Many people who have survived the coronavirus pandemic and ensuing economic fallout relatively unscathed have been focusing on ways to better insulate their finances for the uncertain future. It is natural for us to take current circumstances, both positive and negative, and extrapolate that things will be on the same path into the future. As my dad used to tell me growing up, most people “make decisions assuming nothing will ever change, but you can always count on things changing”.
Sometimes, it takes seeing millions lose jobs just like the one you have, your favorite restaurant closing and possibly never reopening, or retirement accounts dropping 25%+ in a month to make you step back and examine your finances and priorities. For many, the number one stressor is financial insecurity, regardless of income.
There is a renewed interest in Financial Independence for those that can afford to think about it now. Over the next several posts, we’re going to cover the key areas of becoming Financially Independent.
In our first two posts, we focused on focusing on saving instead of spending and again on increasing your savings rate. But, what if you’re trying to find more room in your “budget” to save more money? How should you think about approaching your spending?
I have found one of the most effective ways to think about spending is to separate expenses into different three categories, each with their own unique characteristics: Taxes, Fixed Expenses and Variable Expenses. By compartmentalizing each expense into the appropriate category, it becomes easier to understand the dynamics of why it can be hard to find more in your budget to spend.
Everyone’s favorite category! It is really important to pull income taxes out of your all spending. This includes:
- Local (if applicable)
- Social Security
- Medicare Taxes
- Self-employment taxes (if applicable)
Most of these can be found on your paystub, although it is important to do a tax projection annually to make sure you are withholding the right amounts. If you get a large refund or owe a decent amount when you file your taxes, budgeting for taxes becomes more difficult.
Regardless, accounting for your taxes upfront helps keep your options in perspective. You have the least flexibility in this category, although for many people, proper tax planning can help bring your tax burden down. As you think about tax planning, it’s not just allowing you to reduce your taxes but it also frees up money to move from “expenses” to “saving and investing”.
Fixed expenses are those expenses that you know you have to pay each and every month/quarter/year and you have very little ability to make any changes in the short run. This includes:
- Rent / Mortgage (both Principal & Interest and Escrow)
- Property Taxes, if paid separately
- Life / Disability / LTC / Auto & Homeowners premiums
- Minimum Car payments
- Minimum Student Loan payments
- Health Insurance
- Childcare expenses
Each of these are obligations that you must pay, and they are generally very stable. For things like car payments and student loans, the only amount that should be included in the fixed category is the minimum monthly payments, since any attempt to pay these off early should be considered a form of Savings and Long-term planning.
One note on food: the biggest question I get on the fixed expense category is that there is no food budget included. While it is true that you need to eat to survive, almost all of the food budget is variable and discretionary. You can choose to eat at home on the “poor college-student diet” or you can order expensive restaurant meals all week.
The last main expense category is Variable Expenses. This essentially includes everything else you spend money on: Food, entertainment (including subscriptions), travel, clothes, etc. Variable expenses have the most flexibility and are the place many people look first to cut spending.
If you like to be detailed, you’ll want to separate out all the variable expenses to get a good handle on the specifics. There are a lot of different budgeting software programs and apps that can help organize, including Quicken, YNAB, or Mint.com. If you just want to look at the big-picture, keeping track of a Variable Expense category is still important, even if you do not dive any deeper.
In addition to reducing taxes (to be covered in another post), there are two obvious ways to reduce expenses and increase savings: Reduce or Eliminate Fixed Expenses and Reduce Variable Expenses.
Once you separate out the fixed expenses from the variable expenses, many people realize how little “extra” is in their budget, because of significant fixed obligations. That is why the FIRST place I recommend to look is to use any extra cash flow to get your Fixed Expenses under control.
Remember, any additional payments for debt like student loans or car loans are forms of savings. As these Fixed Expenses diminish, you can use this freed-up cash flow to knock out other Fixed Expenses or increase your Net Worth in other ways by saving and investing.
Hopefully this framework is helpful to get a clearer picture on where you money is going. In our next post, we’ll address the growing backlash towards high savers from both the media and governments.