To plan for the short and long term, you'll need a basic understanding of your finances. In this section, we'll give you the kick-start you need to begin your budget boot camp.
Know Your After-Tax Monthly Income
You know your hourly wage or monthly salary, but do you know off the top of your head how much you take home after taxes or how this number is calculated? It's important to know, because taxes significantly reduce your paycheck, especially if you have to pay state and/or local taxes.
The easiest and more accurate way to find out how much you really make is to look at your last pay stub, but if you don't have one handy, you can calculate your take-home pay using an online paycheck calculator. Or, if you want to understand the formula that the Internal Revenue Service (IRS) uses, check out the federal tax rate schedules.
A comprehensive understanding of taxes isn't necessary to keep a good budget, but if you're curious, here's how income tax works:
Let's suppose you're filing as a single person and your salary is $40,000 a year. According to the IRS 2017 federal tax rate schedules, your marginal tax rate is 25%. In this scenario, your first $9,325 is taxed at 10%, the next $28,625 is taxed at 15% and the remaining $11,375 is taxed at 25%. On top of these federal taxes, you'll also pay Social Security at a rate of 6.2% and Medicare at a rate of 1.45% on all $40,000, along with any state or local taxes. Your annual $40,000 salary is reduced by $5,738.75 in federal income tax plus $2,480 in Social Security tax and $580 in Medicare taxes, for a total tax liability of $8797.75. That leaves you with an annual, after-tax income of $31,201.25, or $2,600.10 per month. If your employer deducts health insurance premiums, 401(k) contributions or anything else from your paycheck, your take-home pay will differ, especially because those two expenses are taken out of your pre-tax income and reduce your income tax liability. (Learn more in Tax Withholding: Good for Government, Bad for Taxpayers.)
Ensure That Necessities Fall Within After-Tax Income
Once you know how much money you bring home each month, start by listing all of your necessary expenses, like rent and utilities, and making sure their total cost is less than your take-home pay. If it isn't, can you cut back somehow? Housing expenses take up the largest chunk of most people's budgets, so that's the best place to think about reducing your expenses if you're having trouble making ends meet. If you can't reduce the cost of your necessities, it's time to figure out how to earn more, which may involve both a short-term strategy like starting a side hustle or getting a second job and a longer-term strategy like furthering your education or starting a business. (To learn more, read Invest in Yourself with a College Education and 3 Freelance Gigs to Help You Earn More.)
If you can, consider savings as one of your necessities. This mindset will make you more likely to save because you'll think of saving as a necessary "expense" rather than an optional one. As the saying goes, "pay yourself first." Saving regularly will allow you to accumulate emergency savings, which helps keep you from going into debt when an unexpected expense comes up. It will also allow you to save for retirement and other major life goals. (Learn more in Why You Absolutely Need an Emergency Fund.)
Some Required Expenses Don't Occur Monthly
Costs like car insurance and visits to the doctor may not be monthly charges for you, but rather expenses you pay only once or twice a year. Nonetheless, you have to pay them, and you know they’re coming, so don't forget to factor them into your necessities. One way to do this is to make a list of all your expenses that only occur a few times a year, add up their total cost, divide it by 12, and add the result to your required monthly savings. This will ensure that you have enough cash on hand to pay these bills when they are due.
Check Your Breathing Room
Hopefully, you still have some money left over after meeting your basic necessities. Make sure you know what this amount is so you won't overspend. If you're not satisfied with how much discretionary money you have, use the ideas in the last section to increase your cash flow. Since not having as much discretionary money as you'd like isn't as dire of a situation as not being able to pay for food or shelter, you can consider short-term strategies to increase your income, like acquiring a temporary second job or selling some possessions you no longer use. (For ideas, see Increase Your Disposable Income and Start a Side Gig for Extra Cash and Fulfillment.)
Some Discretionary Expenses Also Aren't Monthly Costs
Expenses like gym memberships, vacations and gifts are not required expenses and they may not occur every month or be the same amount each month. If you want to be able to afford them, you should again make a list of all these optional expenses that only occur a few times a year, add up their total cost, divide that sum by 12 and add the result to your optional monthly savings. This way, you won't be tempted to go into debt, nor will you have to skip out on these items.
Calculate Long-Term Costs for Necessities and Discretionary Spending
To determine whether your spending in a certain category is really worth it to you, think of it in terms of yearly rather than monthly cost. Maybe $1,700 a month for a luxury apartment seems like an acceptable price, but how about $20,400 a year? And that's after tax. Similarly, $300 a month for lunch with coworkers might sound reasonable, but is that how you want to spend $3,600 a year, especially if you’re coming up short in other budget categories that are more important to you? If an expense is worth it to you and you can afford it, there's nothing wrong with it, but sometimes looking at the big picture gives you a different perspective.
Let's move on to part 5, where we'll share some tips for managing and staying within your budget.
Budgeting Basics - Budgeting Tips
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