A New Way to Look at Income Allocation (and Your Savings)

new way to look at income allocation and savings

I’ve recently talked about how, as a financial advisor, I’m often approached with the question,

How much do I need to be saving for my future goals?

Putting a dollar amount on something set for the future is no easy task, so I’m never surprised when I get asked this question. We all have a list of objective things we want to save for (retirement, a home, cars, even a tank of gas), but understanding the amount we need for each of these goals isn’t always so straightforward.

The breakdown I give my clients is fairly simple: I give them a specific ratio for income allocation. But in order to structure that income allocation, I introduce a term that most of my clients have never heard before: “achieving expenses.”

What Are Achieving Expenses?

I started working with the term “achieving expenses” to use in contrast with “living expenses” to simplify everyone’s overall financial picture. By understanding what these two types of expenses are, it becomes easier to categorize various financial wants and needs. Here’s a breakdown:

Living expenses are the lifestyle expenses that recur throughout life. Typical examples of living expenses are monthly bills, food, entertainment, housing, and transportation. Some of these expenses are paid monthly, some a few times a year, and some once every few years. What they have in common is that they come around again and again.

Achieving expenses are financial goals – expenses tied to achieving single events that don’t usually repeat throughout life. Typical examples of achieving expenses are paying off debt, paying for college, paying for a wedding, buying a home, and saving for retirement. What they have in common is that they’re usually only paid for once.

The one thing that living expenses and achieving expenses have in common is that they both can include wants and needs. The basic difference between the two is whether they’re recurring or not. In other words, one (living expenses) is a category that you’ll have to allocate income to for the rest of your life, whereas the other (achieving expenses) will only require temporary income allocation.

Calculating Your Income Allocation Ratio

When it comes to understanding how much you need to save for the future, the most important thing is that you just start somewhere. While we all want to nail our financial plans, it simply doesn’t work that way. We’ll always find ways we can improve on our plans or improve on our execution thereof. Getting started is the surest way to make progress – learning along the way and iterating as necessary is how you can maintain that progress.

If you’re looking for guidance on how to get started, try this ratio:

Allocate 80% of your income to living expenses and 20% of your income to achieving expenses.

When you reserve 20% of your income for achieving expenses rather than spending 100% of your income on living expenses, you’re effectively living below your means. This is a great place to be financially as it sets you up for success. If you want to make it easier to maintain this ratio, practice paying yourself first. You can do that by putting the 20% of your income for achieving expenses into a savings account as soon as you receive the income (whenever you get paid). This will ensure that you really do put that 20% aside for achieving expenses, rather than inadvertently using it for other things throughout the month.

Following this ratio can get difficult when you actively need 100% of your income to cover your living expenses. If this is the case, then you may need to run the numbers on your spending plan a few times to see if you can make any changes, such as cutting or reducing certain costs or frequency of those costs. The next step, if there still isn’t any wiggle room, is to consider ways you can earn extra income and make the whole pie that you’re working with larger.

Remember that all of this requires trial and error. Until you get to the 80/20 ratio, simply put any surplus you have (money not spent on living expenses) towards achieving expenses. Once you have a predictable amount of surplus, pay yourself first by putting that away at the beginning of the month or pay period.

There are so many great things you can do with your surplus, or add to your achieving expenses, such as making additional debt payments, putting aside money for a down payment on a home, boosting your retirement savings, rebuilding an emergency fund, and so on. As you start to line up your goals and have a predictable amount of savings going into your achieving expenses category, it will get easier to understand how long it will take you to achieve these goals.

Diving Deep Into the Details

Once you’ve gotten started and feel comfortable with this ratio, you can start to dive deep into the details. Since financial planning always takes some level of trial and error, you’re going to learn a lot as soon as you start moving forward. In terms of income allocation, what you’ll probably learn is that there may be some further attention needed on your categories.

For example, you can divide your two major categories (living expenses and achieving expenses) into these two subcategories: typical expenses and atypical expenses. If you examine atypical expenses first, you may find it easier to allocate your income for typical expenses because you’ve already taken care of the exceptions.

One of the most difficult things about financial planning is that most of us have a larger amount of unexpected expenses than we realize. But when we break down all of our expenses and start looking at the frequency of what goes under typical and atypical, we often find that our atypical expenses are, in fact, typical. When you figure out which expenses this is happening with, you’ve unlocked the key to your most effective financial planning.

Finally, you can make your life a lot easier when you look at your frequent (monthly) and infrequent (quarterly, annually, and so on) expenses. We are already programmed to plot out funds for our frequent expenses because we have to pay them every month – but the infrequent can take us by surprise. You can prevent that from happening to you by calculating how much you would have to spend per month if you were billed monthly on these infrequent expenses, and then putting that amount of money aside until the bill is actually due. For infrequent expenses that are less predictable, you can make estimates and put them into a broader category, thus pooling the risk of underestimating on some expenses and overestimating on others.

Remember: It’s All Trial and Error

The goal of this planning isn’t to predict the future of all your expenses – it’s to decide how much of your income can’t be spent on other things so it’ll be there when future expenses occur.

You won’t nail it right away because you never really “nail it” – none of us do. It has to be a trial and error process. But if you can get yourself close, you will minimize the impact irregular expenses can have on the rest of your finances. The instructions for this spending plan worksheet has tips for estimating some of the trickier and least typical expenses.

Need extra help? Reach out to a financial planner! Financial planners can help you create a spending plan that makes sense for your life specifically. And, if you choose a fee-only planner, you can get advice without having to worry about being sold unnecessary financial products.

Author: Dylan

Dylan Ross, CFP®, AFC®, is the Director of Communications and Financial Planning for the Garrett Planning Network. He became a financial advisor in 2000 and has been writing about personal finance since 2005. Follow him on Twitter @SemperFrugalis.