There are many โmoney systemsโ and โmoney rulesโ out there.ย Some are OK, others are marketing gimmicks.ย One that I get asked about often is the 50-30-20 rule.ย
It has positive components that you should learn from for sure but I actually recommend that you do not use it. The primary reason is its’ not customized to you.ย Itโs a once size fits all solution which never works.
In this article I detail what the 50-30-20 budget rule is then I explain why you should never use it or any other similar “one-size-fits-all” approaches.
What is the 50-30-20 Rule?
The rule is an easy budgeting method.ย The good thing about the 50-30-20 rule is that it’s easy to understand.ย
You divide your monthly after-tax income into three spending categories:
- 50% for needs;
- 30% for wants; and
- 20% for savings or paying off debt.
Below I highlight the 5 reasons why you should not follow this rule.
Reason #1: It Doesn’t Account For Income Amounts And Types
The 50-30-20 ruleย doesnโt take into account the level of your income nor the type of income you have!ย ย
If you make the median income in Boston ($35,000 a year) you are going to be spending way more than 50% of your income on needs.ย If you make $200,000 a year then youโll be spending way less on needs.
On top of that, your income type will have a massive impact on your budget.ย Let’s say your income is primarily commission as opposed to a steady salary.ย You need more of a cushion in case you have a bad month and donโt earn any commission.ย Therefore, you may need to save more than 20%.
The correct way of budgeting always starts with your income.
Reason #2: We All Have Different Needs
The 50-30-20 rule says to use money for needs.
Needs?ย Every one of us considers different items as โneeds.โ Plus, each on of us lives in different locations.ย Therefore, these day-to-day expenses such as rent change based on where we live.ย
Combine cost of living differences and income differences and it’s easy to see why the 50-30-20 rule doesnโt work.
Reason #3: It Doesn’t Consider The Type Of Investments Available To You
Let’s use an example. I’ll assume that you have a significant amount of debt, such as student loans, and your monthly payment is 20% of you income.
I will also assume that your employer matches 6% of you income in a 401k.ย
Are you going to ignore your employer match so you can spend 30% on โwants?โ That is absolutely ludicrous and doesnโt make any financial sense whatsoever.
Plus the 50-30-20 rule is based on after-tax money.ย There are accounts such as 401k, 403b, Traditional IRAs, and HSAs that have pre-tax benefits.ย The 50-30-20 rule completely ignores those benefits!
Reason #4: It Doesn’t Consider Your Type Of Debt
Letโs say you have multiple forms of debt and the monthly payments add up to 20% of you income.ย
One of those forms of debt is a credit card that has a 20% interest rate.ย Are you going to keep paying that ridiculous interest rate and spend 30% on โwants.โ Absolutely not!ย That would not be good financial planning.
Reason #5: What About Your Insurance Needs?
The 50-30-20 rule completely ignores insurance needs.
In short, insurances are financial products you purchase in order to protect your income against unexpected events.
This is key to minimizing the risk to your financial plan.
Insurances are not savings, debts items, or wants but are a necessity to protect your finances and your financial plan. By not accounting for this typical type of need, this magic formula, once again, should not be used in my opinion.
By Joseph Reinke, CFA
