Step One: Calculate Your After-Tax Income
Your after-tax income is what remains of your paycheck after taxes are taken out, such as state tax, local tax, income tax, Medicare, and Social Security. If you’re an employee with a steady paycheck, your after-tax income should be easy to figure out.
Look at your pay stubs. If health care, retirement contributions, or any other deductions are taken out of your paycheck, add them back in.
If you’re self-employed, your after-tax income equals your gross income less your business expenses, such as the cost of your laptop or airfare to conferences, as well as
the amount you set aside for taxes. You’re responsible for remitting your own quarterly estimated tax payments to the government because you don’t have an employer to take care of it for you.
Step Two: Limit Your Needs to 50 Percent of Your After-Tax Income
Now go back to your budget. How much do you spend on “needs” each month, things like groceries, housing, utilities, health insurance, car payment, and car insurance? According to Warren and Tyagi and their 50/30/20 rule, the amount that you spend on these things should total no more than 50 percent of your after-tax pay.
Of course, now you must differentiate between which expenses are “needs” and which are “wants.” Basically, any payment that you can forgo with only minor inconveniences such as your cable bill or back-to-school clothing is a want. Any payment that would severely impact your quality of life, such as electricity and prescription medicines, is a need.
If you can’t forgo a payment such as a minimum payment on a credit card, it can be considered a “need,” according to the Warren and Tyagi. Why? Because your credit score will be negatively impacted if you don’t pay the minimum. By the same token, if the minimum payment required is $25 and you regularly pay $100 a month to keep a manageable balance, that additional $75 isn’t a need.
Step Three: Limit Your “Wants” to 30 Percent
This sounds great on the surface. Can you put 30 percent of your money toward your wants? Hello, beautiful shoes, trip to Bali, salon haircuts, and Italian restaurants.
Not so fast. Remember how strict we were with the definition of a “need”? Your “wants” don’t include extravagances. They include the basic niceties of life that you enjoy, like that unlimited text messaging plan, your home’s cable bill, and cosmetic (not mechanical) repairs to your car.
You might spend more on “wants” than you think. A threadbare minimum of warm clothing is a need. Anything beyond that, such as shopping for clothes at the mall rather than at a discount outlet, qualifies as a want.
Yes, the rules are tricky, but if you think about it, they make sense.