This is the first of a three part series exploring various aspects of our family’s budget for 2018. Part one covers the process I used to create our budget. The second part will review our projected spending, saving and taxes in greater detail. Part three will cover how our budget fits into our broader goal of financial independence. Please also see my posts on goals for 2018 and calculation of my estimated 2018 federal income taxes for additional background.
One of my goals for 2018 was to build a budget for my family and stick to it. We historically have been blessed to earn more take-home pay each month than we absolutely needed to live, so we didn’t really feel the pressure to stay on a budget too closely. We still saved a lot into 401ks using payroll deductions (so we’d never see the money), but probably could have saved even more if we were disciplined on spending.
All of the detailed work behind the scenes of our budget can be summarized in two pie charts. The first is how our total resources split up between spending, saving and taxes. The second is the split of spending vs. savings on an after-tax basis.
For simplicity, I’ve excluded employer matches on our 401k contributions and any principal repayments on our HELOC. I think it’s cleaner because this is trying to figure out the mix of spending/saving/taxes I could actually achieve. Yes, I am “saving” our employer matches, but I couldn’t repurpose that money for spending or taxes right now.
PVF’s Budget Process
Before we get to the steps, Let’s discuss my budget’s key underlying assumption:
Resources (earnings, etc.) = Expenditures (spending, saving, taxes)
It’s a balanced equation. If one side changes, the other side has to change too by the same amount. If one side doesn’t change, but part of the other does, something in that other side has to change by the reverse amount. As an example, if you wanted to increase your savings, you have to either increase your earnings, decrease your spending or decrease your taxes. Expenditures as a percent of resources always has to add to 100%.
Now let’s get to the steps…
Step One: Determine Resources
This one is relatively easy for me, since I already did the work when estimating my income tax burden in 2018 based on the revised tax law. I included total earned income from each of our jobs, interest income, non-qualified dividends and business income from real estate investments. I excluded qualified dividends since they are all going to be reinvested and any employer matches as well.
Step Two: Determine Target Tax-Advantaged Savings
This step is necessary next since it’s an input for calculating your tax burden in step three. Even if you have the same total amount of savings, putting more in tax-advantaged accounts will decrease your tax burden and increase your spending (or saving) capacity.
Step Three: Determine Tax Burden
Based on your resources and other tax inputs, you can calculate how much you should have to pay in taxes. I did a detailed review of my calculations for 2018 taxes in a prior post. Note that the number here is not necessarily how much is withheld from your paycheck. This is trying to estimate your actual tax burden. Don’t forget to include Social Security (6.2% of income), Medicare (1.45% of income) and any state and local income taxes due.
Step Four: Determine Target Spending
Next you should determine your target level of spending based on your specific circumstances. What did you spend last year? What changes are going to happen this year that need to be accounted for? Are there areas you want to try cut back on? Part two will of this series shows our family’s numbers in detail.
Step Five: Balance Back to Resources Using After-Tax Savings
After-tax savings is the last number left to calculate. It is simply equal to resources less taxes, spending and other savings. If done correctly this should be a positive number; negative savings means you’re selling technically assets to fund your consumption and need to refine.
Step Six: Refine and Re-Run
If the after-tax savings number from step five is negative, you will have to refine assumptions. The most likely culprit is spending in step 4. You could also increase your resources to balance, i.e. assume you’ll earn more, but that feels a bit like a cop out to me.
One final note: If you end up with a large amount of after-tax savings try to take better advantage of tax-advantaged savings, if possible. That will decrease your tax burden further and, if your earnings and spending stay the same, allow you to save even more in total.
Following a process like this has allowed me to really think about how changing one assumption impacts outputs across the entire budget. It also helps me think more broadly than just spending, since my ultimate goal is to maximize savings to decrease our time to FI. What process do you use to build your spending/saving/tax budget for the year?
John started Present Value Finance in 2017 to share his experiences and insights on personal finance to help people make better decisions and take control of their financial lives.
He achieved financial independence in 2016 by walking away from the high stress world of corporate finance to focus on his family. He’s a husband, father, family CFO, and all around finance geek.
He uses Personal Capital to track his spending, investments and investments for free and recommends you do too.