Budgeting Part 2: Income and Expenses
With the basic budgeting techniques covered in Part 1, we will now cover your income and expenses in more depth. In this article, I'll cover some common questions about each high-level category and provide tips on navigating, finding, and budgeting for each side of the equation.
If you missed Part 1, check it out here: Budgeting Part 1: The Basics – Gilbert Wealth
Determining Your Income
This is the fun part – how much money you have coming in the door! Your income is the first step in developing a budget because it tells you how much you have to budget. Your income guides your savings rate, determines taxes, and how much insurance you should have. As a financial planner, understanding a client’s complete income picture is critical to recommending effective strategies.
Income can come from many sources:
- Wages
- Self-Employment
- Side gigs
- Commissions
- Real Estate
- Pension Income
- Social Security
- Annuity Income
- Investment Income
- IRA Distributions
- Trusts
- Gifts Received
Gross Income
Gross Income, sometimes called “Pre-Tax Income” or “Before Tax Income,” is all of your income before any deductions like taxes, savings, or insurance. It is your full stated salary, bonus, commissions, self-employment, rental income, investment income, and more. You might not see all of this income in your bank account, but it is money attributed to your financial situation and should be visible for the most complete financial picture.
Net Income
Net Income, sometimes called “Take Home Pay” or “After-Tax Income,” is just your Gross Income minus Taxes.
Where people get confused is “Take Home Pay” on your paystub often has other items already deducted, such as your retirement savings, health insurance, life insurance, disability insurance, and other benefits. If you are using a percentage budget, you’ll want to make sure to account for these categories.
It is also important not to ignore these categories simply because they are taken out of your paycheck. There are important decisions and alternatives that can be made surrounding your benefits and the cost of those benefits. Additionally, many people over withhold on their taxes, so they receive a nice fat tax refund. While it’s a nice feeling to get a refund, the reality is that it was your money, to begin with!
If you are self-employed, you will need to be more proactive in calculating your net income, as you are responsible for not only federal and state taxes but also the full load of SECA taxes.
Which is better? Gross or Net?
As a financial planner, I am most interested and prefer working off of your gross income as this tells me all of the resources you have available to you.
If your budget is off of Gross Income, you will have a complete picture of your finances as you will see how much of your income goes to taxes. If you budget off Net Income, you will only have to budget for taxes that are not already withheld, such as if you have to pay an estimated quarterly payment.
Where to find your income?
The easiest place to find all of your income is from your tax return and its supporting documentation. Forms like your W2s and 1099’s will show most people’s sources of revenue. The supplemental documents will also show rental income, farm income, and self-employment income, both in aggregate and taxable.
Some Finer Points on Income
Investment Income. Whether to include investment income in your budgeting depends on your goals for that income. If you are using it to continue to grow your investment portfolio, I wouldn’t include it in budgeting, but you should factor it in for taxes. However, if you intend to use these funds for spending, you should include them.
Taxable Income vs. Cash Flow Income. On a more technical note, one important concept is the difference between taxable income and cash flow income. Taxable income is any source of income that might increase your federal or state taxes, including wages, pension, taxable investment income, real estate income, IRA distributions, etc. Cash Flow Income is your total annual cash inflow which may or may not be taxable. For example, Social Security is at a maximum 85% taxable, which means at least 15% is tax-free. That 15% increases your cash flow but not your taxes.
Tax Refunds. Most people love to receive a refund rather than having to cut a check to Uncle Sam every year. But in reality, a refund is just getting your own money back without interest. Tax withholding aims to get as close to your actual tax liability as possible. To aid in calculating your tax liability, the IRS has an excellent tax withholding calculator that allows you to estimate and adjust your withholdings so that you do not receive an overly large refund or owe at year’s end.
Withholding Calculator: https://apps.irs.gov/app/tax-withholding-estimator
If you insist on receiving large refunds, this should be included in the budget, not counted as free money. Remember, it was your money to begin with. Uncle Sam just held it until you were able to claim it.
Bonuses. Bonuses should be included in your budget though they should be included conservatively as bonuses are not guaranteed, and it would be prudent not to pre-spend based on a bonus. Make plans, yes. Pre-spend, no.
Cost of Living Adjustments. Cost of Living Adjustments (COLA) represents regular pay increases that occur to keep up with inflation. If you are not receiving these, you should consider a performance review with your supervisor and discuss a regular raise to compensate for the loss of purchasing power. COLAs can also be accounted for when updating your budget from year to year. When projecting further out into the future, as I do with my clients, you will want to have a realistic estimate of COLA adjustments.
Promotions. Promotions can provide a significant boost to your income and your budget. When you receive a promotion, it would be wise to revisit your budget to adjust appropriately. In particular, you should consider a promotion’s impact on your savings rate.
Income is as important if not more important than Expenses!
Often budgeting conversations are focused entirely on the expense side of the equation. However, your income is arguably the more critical side. After all, budgeting doesn’t do anything for you if you have no income or assets. Growing your income through your job, self-employment, or investments should also be a significant focus. The best way to create a Cash Flow Surplus is to get a raise, promotion, or land a new client because you now have more money to save and spend!
Yes, budgeting is a great way to allocate income and ensure you use it to its fullest. But you should also find ways to increase your value and income to give you even more resources to work with!
Determining Your Expenses
Now that your income is figured out, you can turn your attention to your expenses. Expenses reflect the way you live your life! It’s the food you eat, the place you live, and the vacations you take.
Expenses can be broken down into two broad categories: Essential (Needs) and Discretionary (Wants).
I covered these topics briefly in Part 1 as well: Budgeting Part 1
Essential Expenses (Your Needs)
Not all expenses are created equal and have the same level of importance in your well-being. Essential expenses represent those expenses that, if you aren’t able to cover, would have a significant impact on your lifestyle. Expenses that put food in your refrigerator, clothes on your back, and a roof over your head all fall in this category.
You can get as detailed or high level as you want with essential expenses. For example, your grocery budget, a necessary expense, might be $1,000 per month. But, if things got tough, you could adjust the grocery list and get that down to $600 per month, which means you could say groceries are $600 essential and $400 discretionary. Housing is another example of this. Your mortgage payment of $2,500 per month could be essential. But could you live in a cheaper house with only a $500 per month payment or none at all because you have enough equity in your current home? You get the point. How aggressive you want to get with this is up to you.
There are six categories of essential expenses: Housing, Basic Food, Health Care, Transporation, Child Care, and Other Obligations.
Housing Costs
- Keeping a roof over your head is an essential expense and many expenses can go into your housing costs. Housing expenses can vary significantly by the home’s value, size, age, and location.
If you own your home, there are several expenses to consider and budget for:
- Financing Costs: If you have a home loan (Mortgage, Home Equity Loan, Home Equity Line of Credit, etc.), you will want to include the payment into your budget. The main part of the payment consists of principal and interest but usually includes home insurance and property taxes in escrow. It is helpful to break these expenses out even if they are in escrow because the principal and interest payments will eventually end. In contrast, the insurance and property taxes will not.
- Homeowners Insurance: The premiums you pay to protect your home should be reviewed every few years as home values may increase above limits.
- Property Taxes: Property taxes often increase as the property value increases. Most properties have different exemptions or deductions on the assessed value for tax purposes.
- Utilities: Gas, Electric, Water, Sewer, and Trash all fall into this category. The trick with these utilities is that they ebb and flow based on the season. Your gas bill may be higher in the winter and your electric bill higher in the summer months. Many budgeting software programs offer the ability to plan for variable expenses like this, which is helpful in a tight cash flow budget.
- Condo or Home Association: Some homes have a fee to be part of the community that could be paid monthly or annually. You want to ensure you budget for this because not paying the fee could result in some angry neighbors and repercussions from the association.
- Minor Repairs and Maintenance: This category encompasses expenses like regular care for a lawn (mowing, mulching, tree cutting, etc.), routine maintenance for appliances such as annual checkups, replacing lightbulbs inspecting home components, and replacing a toilet seat. Generally, these are tasks you do yourself regularly. Specific characteristics of your home can increase the costs to maintain it, such as locations near large bodies of water, especially salt water. Additionally, adding house features such as a pool increases maintenance costs. It is important to make sure your budget reflects these adjustments.
- Major Repairs and Replacement: Major repairs and replacements are the categories that are harder to budget. Included in this category are replacing a roof or driveway, repair work on a foundation, replacing windows, or replacing your major appliances like your HVAC system or kitchen appliances. While it is hard to plan exactly when these might happen, it is important to regularly assess how soon these could occur through regular maintenance and begin to budget for them as they approach.
Homeowners’ Insurance and Property Taxes are commonly held in escrow, meaning they are part of your total mortgage payment. However, it is important to keep track of those expenses as they will continue after the mortgage is paid off.
If you rent your home, your expenses will be somewhat more straightforward as your rent payment will cover expenses to maintain, repair, and service financing costs.
- Rent Payment: An easy line item to include in your budget.
- Renters Insurance: You need to set up your own renter’s insurance to cover the loss of your things in the event of a fire or theft. The building insurance policy does not cover this.
- Utilities: Who covers the utilities and how depends on your rental agreement. Some landlords include some utilities in the rent, while others may have you pay those yourself.
- Other Fees: Renting incurs other costs such as parking and using facilities like a pool and laundry.
Basic Food
Everyone likes to eat, and it’s especially important to ensure you have your basic eating needs met. In most situations, regular grocery shopping will be more cost-effective than dining out. If your financial situation needed to be reduced, you could significantly reduce your food bills to just the essential items.
Groceries: Your entire grocery bill can encompass many expenses, from basic groceries like milk and eggs to home products, medical supplies, furnishings, alcohol, and even auto parts. However, it is essential to narrow this down to what is truly basic groceries. If you need a baseline, the USDA releases a food cost report for Low, Moderate, and Liberal food plans. USDA Food Plans: Cost of Food Reports (monthly reports) | Food and Nutrition Service
When dining out should be included? Dining out can be included in basic food if that is required for some reason. An example might be if you travel for work for long periods and regular grocery shopping is not possible, so you have to resort to eating out.
Health Care
Whether you are healthy or not, you will likely have some expenses related to health care. Understanding what you pay now and how that might change over time is important for any plan.
Health Insurance Premiums: Your medical premiums may be deducted directly from your paycheck, or you may pay them yourself. If you are on Medicare and claiming Social Security, your Part B, and Part D premiums are automatically deducted from your Social Security benefits.
Out-of-Pocket Expenses: Deductibles, Co-Pays, Co-Insurance, and any uncovered medical bills you may incur.
Prescription Drugs, Dental, & Vision: You may have these expenses included in your work benefits or have to cover them yourself.
Transportation Expenses
Whether you own a vehicle or use mass transportation, getting around is essential for work, connection, and getting food.
Auto Loan: Included in your budget for as long as you have your vehicle.
Auto Lease: Your lease payment should be included, but you should also consider what expenses might be incurred at the end of the lease.
Gas: Your gas bill is directly related to the fuel efficiency of your vehicle and how many miles you drive. Except for extensive road trips, this expense should be pretty stable.
Insurance: Directly related to the number of drivers, quality of drivers, and vehicle type. Good driving habits can reduce the cost of your insurance.
Other Travel Costs like Parking & Tolls: If you regularly commute and incur these costs, you should include these in your budget.
Maintenance: Regular auto maintenance like oil changes and tire rotations are needed to keep your vehicle in top shape, but you should also budget for more significant expenses like tire replacements or engine repairs based on the age of your car. Planning these can prevent an unexpected large cash outflow.
Mass Transit Costs: If you don’t own a vehicle but instead use mass transportation, include your monthly passes and extra expenses you might incur.
Child Care
If you have children, you are responsible for taking care of them. In addition to basic food, you may have to pay for child care so you can work.
Daycare Costs & Tuition: These costs should be included if they are required for you to work.
Other Obligations
Typically includes credit card payments, student loan payments, child support, alimony, and life insurance.
Credit Card Debt: Paying down credit card debt is one of the biggest priorities if you have it. It deserves this attention because credit card rates are so high that paying them off gives you one of the highest returns for your money. Not to mention the relief of not having the debt lingering. Building up credit card debt should never be an issue if you live within your means but just run expenses through your credit card.
Student Loan Payments: Student loan repayments can be based on various repayment options. It is important to review how these work and budget accordingly. If your repayment plan is tied to your income, you will want to project forward your payment structures based on future income, so you do not overcommit to other expenses as your income rises.
Child Support & Alimony: If these payments apply to you, they should be included in your budget for as long as they exist.
Life Insurance: Paying life insurance premiums are critical to keeping the policy in force and protecting your loved ones.
Discretionary Expenses (Your Wants or the Fun Stuff!)
Finally, the fun expenses! As mentioned previously, discretionary expenses are those you choose to spend above what is an essential expense. Sometimes, this is termed as lifestyle expenses as it generally covers what people do not just to survive but thrive!
Discretionary expenses are not the same for everyone. We all have unique passions and interests that show up in discretionary spending.
Common Items Include:
Any Eating or Drinking outside of your Residence Shopping Entertainment Travel & Vacations | The latest gadgets Fancier cars That new pool Golfing Hosting parties
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How to Plan for Unknown Costs
One of the most frustrating experiences with budgeting is when you’ve done a great job tracking each expense and staying within your budget for a month; you start to feel like you’ve got this, and then life gives you lemons. Except you can’t make lemonade because they’re rotten. The transmission in your car has gone out, which will cost $1,500 to fix. How can you make lemonade out of that?
Unfortunately, it is impossible to know when these types of expenses might arise. The most common unforeseen expense is medically related, but it could be because of your car, family, or home. Proper maintenance and insurance may help mitigate those costs but not usually all of the costs. How do you plan for it? Here are two methods:
- Add a budget category for “Unknown” or “Miscellaneous” expenses. While knowing what area of your life will have an unexpected expense is difficult, you can reasonably expect that there will be one from somewhere. So why not add it in?
- Don’t budget for 100% of your income. If you’ve budgeted down to the penny of your income and an unexpected expense arises, you have no margin of safety to absorb that. In this case, you must assess your categories and see where you can shift money to cover the expense. Hint – it shouldn’t be from the essential expenses.
One note: A Super Sale of electronics or clothes does not count as an unexpected expense. That goes in the shopping budget or whatever category you set up.
Saving for Retirement or Saving Short Term Goals
Savings or “Financial Goals” are not actual expenses but do reduce your cash flow today so you can have the freedom to spend in the future. The savings “budget” is based on your entire income. If you make a dual income, don’t make the mistake of leaving out an income, even if it is small.
For example, if Spouse 1 makes $60,000 and Spouse 2 makes $40,000, calculating your savings budget should be based on the combined $100,000 income.
Most of the budget schemes discussed previously do not include an employer’s contributions to the plan. Instead, this is your contribution to your future, regardless of how generous your employer is. There are arguments for and against this, but I tend to land on the be more conservative and save a little extra if you are in wealth-building mode.
Net Cash Flow
Once you have accounted for Income, Expenses, and Savings, you may have money left over in your budget, called a Cash Flow Surplus. A cash flow surplus is unaccounted-for money, and you shouldn’t have any if you are doing a zero-based budget.
As a planner, I like to see Cash Flow Surplus over Cash Flow Deficits. However, it is crucial to go the extra step and know what you do with that Surplus. Does it end up in your bank account just sitting there? Do you periodically invest above your regular savings? Or do you spend it on vacations, home projects, or stuff?
If you constantly find yourself spending this Surplus, you must be very careful of Lifestyle Creep. Lifestyle creep is where you become accustomed to a higher standard of living as your income rises but do not adequately adjust your savings to support this more expensive lifestyle. Often, it happens when those one-time splurges become regular annual splurges.