Demystifying the 50/30/20 Rule for Budgeting

The 50/30/20 budget has become one of the more common budgeting methods, slowly gaining traction. It began its slow climb following its introduction as the 50/30/20 rule in the 2005 book All Your Worth by Senator Elizabeth Warren and her daughter, Amelia Warren Tyagi.

It’s a great budgeting tool — one of the best out there. However, it suffers from two problems: people’s fear of mathematics and misconceptions of its value. The 50/30/20 rule for budgeting divides after-tax income into three categories: needs, wants, and savings. Fifty percent of after-tax income is allocated to needs, 30 percent to wants, and 20 percent to savings.

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The Premise of the 50/30/20 Rule for Budgeting

The overlying premise of the 50/30/20 budget is addressing two major resource allocation issues. First, we don’t save enough. No surprise there. And second, we also tend to spend too much. This is a more subtle, yet pervasive, problem. The 50 percent limit on needs is a major benefit to this methodology.

Wants vs. Needs

A need here is absolute. It’s what you require to live, and nothing more. To the extent that something is chosen at a level higher than needed, it’s a want. Argh, the math just got more complicated. Not much more, but enough to send many people fleeing to other budgeting tools.

Let's say, for example, that you're considering buying a car. The minimum you could reasonably spend, considering how the vehicle will be used, is your need.

The difference between the minimum needed vehicle and the one you’re going to get because you love it is a want.

People don't want to do this kind of math, but we’ll make it simple before we’re through.

Defining Needs

Needs are your “must haves” — the things you can’t realistically do without. Here’s a nice, simple way to think of it: If you lost your job and know you couldn’t get another for six months, what would you have to spend money on? Quickly, by this definition, we can remove many discretionary expenses. You don’t have to eat out, go to the movies, or buy new clothes. They’re wants.

You do have to pay your rent or mortgage, make the minimum payments on your debts, eat, and pay the utilities. You also need to keep your basic insurances, buy fuel, and maintain the car — lots of everyday things. And the car payment you were supposed to break into both a need and a want is suddenly a need. You have to pay it whether you're working or not.

If we consider needs as anything you have to continue doing, even if you’re not working, then we have a clear and simple way to determine if something is a need and not a want.

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Defining Wants

Let’s make this really, really simple: Wants are the things we could discontinue if we had to — for example, if we were to experience a loss of income. Netflix. Gym membership. Vacations. New clothes.

Note that it doesn’t mean we will stop them completely. The key is that we could.

The murky ones here are things that we've committed to, so they’re not so easy to stop. Mortgage on a vacation property. Payment on a sports car.

We can’t make any sort of reasonable case that they’re needs just because we’ve committed to the expense. They’re wants.

A smart way to deal with such wants is to never be in a position in which we’re forced to sell them, but also to not purchase them unless we’ve put enough down that we could sell them.

Defining Savings

This should be simpler than it was presented in the book. Sorry, but math is a big obstacle for many people.

The 50/30/20 rule says you should add your 401(k) or other retirement plan contributions back into your take-home pay, consider employer contributions as a part of your 20 percent saved, and even consider debt payments over the minimum as saving because they build net worth.

All of this is technically correct. But it's all way too complicated for most people to figure out.

Which numbers go on the bottom, which ones on top? Which ones go in both places and when do you multiply by 100? See the problem?

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Simplifying the 50/30/20 Rule for Budgeting

It really doesn’t have to be this difficult. There’s a better way — a simpler way. Remember why this budget is great in the first place. There’re two things: It gets our savings up, and it gets our committed expenses down.

We do need a baseline. So add one thing back into your take-home pay: your contributions to a retirement plan. That’s the number you’ll calculate the percentages off of.

Your savings should be 20 percent or higher. Don’t consider your employer’s contributions here.

Are you putting away 20 percent of your take-home pay between retirement plans and other savings? If not, it probably needs to go up.

Your needs should be no more than half of the take-home number. This allows you to have money to save and money for fun stuff like going out and taking vacations. And it has you living within your means — a reasonable lifestyle for your income.

If you’re there with the savings and needs, then the wants category takes care of itself. If not, the wants area is one to adjust to help get other things in line. You can forgo some fun in order to work on getting your financial house in order. And there’s not nearly as much math this way.

The Value Misconception Disconnect

The 50/30/20 rule for budgeting allows you a lot of freedom, while also making sure you don’t undersave or overspend. A common misconception is that it's somehow lacking in specificity, that it doesn’t go into enough detail. But every expense item falls into one of three categories — each one is considered.

If you meet the guidelines, you’re free to manage that as you wish. But you still have to manage it. Can’t really get a lot more specific than looking at everything. The problem isn’t the budget. The problem is the budget being discounted by people who don’t understand it.

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Going Forward With the 50/30/20 Rule

Many people will find that they’re way over on the needs. That’s an issue. Most will find they’re under on the savings — also an issue. But you don’t need to be there Day 1. The important thing is to move in that direction.

The 50/30/20 rule for budgeting can really help you clarify some tough decisions. For example, do you want two nice cars or a big house? Because doing both has you saving too little and spending too much. It’s working already.