goals of 10% of earnings, 20% might seem particularly harsh. Those who live in expensive parts of the country will find it especially challenging to rein in their discretionary spending to comply with the 30% portion of the budget. Even the 50% part of the budget can be difficult for those in high-cost areas, as well as for those who don't have high incomes and therefore face fixed costs that are higher in percentage terms than most people face.

However, the bigger problem with the 50/30/20 rule is that it leads upper-middle-class and high-income earners to spend far too much on things they don't need. For instance, someone making $180,000 a year would arguably be able to afford a $1 million home, with a monthly payment of just under $5,000 on a 30-year mortgage at current interest rates. Yet outside of the priciest real estate markets in the nation, a $1 million home is far beyond what most people would need. Purchasing a cheaper home would let you divert more money toward savings, which will get you to your long-term financial goals much more quickly.

Similarly, someone making $100,000 after tax would have $2,500 per month to spend on purely discretionary items. Again, that's affordable with a salary of that size, but most people wouldn't find it absolutely necessary.

The double benefit of greater savings

The best thing about budgeting techniques that involve large amounts of savings is that they have two benefits. Not only do you grow your financial nest egg more quickly, but the size of that nest egg can be smaller because you've learned to live with less. The key here is that your needs in retirement will depend on what your expense level is. Most financial advisers incorrectly focus on replacing earnings, which is fine for those who spend most of what they make, but grossly overestimates your actual financial needs if you routinely save a lot.

The smarter approach is to start by cutting yourself some slack on the 20% side of the 50/30/20 equation. If your first job gives you very little in earnings, then you might need to spend most of your income on absolute necessities. If you're spending 70% to 80% of your after-tax income on rent and groceries, it's a lot to ask to go entirely without discretionary spending.

Yet the trade-off you must agree to up front is that when your income starts going up, you'll ratchet up your savings percentage. Eventually, you'll hit that 20% mark -- and understand completely why you would keep going beyond that level as you get future raises. Committing salary increases to savings won't hurt you when it comes to your spending needs, but it'll help build up your savings over time more effectively.

Be smart with budgeting

For simplicity, it's hard to beat the 50/30/20 rule. But by understanding where it can let you down, you'll be able to build on the ideas it presents and customize it in a way that will work for you over the long run.

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