Budgeting Rules of Thumb

When trying to set a budget and economize, one is limited by one's future earnings. If expenses continually exceed earnings, one has to borrow money to pay expenses. Eventually, one reaches a point when it becomes impossible to eliminate debt, which may lead to bankruptcy. A few rules of thumb can be used as guidelines in cash-flow management to help formulate your goals and priorities.

Taxes

Taxes should be avoided. However, evading taxes is illegal. Doing so can ruin your budget and really mess up your goals when you are caught. So let's plan to pay taxes, yet strive to pay the least amount allowable by law. This means taking advantage of all the legal opportunities available to reduce taxes, such as participation in employer-sponsored retirement and benefits plans, as well as funding your own individual retirement accounts (IRAs). Federal and state income taxes, Social Security, and Medicare taxes generally will reduce your gross earnings from work by 25–35%. Since these taxes are deducted before you get a paycheck, plan your budget on the net amount. That is, if you earn $50,000 per year, don't plan to spend more than about $32,000.

Guideline Expenses

Demographic studies show that persons of similar ages, family size, and earnings tend to spend similar amounts on annual living expenses, but different amounts compared to different age/income/family size groups. While these percentages of income per category are somewhat different for each group, here are broad guidelines based upon gross family income before taxes:

In setting your own goals and priorities, if any of your planned (or actual) expenses exceed these guidelines, then perhaps that is an area you need to reconsider.

Inflation

The prices of goods and services tend to increase over time. This is called inflation. While it is quite impossible to predict future inflation rates, historically they have ranged between 0% and 10% per year in the United States. Under current US fiscal policy, the Federal Reserve is trying to manage inflation between 2% and 4% per year. To predict the future costs of goods and services due to inflation, the Rule of 72 might be helpful.

Rule of 72

The Rule of 72 can tell us how long it will take for the price of something to double, if we know the rate of inflation. Dividing 72 by the inflation rate equals the number of years it will take for the cost to double. You must use a whole number as the rate, rather than a decimal or percentage. That means that if inflation is 3%, use 3, not 0.03. For example, if you want to know how long it will take for the price of bread to double at 3% inflation, you will proceed as follows: 72/3 = 24 years. Those of you who passed algebra also see that this formula is useful in determining what rate of return is required, in order for an investment to double in a fixed number of years. Using a hypothetical example, in order for an investment to double in 12 years, the investment return must be 6% (72/12 years = 6% return). And the rest of you thought algebra was a waste of time! You can see that using the Rule of 72 allows you to predict future costs, income, and savings without using a fancy financial calculator or computer. But remember, it is only a rough estimate.

A tool individuals, companies, and governments use to plan earnings and expenses for a period. A personal budget lists income and expenses such as housing, food, clothes, and entertainment. A balanced budget also includes saving a portion of income. To budget is to create a plan for funds, time, or other items.

The net income of a business, investment, or individual over a specific period, such as a quarter-year.

The medium of exchange used in trade or commerce.

A liability in the form of a bond, loan agreement, or mortgage, owed to someone else with the promise of repayment by a certain date, which is the debt's maturity.

The result of a court decision to excuse some or all of the debts of an insolvent person or corporation. Bankrupt corporations usually go out of business. Bankrupt people usually have a hard time getting credit later, and may lose property, which a judge orders sold to repay as much debt as possible.

A stream of revenues and expenses over time.

A payment to federal, state, and/or local governments based on the sales price of a product, on worker income, or on other property and activities.

Termination of employment due to age, choice, or physical limitation. Certain benefits, such as Social Security payments, are available to those who retire. In finance, retirement is the paying of a debt when or before it is due.

The amount to be paid to an insurance policyholder or a beneficiary at retirement, death, or at the end of a period of insurance or other coverage. In retirement planning, benefits are the amount to be paid upon retirement.

A retirement plan created by the US government to encourage people to save for their own retirement. Benefits include tax-deferred growth and, depending on the type of IRA, tax deductibility or tax-free withdrawal. There are several qualifications and limitations as to who may contribute and when withdrawals may be made.

A tax on the money one makes from labor and/or investments. Income taxes collected by the state and federal governments pay for public programs, defense, and entitlement programs.

A program of the federal government that provides workers and their dependents with retirement, disability, and other payments. The money for Social Security payments comes from a tax, usually labeled FICA on one's paycheck, that employees and employers pay equally.

The federal government's hospital insurance plan, which pays for certain health care expenses for people age 65 and older. The Social Security Administration manages Medicare.

Total sales or income, before deductions are made.

The monetary return on one's labor or investments. Income may be wages, salaries, bonuses, dividends, or interest.

A rise in the general price level of goods and services; inflation is the opposite of deflation. The Consumer Price Index and the Producer Price Index are the most common measures of inflation. As a probable result of inflation, labor asks for higher wages to buy more, prices rise to meet those wages, and inflation becomes a cycle.

Government measures used to stabilize the economy through taxation and spending.

The central banking system of the United States. Created by the Federal Reserve Act of 1913, it establishes the federal discount rate and the Prime Rate, supervises the national banking system, creates monetary policy, loans money, and buys and sells government securities to regulate the money supply. The Federal Reserve System (the Fed) is made of twelve regional banks and is overseen by the Federal Reserve Board.

What one must pay for materials, services, and other necessities to operate a business, organization, or household.

A shortcut for estimating how long it will take to double money at a certain interest rate. To use the rule, divide 72 by the interest rate. The answer is the number of years it will take for any amount of money to double. For example, if money in savings earned 3% interest, then you would need 24 (72/3) years to double it. You also can use the Rule of 72 to estimate the interest rate needed to double your money in a certain number of years. For example, if you want your money in savings to double in 9 years, then you will need to earn 8% (72/9) interest on it.

The earnings on securities or other investments, whether they are dividends or interest, realization of profits or receipts, income, or some other source.

The purchase of a potentially appreciable asset such as a stock, a bond, a property, or a unit of production. The purchase provides funds for the growth of businesses and governments.