Over the past few decades, a growing number of American high schools have decided to incorporate personal finances into their curriculum, usually to give their students the “tools and skills” they need to make it in the “real world.” Considering where our society was before these classes came to fruition, the introduction of these sorts of classes has undoubtedly been a good thing.
However, the general “rules of thumb” you learned when you were 15 might be pretty different from the lived experience you have by the time you turn 25, just ten years down the line. It is very easy to look at a chart in high school and think to yourself, “oh yeah, if I make a slightly above average salary and put aside 30 percent of my savings into retirement, it should be very easy for me to buy a house, raise a family, and retire at the ripe, young age of 55.”
These thoughts are just theoretical. When the real world starts to creep on you and, even if you make quite a bit more than you initially expected, budgeting your life over multiple decades becomes more complicated, especially when the cost of living continues to rise, and homes seem more unaffordable than ever.
And as soon as you realize you are falling behind, it can be easy to give up on the basic principles of budgeting altogether. When the original “30 percent” rule of thumb—something that is quite a stretch for most Americans—appears to be so far out of reach, it might feel like you’ll never achieve your financial goal. In the end, you might find yourself not settling for 20 percent, or even 10 percent, but just giving up on building your savings altogether.
As you will find in nearly all aspects of your life, doing something will be better than doing nothing, even if that supposed “something” appears to be less than what is suggested by a haphazardly thrown-together chart you studied in high school.
So, in this brief guide, we will discuss a common rule of thumb used in the personal finance world, the so-called 50-30-20 rule. More importantly, we will also discuss a few of the essential questions you should ask yourself when determining how much of your salary you should be currently dedicating to savings.
What is the 50/30/20 Rule?
First off, as a general rule of thumb, you should take any rule of thumb—especially “rules of thumb” related to personal finance—with quite a large grain of salt. The personal financial advice that objectively makes the most sense for one person will rarely be the sort of personal financial advice that makes the most sense for another.
Nevertheless, it certainly doesn’t hurt to have a good starting point. The 50/30/20 rule was initially popularized by the current Massachusetts Senator Elizabeth Warren, who, before serving in the Senate, was a professor at Harvard who taught quite a few classes related to budgeting, bankruptcy, and other personal financial topics. Whether you agree with Warren’s political views, this rule is now widely taught as a budgeting tactic across the country.
Essentially, the 50/30/20 rule states that whatever your after-tax income might be. A good budgeting starting point will likely involve dedicating 50 percent of your income to essential financial commitments—rent/mortgage, car-related payments, insurance, debt, utilities, etc. Next, you should allocate 30 percent of your income to discretionary spending—basically, anything you want to have “the good life,” like going out to eat, vacations, clothes, electronics, and other things, but things not essential for you to get by. The remaining 20 percent of your after-tax income should go toward savings—money you are setting aside for future financial goals, which might include a down payment on a home, college savings for your children, or, most commonly, retirement.
Things to Consider When Budgeting
If this is your first time thinking about budgeting, Warren’s 50/30/20 rule is an excellent place to get started. At the very least, sorting your after-tax financing into these three buckets—needs, wants, and savings—will help you make your finances a bit more organized. But, as suggested, these rules might not necessarily apply to everyone. You might need to adjust how you distribute your income across these buckets a little bit (or, in some cases, a lot).
So, what sorts of adjustments might you need to make? We recommend starting by asking yourself these essential questions:
1. How Old Am I?
Despite our general criticism of using rules of thumb in personal finance, we are going to answer this first question with yet another rule: the older you are, in general, the more you should be setting aside for retirement. When you are young with broad financial goals, you can often get away with tinkering with your budget a little bit here and there. Though saving an additional one percent of income when you’re 25 can produce thousands of nominal dollars over time, you might still consider using a small chunk of your savings for a big commitment (mortgage, vacation, car—whatever). However, when you are closer to retirement, there is no other way around it. If you want more money when you retire, you need to up your savings now.
2. How Much Debt Do I Have?
One of the worst things about debt—especially high-interest debt, like credit card debt, car loan debt, or student debt—is that unless you pay it off right away, it will always end up costing you more than the figure you see on the screen. And that figure might already be quite high. While a high-yield investment account might increase your wealth by ten percent per year, your credit card debt is likely costing you much more than that per year. In other words, paying off existing debt will usually make more financial sense than making long-term investments.
3. What is My Current Income?
While many “rules of thumb,” like the 50/30/20 rule mentioned above, are designed to be “income neutral,” there is a base level of income you need to make for these rules to be even remotely realistic. Simply, saving money will be more challenging if your income is lower. While you shouldn’t abandon saving altogether (even just $10 per month can make a long-term difference), you also shouldn’t allow impersonal financial articles (like this one) to make you feel bad about addressing your most basic needs first.
4. Does My Employer Contribute to Retirement Savings?
When determining how much you should save, one of the most significant factors you will need to consider is whether or not your employer is actively making contributions to your retirement savings. Suppose you are one of the roughly 50 percent of employees who are employed by someone who matches a 401(k), or one of even the more fortunate ones whose employer matches their 401(k) directly. In that case, you should try to take advantage of these matches to the greatest extent you possibly can. A typical cut-off for 401(k) matching is 3.5 percent of your income, though that will vary by employer. But by choosing not to accept whatever your employer is currently offering, you will be leaving what some financial advisors consider to be “free money” on the table.
5. What Are My “General” Financial Goals?
Not everyone has the same financial goals, which is why it is impossible to come up with a universal number for what everybody should be saving. While some people might be content with a tiny cabin in the woods, others might want to buy a mansion and pay for all of their grandkid’s college funds. Most people are somewhere in between. No matter what you have in store for the future, you should keep the following advice in mind: if you want to have more money years down the road, you should probably increase the amount you save now. If your future financial goals are less aggressive, you can probably get away with saving a bit less.
6. Do I Currently Have Any Assets (or Wealth)?
Regardless of your views on the current economy, the reality is some people have more wealth than others. Whether it was earned through work, inherited, or won through the lottery, your current access to wealth should undoubtedly influence the amount of money you are setting aside. And, as you might guess, people who have no current wealth probably should be setting aside more money than people sitting on large amounts of cash. Cash, after all, will always be valuable (though less valuable tomorrow than it is today!).
Many people want a straightforward answer to “how much should I be saving?” Unfortunately, no such answer exists, at least not in a way applicable to everyone. Some people find the 50/30/20 rule simple and easy to follow, while others might have to spend more than 50% of their income on housing and debt. As housing becomes more and more expensive in the U.S., it’s evident that it will be harder for young professionals or households with limited income to save. However, even with that truth in mind, here is our advice: save as much as you possibly can, find unique opportunities for building wealth, and make saving a regular activity, no matter what your current finances might be.