Understanding your cash-flow is the foundation of a successful financial plan. If you don’t understand what your lifestyle costs, or what you are spending to support yourself, you certainly cannot plan effectively for your retirement—or any other financial goals.
Use the ten steps below to create a budget that accurately reflects your spending. Once you’ve created a budget, you will be able to evaluate your cash-flow situation and understand if you need to reduce your spending or if you have excess cash flow available to allocate or redirect to your financial goals.
Step 1: Find or create a budget worksheet.
You need a way to capture all your spending categories on a monthly and an annual basis. You can create one using a word processing software—many of my clients use Excel, or you can find a template available from a trusted source. We have one available on our website.
However you create or obtain a worksheet, be sure to adapt it to your spending by adding or subtracting spending categories that match your lifestyle.
Step 2: Capture all your gross income.
Before we begin listing the expenses associated with your lifestyle, we must first evaluate your gross income. Gross income encompasses all the income received before you pay any taxes. It includes: W-2/salary/bonus income, 1099/consulting income, rental income, investment income, and possibly a portion of Social Security (this depends on your total household income). If you receive gift or trust income on a regular basis, I would recommend counting that income as well.
Step 3: Account for taxes.
We next need to account for your taxes. It is important we build a budget based on your income after taxes—otherwise known as net income. You do not want to be spending Uncle Sam’s money for your lifestyle and come up short at tax time.
If you are a wage/W-2 employee, then you likely have your taxes taken out monthly based on your withholdings. If you end up owing the government a lot more every April even after your withholdings, be sure to factor that amount into your net income—and consider adjusting your withholdings so you are not surprised when you file every year.
Having other sources of income, such as rental or investment, may require you to review your previous tax returns and estimate how much of that income was paid in taxes. Once you’ve determined your total tax liability for your income, deduct it from your gross income. This will give you the annual net income you have each year coming into your household. From there, divide by 12, giving you the monthly net income available to put towards your lifestyle.
Step 4: Account for lifestyle expenses.
Lifestyle expenses are anything it costs to maintain your life, with the exception of medical and savings (those will be discussed in later steps). It includes categories such as: housing, transportation, food, pets, utilities, etc. If you are creating your own budget from scratch, we recommend reviewing a budget template, ours or another source, and using the categories listed as ways to jog your memory of all the various spending categories you may need to include.
Note, do not forget to include things such as household services (gardeners, housekeeping, etc.), any entertainment subscriptions such as Netflix and Prime, and your travel/vacation spending. We recommend reviewing your credit and debit card statements to make sure you capture everything.
Step 5: Account for your medical costs.
Within this category, we include any medical costs such as insurance premiums for medical, dental, vision, etc. We also want you to look at your out-of-pocket expenses such as co-pays, regular purchases of over-the-counter medicine, or other things not covered by your insurance plan.
If you are obtaining medical through work you may be paying a portion of your health insurance premium; check your pay stub and determine how much out-of-pocket you are paying. Note, some of the premiums may be pre-tax (deducted before you pay taxes on your income) and some may be after tax depending on the coverage and type of insurance. So make sure if you’ve already subtracted your medical costs deducted on a pre-tax basis from your pay stub to determine your net income in step 2, don’t double count the deductions in this step. For those of you with private insurance, be sure to account for the monthly premium you pay for your plan.
Note, for those contributing to a Health Savings Account or a Flex-Spending Account, these contributions will be captured in Step 8, when we inventory your savings.
Step 6: Factor in any other insurance benefits you pay for through work or privately.
In addition to medical insurance, you may be paying for other types of insurance such as life, long-term care, or disability insurance. Some employers also offer legal insurance and accidental insurance. Be sure you factor in any costs associated with these premium payments. If you have any of these benefits through work, check your pay stub and determine what you are paying each month towards these benefits. If you have any of these types of coverage privately, be sure to factor in your monthly premium payments.
As with medical insurance, if you already accounted for the insurance benefits deducted from your pay stub to derive your net income, do not double count these premium payments in your budget.
Step 7: Evaluate what your debt is costing you each month.
Any debt you are paying on needs to be included in your budget. Common types of debt in this category include: student loans, consumer/credit card debt, personal loans, IRS debt, etc.
Note, if you are paying for your expenses through a credit card that you pay off each month, do not double count this payment and the lifestyle expenses you have already listed. Only include any debt payments that are above and beyond the lifestyle expenses you have already captured. Another category be sure not to double count is your mortgage. If you have already accounted for your mortgage in your housing expenses category, do not count your mortgage as an expense in your debt category.
Step 8: Plan for your monthly savings (including retirement).
This is my personal favorite category, as this is where we are planning for your financial future. Within your budget, you want to include any amounts you are already contributing to your financial goals. For those of you contributing to a work retirement plan, such as a 401(k) or 403(b), be sure to account for the monthly amount you are contributing from your pay. (Do not double count if you have already deducted these contributions from your gross pay to determine your net income.) If you are contributing to any other retirement plans like a Roth or traditional IRA, factor in that amount.
Some people also contribute to a brokerage or investment account on a monthly basis, or to their liquid savings account. Be sure to include any and all savings in this section. Note, as mentioned above, if you are contributing to a Health Savings Account or a Flex Spending Account, your contribution amount would go within this category as well.
Step 9: Evaluate your budget.
Hopefully you have accurately captured all the expenses, debt, and savings associated with your lifestyle. Before moving onto the last step and beginning to plan for your financial future, you will want to evaluate how accurate your budget truly is.
If you know each month you are living paycheck-to-paycheck, or stacking up debt, but this exercise indicated you have a lot of “excess” monies each month, then you need to go back through your budget categories and reevaluate your spending—you may have underestimated your spending or missed some expenses. For anyone overwhelmed with getting on track, we offer budgeting services if you want to some help on how to get on track.
If upon review, however, this budget accurately reflects your financial choices and your lifestyle, then you are ready to move on to step 10!
Step 10: You’re ready to plan your next steps in your financial plan.
No matter what the outcome of this exercise—you are ready to take this information and use it to help you move forward in the next steps of your financial plan. We offer financial planning services if you want some advice or assistance in achieving your next financial goal.
Wherever you are in your journey, I hope you found this helpful, and I wish you many happy market returns.