Can I afford to buy a new car this year? How much can I afford to put into my 401(k) each month? In order to answer these questions, every person or family needs to have an annual budget so that they can estimate what their basic living expenses will be, how much they can save for retirement, and how much they have for discretionary spending. Every company and every hospital does this when creating its annual budget for the next fiscal year. But we are often less diligent about making our personal budgets than we are making our hospital or corporate budgets. In theory, making a budget for yourself sounds easy – just estimate how much income you anticipate and how much expenses you anticipate. But budgeting is deceptively difficult and you can be misled depending on what sources you use for income and expense calculations. Here is an accurate way to create your annual budget.
Where to start: total income
The first step is to estimate your income for the upcoming year. If all of your income comes from your wages from your employer, then this is simple – just look at last year’s income and add in the amount of any raises or bonuses you expect next year. However, most people also have additional income from dividends, capital gains, and interest from investments. Or maybe a side gig from consulting, speaking honoraria, or rental income. These extra sources of income are often variable from year to year and it can be difficult to predict what the amount of these other income sources will be next year. So, you will need to gather data from multiple sources:
- Final annual payslip. This will have your total gross pay which is the amount that you earned from salary and bonuses last year before any tax deductibles are subtracted out. Gross pay is what you want to use when preparing your budget. Your final payslip will also show the amount you paid for employer-sponsored health insurance, 401k/403b/457 contributions, pension contributions, etc.
- 1099 forms. These will contain additional income from consulting (or other outside employment), dividends, interest, and capital gains.
- Records from other income. This can include cash payments you receive for gig work, income from rental property, etc. These will often be reported on Schedule C of your federal income tax returns so the Schedule C form from last year can serve as a useful source for this information.
- W-2 forms. The income reported on various lines on your W-2 forms will be adjusted for tax deductions, such as employer-sponsored health insurance premiums, 401k/403b/457 pre-tax contributions, etc.
- IRS 1040 forms. The various entries on the 1040 form come from your W-2 forms and will have similar adjustments with the result that your income on the 1040 form will be less than the final gross pay that appears on your final annual payslip.
By adding up all of the income from all of these various sources, you can determine what your total gross income was last year.
Where to start: total expenses
Most of us do not do a very good job of tracking where all of our money goes each year. Some expenses are taken out pre-tax by our employer and we never even see that money. We pay for stuff with checks, credit cards, and cash. Families may have multiple checking accounts and several different credit cards.
I recommend staring with your checking account. The reason for that is that most people use their checking account as the central hub of their personal finances. We usually deposit our monthly paychecks as well as other income from consulting etc. into our checking accounts. We also draw from those checking accounts for paying expenses directly (by writing checks), taking cash from ATMs, and paying off our monthly credit card balances. Your monthly credit card statement will list your total deposits and total withdrawals as well as the details for each specific transaction.
- Add up all of your monthly checking total withdrawals. Do this for each checking account that you and your spouse have.
- Subtract out any expenses that you pay but that you later get reimbursed for. For example, work-related travel if you pay for your hotel and airfare but then get reimbursed for those expenses by your employer after the travel. You will need to go through all of your individual checking account withdrawals and credit card charges to find these expenses.
- Subtract out withdrawals from your checking account that were for transfers to your other checking accounts. This can happen if you have checking accounts at two different banks or if you move money to a spouse’s checking account.
- Transfers to children’s checking accounts are different and I recommend not subtracting out these withdrawals and instead including them as part of your basic living expenses in order to keep the budgeting process as simple as possible.
- Account for transfers to savings accounts and money market accounts. You should always keep a pre-determined amount of money in these accounts as your emergency fund. But many people also use these accounts for short-term savings, with the intention of spending money in these accounts in the next few months. In this situation, you need to determine if you pay expenses directly from those savings and money market accounts or whether you “park” money there temporarily and then transfer it back to your checking account to pay expenses. To avoid double counting, do not include transfers from checking to savings accounts or checking to money market accounts in your total expense withdrawal calculations. But do include any expenses you pay directly from savings or money market accounts in your total annual expense withdrawals.
By adding up all of these withdrawals, you will have the total amount that you spend each year from your take-home pay. It takes a moderate amount of time to go through all of your monthly checking account statements but they are generally available through your on-line banking account website so the process goes fairly quickly.
Categorize your expenses
This can get very complicated so I recommend just using very general, broad categories to make the process as simple as possible:
- Income taxes
- Retirement savings
- Non-retirement investments
- Education expenses
- Discretionary spending
- Basic living expenses
You will need to go to various sources to assemble all of the data you need to stratify expenses into these various categories. For income taxes, the easiest way to determine your total taxes from your federal, state, and local income tax forms from the previous year. Be sure that you have included both your regular federal income tax plus your Social Security/Medicare tax.
For the retirement savings category, start with your end-of-the-year payslip. This will contain information about your 401k/403b/457 contributions and pension plan contributions. Do not include any employer contributions to those plans, only your own contributions. Next, look at your checking accounts and credit card statements to pick out transfers into other retirement accounts such as an annual IRA contribution, SEP contribution, or backdoor Roth contribution.
For the non-retirement investment category, pick out any withdrawals from checking, savings, money market, or credit card accounts that went into purchasing stocks, bonds, mutual funds, certificates of deposit, etc. Alternatively, if all of your non-retirement investments go through an investment company (such as Vanguard, T. Rowe Price, or Fidelity), you can look up your annual investment purchases on your annual statement from the investment company.
For educational expenses, include money that you transferred into 529 college savings accounts and money paid directly from your checking accounts to schools for tuition, etc. If you use other accounts to save for your children’s college education (such as uniform gifts to minors accounts), then include these as well.
For insurance expenses, start with your end-of-the-year payslip for premiums you pay for employer-sponsored health, vision, dental, disability, and life insurance premiums. These will generally appear as pre-tax or tax-deductible expenses on your payslip. Once again, do not include any insurance that your employer pays for, only include your own contributions to insurance premiums. Add in payments from your checking, savings, or credit card accounts for other insurance premiums such as homeowner’s, car, life, and umbrella insurance.
Discretionary spending is more complex and depends on what you define as being discretionary vs. basic living expenses. It is better to over-simplify your definition of “discretionary” to avoid the expense accounting process from getting to onerous. I recommend only including “big ticket items”, like vacations and new car purchases, since those are fairly easy to track. Add in other high-cost but non-essential items such as new TVs, computers, appliance upgrades, season sports tickets, and elective home renovations. Many credit card companies and banks will have “money manager” apps on your on-line credit card and checking accounts that will automatically group credit card charges or checks into categories like travel, entertainment, etc. and you can alternatively use these apps to calculate discretionary spending.
Basic living expenses are everything that is left over. It can be argued that things like movie theater tickets, new clothes, and wine purchases are better characterized as discretionary expenses but for most of us, it would take hours and hours to group each of these small expenses as being either basic living or discretionary expenses. It is easier to put them in the basic living expense category but then realize that in a financial emergency, you could cut back somewhat on the amount that you have historically spent on basic living expenses. Because everyone should have an emergency fund of at least 3 (and preferably 6) months of basic living expenses, this number is useful to help guide you about the minimum amount of money that you should keep at all times in your combined checking, savings, and money market accounts. A lot of different types of expenses will be lumped into basic living expenses including housing, food, utilities, property tax, transportation, license fees, annual dues, and loan payments.
Putting the budget together
Once you have all of the financial information and have categorized your previous year’s expenses, you can plan for next year. Start with your projected income. For most people, this will be similar to their previous year’s income plus the amount of any raises that are expected in the coming year. If your income is similar to the previous year’s, then your taxes will also be similar, unless you are moving to a different city or state. The current federal income tax rates are set to increase after 2025 (unless there is congressional legislation to continue the current rates) so your budgeting for 2025 and beyond will need to take into account any changes in tax rates. For most people, insurance premiums will also be same or just slightly higher, unless they anticipate a change in marital status or change in spousal coverage by health insurance. Health insurance premiums are the biggest insurance expense and by January, you should know what your premiums will be for the upcoming year. For basic living expenses and discretionary spending, you should account for the effect of inflation. No one can predict with certainty what the inflation rate will be 12 months from now so a reasonable estimate can be made by using the rolling 12-month inflation rate from the previous month. So, for example, the 12-month inflation rate in December 2022 was 6.5%. Therefore, increase your expected 2023 basic living and discretionary spending amounts by 6.5%. Next, factor in any large expenses that you know will occur in the next 12 months, such as a wedding, a new car, or a down payment for a new house. Add these one-time expenses into next year’s discretionary expenses. Use last year’s values for retirement savings and for educational expenses as a starting point for next year’s budget.
At this point, you will have accounted for your anticipated income as well as most of your planned expenses for the upcoming year. If the difference between income and expenses is a positive number, great news! – you can afford to put additional money into investments, retirement savings, educational expenses, or discretionary spending. On the other hand, if this is a negative number, you will need to look hard at your discretionary spending or investment spending to see if there are expenses in those categories that you can cut out. Although you could also reduce contributions to retirement savings or educational savings, I would caution against this unless you are desperate since those expenses are really paying for your future annual income in the case of retirement savings, or for future unavoidable expenses in the case of education saving.
January is the best time to do your annual budget. By January, you should have your year-end payslip from the previous year and will have at least started preparing your income tax returns. Beginning in January 2023, there is a $2,000 increase in the annual contribution limits to 401k/403b/457 plans so January is a good time to increase the amount of your monthly contributions to those plans. Although you could wait until December to do one massive contribution to your 401k/403b/457 or to your child’s 529 account, it is better to spread those contributions out to take advantage of “dollar-cost averaging” and also to let those contributions start to grow in your retirement account or 529 account investments over the course of the upcoming year.
Everyone needs a budget
Many people with relatively high incomes (such as physicians), often neglect doing an annual budget, believing that their income is high enough that they won’t run out of money by the end of the year. In reality, everyone needs to create an annual budget and people with high-incomes can spend more than they earn as easily as those with lower incomes. It is particularly important to go through the budget process if you anticipate a major change in your life in the upcoming year – a new job, marriage, new child, etc. Creating a budget is somewhat a skill – the first year you do it, the budget process takes a moderate amount of effort. But each year, it gets progressively easier to create your annual budget as you get more experience with the process.
Once you have that budget, stick to it and use it as a roadmap for your monthly expenditures. This is the best way to be sure that you are able to pay off all of your credit cards every month, make all of your monthly loan payments, stick to your retirement contributions, and ensure your children’s college future. Your annual budget today is your insurance that you will be able to afford to retire when you want to retire.
We cannot predict the future national or global economy but we can control our own future personal economy. Controlling it starts with your annual budget.
January 29, 2023