The 50/25/25 Budget Rule

The Superior Budgeting Heuristic

[Note - Mark it down, you saw it here first 50/25/25 or 75/25. Some personal finance gooroo accounts are starting to sound eerily similar to a Bowtied newcomer. As of today I have yet to hear anyone stray from the 50/30/20 rule. If suddenly 50/25/25 starts getting thrown around remember where you saw it first.]

One of the first things that people ask when looking at their finances/budget is “how much should I be spending on X?” Good start looking to budget, but wrong question. You should start with “How much should I be saving?” and then work backwards.

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It all starts with the savings. That is how you build wealth and get the ability to retire.

“How Much Should I Be Saving?”…This is the right question

-BowTied F’er

Obviously, everyone is different and personal finance is personal, blah blah. Some people live in higher cost areas where even the cheapest housing takes up a larger portion of their budget. While others may still be living with their parents rent-free and should be saving a lot. All these people would have very different budgeting results.

(Anecdotally, my sibling and I built a house around the same time in 2 very different parts of the country. Similar style and materials. Theirs is almost double the size of ours and was slightly less expensive)

However, having a good heuristic as a generalized starting point is helpful. That is where rule of thumb budget rules work well, as a starting point.

(Need a refresher on what a heuristic is? Heuristics, Biases, & Fallacies )

Right now the most popular answer is the 50/30/20 rule which we consider subpar. But before we get into all the reasons 50/25/25 is better, lets introduce the current popular answer…

Introduction To The 50/30/20 Rule

The 50/30/20 rule says to take after-tax income and split it up 50% on needs, 30% on wants, and 20% on savings.

50% Needs include:

• Rent / Mortgage & Utilities

• Car Payments

• Groceries - basics to survive

• Insurance & Health care

• Minimum Debt Payments

30% Wants are anything not essential

• Increases to basic groceries (ie - restaurants & splurging on more expensive versions of food)

• All entertainment

• Life upgrades (ie - luxury car vs economical one, designer clothes, etc)

20% Savings

• Investments / 401k / IRA

• Emergency fund

• Extra debt repayments over the minimum

Overall, 50/30/20 is allright since it is useful in setting a high-level budget. However, we think 20% savings is a bit light and think having 3 different numbers makes it unnecessarily complicated.

Why Does Personal Finance Twitter Love 50/30/20?

Where did 50/30/20 come from and why does personal finance loves the 50/30/20 rule? To be honest, personal finance twitter isn’t a breeding ground of original thought. If you spend much time over there, it is 1,000s of tweets a day re-hashing the same few rules and ideas. So 50/30/20 gets used over and over because:

• It was in a book

• It is directionally correct for most people (ie- most people aren’t saving anywhere near 20%)

• No one thinks critically and just repeats heuristics of each other

So basically, once 50/30/20 got published, people latched onto it and continue to yell it into the void. But we think it is a subpar model.

• 3 different numbers is hard to remember (laugh, but facts, most people don’t do well with numbers)

• Which is 30 and which is 20? Which is save and which is spend?

• 30% and 20% is difficult math to do in you head

• Most importantly, 20% savings leaves you with significantly less wealth than 25%

50/30/20 can easily be improved as a heuristic, and the fact so many people go with 50/30/20 is disappointing.

So what is a better rule of thumb?

The 50/25/25 Rule

50/25/25 removes all the issues we listed above:

• 2 Numbers (1/2 covers your essentials and split the other 1/2 between saving and spending)

• Doing halves is easier than 30% and 20%

• Don’t need to remember if you are spending 30% or 20%

• Bonus - “Fiddy & 2 quarters” rolls off the tongue easier

• Makes you much better off financially

In short, 50/30/20 sucks and 50/25/25 rulez!!!

Comparing 20% vs 25% Savings

How does 20% savings compare to 25% savings?

Let’s run some numbers. We will use a $100,000 gross income, since everyone should be able to achieve 6-figure income. And we will assume a 20% effective tax rate leaving you with $80k after-tax.

That means you have $40k for your ‘essential’ expenses (50% of after-tax income) and…

Well problem #1, what is 30% of $80k and what is 20% of $80k. If you are one of our high-IQ readers, it seems obvious, but taking 30% of $80k requires most people to bust out the calculator…which is a barrier

Under the 50/30/20 rule you have:

• $24k for spending

• $16k for saving

Under the fifty & 2 quarters rule, you just split the $40k in half again since your save = your spend

• $20k for spending and saving

20% vs 25% Compounded Over Your Career

If you have been reading us, you know we caution against simply looking at a historical average return and extrapolating it out 40 years for many , many, and many reasons, but we will use it for ease of illustration here.

We will assume a 6% growth rate over time. What is the impact of saving 20% vs 25%?

The difference over 40 years is over $500,000 dollars. With a 25% savings rate you save over $3 million while you save a little under $2.5 million with a 20% savings rate.

That means you wind up with 25% more savings for your retirement.

Which shouldn’t be super surprising here, as saving an additional 5% of your after-tax income is actually increasing your 20% savings rate by 25%. You contributed an extra $160k over the 40 years and it grew to over $500,000 for your retirement.

Now, some of you may have thought “$2.5 million seems like plenty, why save more money now?”.

First, no….bad bad bad thinking.

Second, that is $2.5 million in nominal dollars. What does it look like if you include inflation of 3% over the 40 years and see how much ‘real’ savings you have?

20% vs 25% Savings With Inflation

If we redo this simple calculation but this time assume a 3% rate of inflation, then we will see what our savings are equivalent to in todays dollar. A 6% average return and 3% inflation means you are getting a 3% real return each year.

Now the results are $1.5 million vs $1.2 million, so you wind up with an extra $300k at retirement (still a 25% higher retirement value).

If I was retiring today, I would much prefer $1.5 million vs $1.2 million.

There are infinite ways to run the numbers with different assumptions, but the general takeaway is saving 5% more of your income with the 25% rate will result in ~25% savings when you hit retirement than saving 20%. That is a material amount.

Tips & Insights with Savings Rules

Hopefully you are convinced that 50/25/25 is a better version of 50/30/20. But either way, these are starting points.

In the examples above, the assumption was there was no salary increases and you saved the same 20 or 25% for the entire 40 years. This was done for simplicity. However:

1. In real life, your salary should be growing over time.

2. In real life, your ‘essential’ expenses should be taking up a smaller and smaller portion of your after-tax income as you pay down debts.

3. In real life, you should hit an inflection point with your discretionary spending where you no longer desire to spend any additional money for each additional $ you make.

The result of the above 3 real life events above? Your savings rate should be increasing always. One of the easiest ways to monitor and handle this is to automate as much of your spending as possible. We recommend a 4 account budgeting system that leaves you largely monitoring only 1 account.

1) Salary Goes Up

You make $100k and lets assume you keep $80k after-tax. Let’s also assume exactly 50% of your after-tax income is spent on largely fixed essentials/needs - Mortgage, car loan, student loans, basic groceries, utilities, etc all add up to $40k a year.

You get a raise for 3%.

Your gross wage is up to $103k, or $82,400 after-tax. Your $40k of fixed essential expenses is now 48.5% of your after-tax income (40k / 82,4000 = 48.5%).

Now you have an extra 1.5% going into savings. It may not seem like much but over 5 years your savings rate is 25%, 26.5%, 28%, 29.5%, and 31%…suddenly in 5 years doing nothing but getting mediocre raises you are over 30% savings rate and accelerating towards your financial freedom.

Even if you want to have a little lifestyle upgrade, you should split salary increases between savings and spending. The $2,400 after tax salary increase, you put $1,400 into increased savings and $1,000 into lifestyle upgrades, for example.

Easiest way to do this if you are a W2 employee, is bump your 401k contributions each year with your raises.

2) Essential Spending Decreases As a Percent of Income

The percent spent on your essential bucket can be driven by either your income going up or the spending going down.

Since this bucket is largely fixed expenses (ie-mortgage), it is least likely to experience year-to-year lifestyle inflation (ie-your not moving to a slightly bigger house every year).

Using same example, you make $100k gross and $80k pre-tax, so you budget is around $40k a year in the essential bucket or $3,333 a month to cover mortgage, car payments, minimums on debt, etc. For simplicity lets assume you spend:

• $2,000 Mortgage

• $300 Car

• $200 Student Loan

• $500 Groceries

• $333 utilities, gas, etc.

If you pay off your car loan your ‘essential’ spending drops $300 or $3,600 a year. This means annually you’re spending $36,400 on essentials/needs. This is 45.5% of your $80k after-tax income. You move that extra $3,600 a year into savings and bump your savings rate from 25% to 29.5%.

So even without raises, as you pay down some of your debt, your savings rate can increase.

When you pay off the student loan its the same thing with the extra $200.

3) You Hit Your Spending Inflection Point

We talk about the spending inflection point a lot, because it is a real thing. Everyone has their ‘satisfied’ life. Where you have all the things you need and anything else would be a splurge item.

The below graph is a generalized visual:

Everyone has an inflection point where each additional dollar they make has less and less need to be spent

This is the general shape of everyone’s spending. If you want to tie it back to something academic it is similar to a utility curve.

Starting at the bottom left, you have income below the cost-of-living and every dollar you make gets immediately applied to getting the basics. At some point you are making more than subsistence wages and you start saving some money, but you are still upgrading your life. Eventually you get to a point where you have the house you are fine with, a car you like, eating well, a nice wardrobe etc.

This is your personal inflection point.

Some people it may be at $150k a year. Others it may be $10 million a year. It is different for each person. But once you hit that inflection point, then each marginal dollar can go almost entirely into savings.

You may still have big jumps in life every few years after you make it (maybe you get enough wealth that you move to a nicer location and a bigger home you don’t need, but why not). But in-between those lifestyle jumps, you are putting away more and more wealth.

When you hear people with 80% savings rates, it is because they are well past their inflection points…or have a mental disorder that makes them cheap…

Pre-Tax vs After-Tax Savings

One last point, the 50/30/20 rule uses after-tax income, but there is mixed advice if pre-tax contributions count as whole numbers or if you should tax-adjust them. Similarly, does an employee match count towards your own savings?

We would say, despite the massive debate online, these are both minor points. The goal is to save and increase the savings over time till you are putting the majority of your income away into investments and growing wealth.

However, our opinion is:

• For simplicity, you can use the pre-tax savings rate. So if you put 5% of your paycheck into a 401k pre-tax, you can count it as 5% savings, even if you get taxed on it when you take it out and it is not equivalent to 5% after-tax.

• We do not think you should include employee matches in the savings number. You should get to 25% of your salary on your own. (Also, this offsets the prior point where you are overstating the contribution from pre-tax funds)

Conclusion: 50/25/25 Rule

To wrap this up.

50/25/25 rule is superior to 50/30/20 rule in every way.

• Has you saving 25% more money

• Easier to remember

• Easier to calculate

• Sounds better to say

But both these rules are heuristics to use as STARTING points. You want to keep increasing your savings rate each year. We provided the 3 easiest ways to increase your savings while keeping your lifestyle steady - decreasing the essential bucket, increasing your salary, and hitting a lifestyle inflection point.

If you aren’t saving at least 25% today, you need to spend some time to figure out how to get there. Comment or reach out if you need budgeting help.

Good Luck Anon.