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How to Set a Budget

Peter Drucker, a famous management consultant, and author, once said, “If you can’t measure it, you can’t improve it.” This quote applies to many aspects of life, including your budget. We understand that managing one’s money can be hard, but to improve it, you must manage it. Here we are going to go over how to set a budget. Before you know it, you will be on the fast track to financial success!

Note: This article contains affiliate links. This means that if you purchase a product or sign up for a company through one of our links, Thrive Oak will make a small commission (at no extra cost to you).

Starting with Income

Before we can begin creating a budget, we must first know what we are working with, and that would be your monthly income. To calculate your income, you add up all sources of income that come your way. This will include your AVERAGE:

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  • Monthly salary
  • Part-time jobs
  • Side hustles
  • Royalties
  • Rental Income
  • Alimony
  • Interest and Dividends
  • Governmental Aid (social security, etc.)

You may have other random income like the sale of a home, a work bonus, an inheritance, or gifts. However, you do NOT want to include these in your monthly budget because they do not happen every month. They are a one time, icing on the cake addition to your income that we would suggest using to pay off debts or invest.

(Remember, when determining your income, you must calculate your after-tax income. After-tax income is the amount left of your paycheck after the government has taken out their taxes. If you are unsure what your after-tax income is, you can review last year’s tax return or just roughly estimate using this income tax calculator.)

Income Example

Have you met our imaginary friend, Jill Oaks, yet? No? Well, let us introduce you! Jill Oaks is our favorite imaginary friend because she makes the perfect example of what we are discussing. We will use her imaginary life so you can see an application of how to set a budget.

Jill Oaks is 27 years old and currently works a steady 40-hour a week job, making $4,300 a month. Jill is a smart lady and is currently taking advantage of her company’s 401(k) policy, so she contributes $600 (almost 15%) of her paycheck to her 401(k) retirement account each month. After contributing to her 401(k) each month, she makes $3,700 after-tax. Jill is currently saving up to buy a home, so she started a side hustle of dog walking through Rover. She makes an additional $200 a month from dog walking. So, at the end of each month, Jill makes $3,900; this is the amount of money she has to calculate her budget.

Now, we will move on to expenses and come back to Jill in a minute.

Calculating Essential Needs

When creating a budget, you must start with the monthly essential needs first. These are expenses that are reoccurring costs that you can’t live without like housing, transportation, food, and paying off any minimums on your loans. Let’s bring back Jill. The table below is filled out with Jill’s information. We hope that you are following along using our template!

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If you don’t know them off the top of your head, don’t worry! We suggest checking your bank and credit card statements. As well, if you use a budgeting app, you can find the information there!

Please note that some of these expenses, like homeowner’s insurance and property tax, are annual fees, so you will need to divide them by twelve to get your average monthly cost. 

Essential Needs Budget Example

Here we are going to take a look at Jill's essential needs. She lives in Washington State, so her numbers are based on the averages of this location. Keep in mind when looking at these numbers that they are likely going to be different than yours. Essential needs vary drastically in cost, depending on where you live. If you are living in New York City, the cost is going to much higher than if you live in a small town in Oklahoma. So, if your numbers didn't match up with Jill's, don't freak out!

Mortgage/Rent$ 900
Homeowners/Renters Insurance$ 15       
Property Tax$ 0         
Car Insurance$ 100
Gas/ fuel$ 50
Transportation (Bus, Train, Subway, etc.)$ 20
Health Insurance$ 360
Life Insurance$ 65
Utilities (Electricity, gas, water, garbage)$ 100
Telephone Bill (Landline & Cell)$ 60
Internet/Wifi$ 50
Groceries/Toiletries$ 300
Child Care$ 0
Child Support/Alimony$ 0
Loan Payments (Student loans, Car payments)$ 280 (student loan)
Debt (Credit Cards, Home Improvement, etc.)$ 0
Other$ 0

We can see that Jill needs to calculate $2,300 into her budget for her essential needs. Now, let’s move on to savings!

Calculating Savings

One might think it would be best to calculate your monthly wants next, but we have found that many people tend to simply use what they have left on their wants and forget to calculate for savings. BUT savings are super important. So, how much should you save? First, consider what you are saving for and much that will cost, then apply one of these two rules.

50/30/20 Rule

Many financial planners recommend following the 50/30/20 rule. What this means is that you take your after-tax income and split it up: 50% to essential needs, 30% to discretionary wants, and 20% to savings. This is an excellent rough idea, but it isn't something to live or die by, as there are factors that could quickly change these percentages. Let's look at Jill; if Jill were to follow this rule, it would look like this:

After-tax Income: $3,900
Needs (50%) = $1,950
Wants (30%) = $1,170
Savings (20%) = $780

So far, Jill is pretty close to this rule except for her student loans. She is young and still paying them off, which adds an extra $280 to her monthly expenses. This leaves Jill with two options. One would be to lower her essential monthly expenses until it all fits, OR she can modify her budget. Jill has chosen to modify her expense budget so that she has more money set aside for her essential needs and less money for her discretionary wants.  

You are likely to have different factors than Jill does. For example, if you are young and new to the workforce, it may be impossible to save 20% right this second, so you might have to skew the numbers a bit. On the other hand, you may be making A LOT of money and have more than enough to pay for your needs and wants so that you may add extra to your savings budget. Whatever the factors, you need to find the right balance for you.

Interest Only Retirement Formula

While many financial advisors recommend the 50/30/20 Rule, it is not a flawless route. Savings plans greatly depend on the age at which you start saving, due to compound interest. Let’s take a look at the Interest Only Retirement example provided by CNBC.

In this example, the goal is to have a $60,000 interest-only retirement plan, meaning that you will live off the interest your life-long savings produces without having to touch your nest-egg. This is ideal because it means that you are unlikely to run out of money!

To get $60,000 a year in interest, you must save 2 million dollars before you retire. This is under the assumption that you have zero savings now, will get a 6% return on investment (ROI) as you are saving and a 3% ROI in retirement, and that you will retire at age 65. This formula does not account for inflation, taxes, or additional income. 

So, how do you get to that 2 million dollars? Depending on your age, here is what you would need to save every month to reach that goal!

Age 25 = $1004 per month
Age 30 = $1404 per month
Age 40 = $2886 per month

As you can see, how old you are changes what your savings goal needs to be. Let’s go apply to Jill, shall we?

Savings Budget Example

According to the 50/30/20 Rule, Jill should be saving $780 per month according to her after-tax income. However, Jill is 27 years old, which according to the interest-only retirement formula, means she needs to be saving somewhere between $1004 and $1400 per month to reach that interest-only retirement. What should she do?

Jill, as we said above, is already automatically paying $600 into her company’s 401(k) retirement plan. Remember, Jill decided to base her budget on her after-tax income AFTER she contributed to her 401(k). This means that she has the ability to save another $780 per month. By doing this, Jill will both comply with the 50/30/20 Rule and be saving a total of $1380 per month, which fits the interest-only retirement formula as well!

Jill spoke with a financial advisor about her savings plan and splits that $780 into multiple savings plans, including contributions to her IRA, building up her stock portfolio, padding her emergency fund, saving for her future house, and adding to a high-interest savings account. Now that she has determined her savings budget, she can move on to the final category, discretionary wants.

Wants Vs. Needs in a Budget

Calculating Discretionary Wants

Discretionary wants are all the things that are not vital to living but make life more enjoyable. Some of these costs include eating out, buying a new pair of shoes, going to the movies, entertainment, and any memberships or subscriptions. However, before we go crazy on spending, we have to calculate how much money we have left. To do that, you will subtract your essential needs and savings budget estimates from your after-tax income. It will look like this:

After-tax Income – Essential Needs – Savings
= Amount Left for Discretionary Wants

Discretionary Wants Budget Example

To get a more in-depth example, let’s take a look at our friend Jill. As we saw above, Jill makes $3,900 a month in after-tax income, has $2,300 in essential needs, and $700 set aside for savings. Let’s math it out!

$3,900 (Income) – $2,300 (Essential Needs) – $780 (Savings) = $820

As you can see, that leaves Jill with $820 to spend on discretionary wants. Let’s see what she has in the table below. (P.S. We hope that you will follow along with your own discretionary wants in the available template.)

Dining Out (Restaurants, cafes, fast food)$ 200
Coffee/Alcohol (Coffee shops, bars)$ 80
Fashion (Clothing/shoes/jewelry/sunglasses)$ 50
Events (Concerts, movies, games, dancing)$ 50
Travel (transportation, accommodation, dining, sightseeing, souvenirs)$ 150
Gym/Club Memberships$ 60
Self-care (Massage, hair styling, tanning, nails, etc.)$ 30
Subscriptions (Netflix, magazines, Kindle, deliverables)$ 30
Entertainment (Games, books, movies, etc.)$ 50
Home (Décor, kitchen tools, plants, etc.)$ 40
Other (Anything else you spent money on)$ 60
Total= $800

We get that those might just look like random numbers, so let’s take a quick second to talk about why Jill wrote those numbers.

Jill’s Explanation

Dining Out = Jill eats out once a week with her friends, and it costs an average of $50 per outing.

($50 x 4 = $200)

Coffee/Alcohol = Jill goes out twice a month with friends and spends about $30 each night, plus she hits the coffee shop once a week, which costs about $5 per visit.

(($30 x 2 =$60) + ($5 x 4 = $20) = $80)

Fashion = Jill likes to buy a new article of clothing once a month. Sometimes it is cheap, sometimes it is more expensive, but on average it costs around $50.

Events = Jill enjoys going to the movies, seeing concerts, and attending sporting events. She only goes once a month, but on average, they come to be $50 per event.

Travel = Jill loves to go on big travel trips, but she only has vacation twice a year with her job. Each trip costs somewhere between $500 and $2000. Therefore, she sets aside $150 per month for her trips, and when she has enough saved, she goes on vacation.

Gym = Jill has a gym membership that costs $60 per month.

Spending money

Self-Care = Jill isn’t super girly, but she does get her hair cut and styled every four months, which costs around $120 per appointment.

($120 / 4 months = $30 per month)

Subscriptions = Jill has a subscription to Netflix, Disney+, and Kindle Unlimited. The three cost around $30 per month.

Entertainment = On occasion, Jill will buy a magazine, attend a yoga class, pay an entry fee to a club, or other forms of entertainment. She kept track of her budgeting app and found that she averages $50 per month on entertainment.

Home = Jill is young and is still building up her home. On average, she spends about $40 per month on new cooking tools, cute pillows, fun decorations, and other items.

Other = Every month is different, each producing different expenses. After keeping track in her app, Jill averages about $60 in miscellaneous expenses.

After all this, Jill still hasn’t spent her full $820 discretionary wants budget, leaving her with an extra $20. She doesn't go out and spend the extra money on random stuff but instead keeps it in a high-interest savings account.

How Did Your Budget Go?

Did you do the template along with us as you read? If so, let us know in the comments on how you did! Did it come out as you expected? Or did it come out a bit worse? If you are having trouble with your budget panning out, we suggest taking a look at our cost-cutting article, which will teach you how to cut costs in both your essential needs and discretionary wants, so you have more money at the end of each month!

Remember, the key to a successful budget is not only covering all your expenses but making an active effort to save for the future. Living below your means will set you on the fast track to financial freedom and early retirement! You can do it!