Too many people I speak with don’t have a clear sense of where their paycheck goes and why they don’t have more money left over every month to invest. Retirement has become a hazy concept which will hopefully happen in a few decades. By systematically budgeting, planning, and investing you can successfully plan for retirement and feel confident that you won’t have to work forever. I find it exciting to watch my progress towards my goals every month, and you will too. 

We’ll start by creating a budget showing our after-tax income and our expenses, and we’ll forecast them over the next few years. The sample budget below shows expected income and expenses for the next few years and details the assumptions I used in the model. It shouldn’t take too long to collect the information, as certain expenses should be the same every month such as your rent or mortgage payment, daycare expenses and many other monthly bills. My wife and I use our credit card for almost every expense other than our mortgage payment and daycare, so for us we only have 4 expenses to keep track of: Housing, Daycare, Credit Card and Utilities. As a result, its easy to manage our expenses, and I know if our spending has been too high just by tracking our credit card statement. 

Sample Budget

 sample budget

The sample budget represents a two-income household with one child. From 2019 to 2022, this family’s available income to invest increases by about $15,000 due to higher income and lower childcare costs as daycare is replaced is part-time childcare costs midway through 2021. When forecasting income and expenses, try to be conservative but realistic with your assumptions. Earlier in your career you are more likely to receive 10-15% annual pay increases as you rapidly acquire new skills and knowledge. But as you grow in your career 2-5% annual increases become more common for many professions. Similarly, I expect most expense categories to increase by around 2%/yr. given that the Federal Reserve has targeted inflation of 2%. In the U.S. annual inflation has not increased by more than 2% since 2007-2008, as shown below. Healthcare is the one expense where costs have increased more than the general rate of inflation, with increases of 5-6% per year over the past few years. 

U.S. Inflation, 2000-Present

 us inflation

It’s also important to analyze which expenses are discretionary and could potentially be reduced or eliminated if need be. For example, in the sample budget, Food, Entertainment and Misc. are the three categories that stand out as being at least partially discretionary. Additionally, Childcare is another category that could be eliminated if necessary if one working spouse decides not to work. Finally, I look at which expenses are transitory, as in they will be eliminated or substantially reduced over time. In the sample budget, Childcare sticks out as an expense that will be substantially reduced over time. Your mortgage payment could be another transitory expense category if you are roughly 3-5 years away from paying off your mortgage. However, it is extremely challenging to try and forecast more than 5 years out. 

One other point on budgeting is the fact that your income may be variable in addition to having variable expenses. For example, if your income is heavily commission based, or if your annual bonus makes up a large percentage of your income. If you’ve been in the field for a few years and have a good sense of what a typical year is like, you could use your average income over the past few years as a starting point. If you are newer to the field, start with your best guess and make adjustments over time. Budgeting is an iterative process for everyone, and you should feel empowered to change your forecasts based on new information about your income and expenses. 

Now that we’ve created a budget, we have a sense of how much income we have left over every year to save and how that will change over time. Creating a budget also helps you plan how much income you will need in retirement. Certain expenses such as your Mortgage and Childcare should hopefully be gone in retirement, while others such as food, healthcare, and utilities will clearly still be expenses in retirement. Forecasting your budget allows you to think like the CFO of your household finances. 

Over time aim to create as much flexibility in your budget as possible by increasing the gap between your after-tax income and your expenses so you can accelerate your savings. There are only two levers here we can focus on, increasing your income and managing your expenses. Ultimately, it is up to you to determine which is the most appropriate lever to emphasize and you may want to combine strategies to speed up the process further. Also keep in mind that your priority for where to focus largely depends on your income and expense level. If you already have a high income, you may only need to reduce your expenses slightly to boost your savings. On the other hand, if your income is currently low, increasing your income while keeping a close watch over your expenses will be important. In later posts we will discuss strategies for both reducing your expenses as well as ideas for increasing your income.

Comparing Different Strategies for Minimizing Expenses

To illustrate how different strategies can be appropriate for different people lets examine how Billionaire Naval Ravikant thinks about discretionary expenses compared to Mr. Money Mustache. They have both achieved their definition of financial freedom, but in vastly different ways. Naval describes in his “How to get Rich (without getting Lucky)” tweet storm how you should set a high personal hourly rate:

 us inflation

In further detail, How To Get Rich, Naval describes how he set his personal aspirational rate at $5,000 per hour. This effectively meant that he outsourced nearly every task, as it’s nearly impossible to find a task that would cost more than $5,000 per hour to fix. Ultimately, Naval become a billionaire, partially by eliminating small distractions through a high level of discretionary spending. 

This contrasts dramatically from the approach of Mr. Money Mustache who kept his personal spending to $21,470 for all of 2019, Mr. Money Mustache 2019 Budget. He was able to retire at age 30 in 2005 with a family, but obviously at a much lower standard of living than Naval. 

These examples illustrate extreme approaches to managing expenses, but the point is that you have to find the approach that works best for you based on your financial goals. Either way, it is important to save a substantial portion of your after-tax income to achieve financial freedom. After going through the budgeting process, you should have a good sense of how much you have left over every year and have thought more about which expenses are discretionary as well as transitory. 

Download Budgeting Template

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