When it comes to designing a budget that works, simple is best. The idea of a 50/20/30 rule for budgeting your personal finances comes from Massachusetts Senator, Elizabeth Warren. She worked with her daughter, Amelia Warren Tyagi, to publish a book that outlines the system in 2005. “All Your Worth: The Ultimate Lifetime Money Plan” explains that the plan to get your money in balance should result in the ability to pay off debt, save for the future, and pay all your bills on time.

50/20/30 rule of budgeting outline

To understand the 50/20/30 rule of budgeting, you need to be able to categorize your spending into three areas.

Needs

Rent or mortgage payments, groceries, healthcare, utilities, minimum debt payments, car payments, and insurance all fall into this category. Think about the bills you pay each month to provide services that you need to maintain your day-to-day existence. Some financial planners call these the “four walls” bills.

What does it take to keep your four walls and everything in it financially afloat? Here’s what does not belong in the “needs” category of your 50/20/30 budgeting plan:

• Your morning trip to the coffee shop
• Netflix
• Subscription boxes
• Going out for drinks with friends
• Tickets to sporting events or concerts

The “needs” category of spending represents the “50” in your 50/20/30 budgeting plan.

Wants

These lifestyle upgrades are important to your happiness and sense of well-being. They represent the “30” in your 50/20/30 budgeting plan. This is the category where you add up your costs for Netflix, that HBO subscription you love, your Birchbox and Fabletics subscriptions, your Ultra-High-Speed Internet service, and your unlimited data cell phone plan that includes the payment for your iPhone X.

Vacations, dinner out, movie tickets, gifts, and your new television all belong in the “wants” category.

Savings

This category of your 50/20/30 budgeting plan is the “20” and it includes debt repayment over and above the minimum payments you accounted for in your “needs” category. It’s important to allocate debt repayment in this category because paying off debts early saves you money on future interest charges.

You can add these items to your “savings” category, as well:

• Investments
• IRA contributions
• 401(K) contributions
• Mutual fund accounts
• Emergency savings

How to determine your after-tax income

While most budgeting plans work with your take-home pay, the 50/20/30 budgeting plan starts with calculating your after-tax income. If you work for an employer, simply add your health care and retirement deductions back into your take-home pay. If you pay for life insurance or contribute to a dependent care, HSA, or flexible spending account for out-of-pocket healthcare costs, be sure to add those costs back in, as well.

If you are self-employed, take your gross income minus your business expenses. Don’t forget to include your self-employment tax costs in your calculations. Examples of business expenses to deduct include the cost of a new laptop, mileage deductions, travel expenses for conferences, and the money you set aside to pay quarterly tax estimates.

Designing your personal 50/20/30 budgeting plan

Now that you understand your after-tax income, you’ll divide it into three parts. For example, if you make $3,500 per month after taxes, you’ll create the following categories:

Needs

$3,500 x .5 = $1,750

Wants

$3,500 x .3 = $1,050

Savings

$3,500 x .2 = $700

With this plan, you’ll limit the items in each category, so they add up to less than your budget amount. While this step may seem difficult, with just a bit of adjustment, you’ll find the plan makes sense.

Limit your spending in each category

When you place limits in one category you may find that you can afford to spend more in another category. This shift in mindset can be very useful if you’ve had problems sticking to a restrictive or overbearing budget in the past.

Start with your “needs” category and list every expense that should fit, here. So, for someone who would like to spend only half of their $3,500 after-tax income in this category, the ideal list may look something like this:

$1,750

-$800 Rent

-$75 minimum credit card and personal loan payments

-$50 employer-sponsored healthcare costs

-$65 Electric bill

-$35 Natural gas bill

-$45 Cell phone plan

-$80 Auto and renters’ insurance

-$300 groceries and gasoline

-$300 car payment

= $0

You can see that there isn’t enough income to cover these expenses to begin with:

$1,750

-$800 Rent

-$75 minimum credit card and personal loan payments

-$50 employer-sponsored healthcare costs

-$65 Electric bill

-$35 Natural gas bill

-$85 Cell phone plan

-$120 Auto and renters insurance

-$375 groceries and gasoline

-$300 car payment

= -$155

If you can’t quickly increase your regular monthly income, you’ll need to decrease your spending in this category. In this case, getting a new quote for car and renter’s insurance policies reduces the monthly payment from $120 to $80. Reevaluating cell phone usage and switching to a company with a lower monthly fee reduces this bill from $85 per month to $45. Since the other bills aren’t negotiable, reducing the grocery budget from $375 per month to $300 per month finishes the job of reducing “needs” to fit into 50% of total after-tax income.

If you feel comfortable automating your payments, doing so will relieve you of the tedious task of monthly or bi-weekly bill paying. If you’ve had problems with multiple overdraft charges in the past, consider contacting your bank to have overdraft protection removed from your account. If you don’t have the money in your bank account to cover a transaction, it will be denied without overdraft protection. This could cause problems, but it also prevents you from wrecking your entire budget with a landslide of overdraft fees.

Another way to organize your “wants” and “needs” categories is to use two separate accounts. If you choose this method, you won’t be able to overspend on unnecessary things to the point that it endangers your ability to pay your non-negotiable bills. Some employers will even allow you to allocate a certain percentage or dollar amount of each paycheck to separate accounts.

In the “wants” category, this example offers $1,050 per month to spend. In this area of spending, it’s important to consider each expense as it relates to your ideal life. Look carefully at your past spending by checking your credit card bills and bank statements.

Using this information, think about the kind of life you’d like to have and the activities and things that bring you the most joy. This is the part of your budget where you can design your day-to-day life. So, if working out is important to you, investing in a membership to a gym that is close to your home or work and offers opportunities to participate in your favorite fitness activities would be a satisfying addition to your “wants” budget.

This category isn’t for extravagant purchases. It’s for things and experiences that make your everyday life better. So, upgrading your cell phone plan to unlimited data or paying a bit more for high-speed internet services at home so you can stream movies belong in the “wants” category.

Here’s what our example’s ideal “wants” may look like:

$1,050

-$40 monthly car detailing service

-$150 monthly lunch out and shopping with sister

-$250 drinks out with friends on Friday nights

-$50 Netflix, Spotify, Hulu, and HBO subscription fees

-$100 personal items like haircuts and the occasional makeup splurge

-$70 gym membership

-$40 upgraded cell phone plan and new phone payment

-$100 grocery items like treasures from the farmers’ market or seasonal treats

-$50 monthly breakfast treats for officemates

-$200 for cash on hand to buy miscellaneous items

Be flexible in this category. If you know you’d like to take a weekend trip next month, you could simply control your spending at the farmers’ market, plan to refrain from buying anything during your shopping trip with your sister and dedicate your cash on hand to your expenses for that trip.

With our $3,500 after-tax monthly budget, there is a $700 limit on savings and debt repayment exceeding monthly minimums. So, here’s what our “savings” category may look like with this budget:

$700

-$75 401(k) contribution

= $625

If your employer offers a company match for their 401(k) plan, it’s a good idea to contribute the amount required to get that money. In this case, a $75 401(k) contribution gets a 50% company match. So, not only is that $75 tax deductible, but it’s also worth a total of $112.50 each month because the company contributes $37.50.

In this example, there isn’t an established emergency fund. This person has $5,000 worth of credit card debt spread across three cards. They also have a personal loan with a $2,000 balance, but the interest rate is only 5%.

At this point, it’s smart to split the $650 between saving for emergencies and paying down debt. This budget doesn’t require adding debt to credit cards, so now is a great time to work toward carrying a zero balance from month-to-month if you decide to use credit cards occasionally.

$625

-$200 emergency fund

-$225 toward credit card with 19% interest

-100 toward credit card with 8% interest

-100 toward credit card with 7% interest

= $0

When there is $1,000 in the emergency fund, dedicate the $200 per month contribution toward paying off the credit card with the highest interest rate. When there’s a zero balance on that card, there will be $425 per month available to dedicate to paying off one of the last two credit cards. When all debt is at $0, it’s time to work toward increasing the emergency fund to equal three months of “needs”. From there, you can make decisions about how to invest and create wealth in the future.

Common problems with the 50/30/20 budget plan

Working through this budget in your current financial situation may not go smoothly at first. If you chronically overspend on “wants” or have especially high debt or living costs, this budget may seem like it just won’t work in your situation.

For some people, getting to the ideal 50/30/20 split of income is a process. If your after-tax income is $60,000 per year, but your mortgage is $2,000 per month, your entire “needs” budget is gone right away. You may need to consider moving to a less expensive area, refinance your mortgage at a lower interest rate if possible, or work toward finding a job at a higher income level.

Your goal is to fit your expenses into each of these categories. So, if you currently spend $500 per month shopping for clothes but your monthly after-tax income is $2,000, your entire “wants” budget is $600. That leaves just $100 per month for anything that doesn’t fit into one of the other two categories. In this case, you’ll have to reduce your spending or increase your income. If you want to continue to spend $500 each month shopping and you can get a job or develop a side gig that would increase your after-tax income to $3,000 per month, you would have $900 to spend on “wants” to make your $500-per-month shopping habit fit more easily into the 50/30/20 budget.

If your debt level is especially high, you may want to temporarily shift a portion of your “wants” category to pay down that debt. Especially if the debt carries a high interest rate, paying it off quickly is the best thing you can do for your future financial well-being.

While Warren and Tyagi’s book sparked the idea for the 50/20/30 rule of budgeting, much has been written on the subject since 2005. You’ll find additional information and support about this method of simple budgeting at Chase.com, Lifehacker, the MintLife Blog, and on the Investopedia website.