Budgeting in Four Buckets, Two Accounts

I’ve spoken to people who have said their financial situation isn’t something they can budget for, which I interpret as someone who doesn’t want to know what they’re situation is for fear of getting bad news (kind of like the person who avoids a doctor because they’re afraid of what they’ll hear). Unless you have discretionary income coming out your wazoo (remember Etrade’s superbowl commercial?), a budget will help you stay on track, manage the unexpected, and plan for the future.

It’s really not that complicated. All you need is 4 hypothetical “buckets”, and two actual accounts to set up your budget.    Yes, there will be some one-off scenarios that may fall outside the scope of your 4 bucket categories, but it’s a lot easier tackling those few items and making a decision when all of your other expenses are accounted for.

The buckets, and examples of expenses that fall into them are as follows:

Goal/Savings – The important stuff.  An emergency fund of at least 3 months worth of expenses is a priority, after that, it depends on your situation.
Emergency fund, Retirement funding, College savings, Saving for House, Vacation, Paying off Credit Cards

Regular – Regular monthly expenses that you can easily forecast. Typically a set amount, but can vary slightly.
Utilities, Groceries, Rent/Mortgage, Car payment, Gasoline, Transportation, Child care

Irregular – Regular expenses that you know will happen, but they don’t occur monthly and you have to save some of your regular cash flow to pay them when they do occur.
Healthcare, Life Insurance, Gifts, Home Maintenance, Auto Maintenance, Auto fees, Taxes

Discretionary – Day to day spending. This is the bucket where you can most easily control the amounts going out (ex. brown bagging it, eliminating the daily latte, etc)
Auto Maintenance, Eating out, Clothing, Entertainment, Vacations

Notice some of the expenses are in multiple categories, like Auto Maintenance. That’s because there are some Auto Maintenance expenses that you can forecast, such as oil changes, whereas you can’t forecast when that high pitched noise is going to be heard coming from somewhere in the back of the car. So Auto Maintenance also can be paid for with discretionary spending.

All of these buckets are funded after paying yourself first through payroll deductions towards your 401k or other pre-tax plan. Your after-tax funds are what goes into your budget.

Setting It Up

Step 1 – Figure out your take home pay

Let’s use an example to set up the budgeting process. Assume Joe, makes $100,000 per year. He contributes 8% to his 401k, and he pays about $2,000 per year in health insurance premiums, so his pay before taxes is $90,000. Let’s say his net take-home pay is $75,000, which is $6,250 per month, or $3,125 semi-monthly (per paycheck if paid 2x per month).

Step 2 – Determine the monthly expenses in your Regular bucket

If you don’t know what your regular expenses are (you really should write this stuff down!), there are tools out there like Mint.com that are easy to set up and will aggregate all of your expenses so you can easily see your main expense categories.

Step 3 – Determine the amount of expenses to be included in the Goal/Savings bucket

So you want to buy a house in 5 years and figure you’ll need $50,000 more for a down payment? Oh wow, that means $834 a month out of your take home pay. No can do. Wait, you do get an annual bonus which should be about $5,000 per year, and you generally get about $1,000 back on your taxes . That’s $30,000 over 5 years, which only leaves $20,000 or $334 per month ($167 per paycheck). Much better! See how that works?

Step 4 – Determine the amount of expense to be included in the Irregular bucket

Add up all of your irregular expenses and divide by 12. For example, if your life insurance costs $400 per year, you spend $50 for birthday presents every year for your mom, dad and 2 nephews ($200), 3 oil changes per year ($100), furnace and air conditioning service ($250), and car registration ($100) all comes to $1050. $87.50 per month

Step 5 – Add up the first 3 buckets (Goals/Savings, Regular, Irregular). This amount gets deposited into your primary checking account. Have the rest (Discretionary) go directly into another checking account via a payroll deduction, or move an amount from your primary checking to a discretionary checking every month. Get yourself a debit card to process expenses against the discretionary checking account, and pay all of your other expenses via check or online from the primary checking account. If you have left over monies in your discretionary account at the end of the month, do what you want with it. You can spend it, add it towards one of your goals, or put it in your primary checking to create a bigger buffer in case one of those Irregular expenses is larger than anticipated.

Optional Steps

Components of your Savings/Goal bucket may be better served in different accounts, in which case you’d distribute those monies from your primary checking each month to those accounts. For example, a Roth IRA account for after-tax contributions towards a retirement goal, or a money market account to house your emergency fund. And of course if paying down your credit card is one of these goals, a check to the credit card company every month.

With a little bit of planning, you can set up a budgeting process that is easy to maintain and helps you to reach your financial peak.