Your Guide To Navigating Your Paycheck: How To Think About Allocating Your Money

October 3rd, 2024 by Blake Pinyan

After understanding how taxes and employee benefit deductions impact your paycheck, you’re ready to take the next step: thoughtfully allocating your money.

In this article, we’ll explore how you can allocate your paycheck to achieve multiple objectives. Specific topics include:

• Establishing your spending and savings plan
• Defining your financial goals
• Understanding your individual financial situation

Establishing Your Spending and Savings Plan

A spending plan (or budget) is essential for understanding your unique financial situation. Many people avoid creating or following a budget due to time constraints or fear of seeing where their money goes. Tracking your purchases is a healthy financial practice. It helps ensure you get value from your spending and avoid unnecessary expenses. Regularly reviewing your transactions also helps prevent fraud by allowing you to verify charges and identify suspicious activity on your bank accounts or credit cards.

The goal of your spending plan is to achieve positive cash flow, earning more than you spend each month. This allows you to increase your savings over time and avoid devastating financial emergencies.

In this section, we’ll discuss the following aspects of your spending plan:

• Creation methods
• Key components
• Tracking

Creation Methods

There are several ways to create a spending plan, and the method for you depends on your desired level of involvement, comfort with technology, and time constraints. Here are three primary options:

Method 1: Handwritten

The most time-consuming method involves manually reviewing your bank statements or checkbook each month and recording your expenses and income. While this approach provides a detailed understanding of your spending habits, it can be time-consuming and labor-intensive.

Method 2: Excel or Word Document

Using Excel or Word documents is a slightly more advanced option. Excel offers quick calculations and pre-built budget templates, but it still requires manual data entry. This can be time-consuming, especially if you don’t have a categorized report. Although this method can help you understand your spending, it may not be worth the effort.

Method 3: Budgeting Tool (Recommended)

A budgeting tool is the least time-consuming option. These tools automatically categorize, summarize, and track your spending, making it easier to stay on top of your finances. I recommend this approach to my clients because it increases the likelihood of consistent use. While budgeting tools typically have a subscription fee, they are generally affordable and accessible to most people. There are multiple companies that offer this service and charge in the range of $5-$10 a month. Monarch Money is typically where I send my clients that are looking to get a system in place. You Need A Budget is also a great tool. For those that are savvier with spreadsheets, Tiller is more granular and detailed.

Primary Components

When creating a spending plan, it’s essential to recognize the four primary components:

• Net Paycheck
• Fixed Expenses
• Variable Expenses
• Savings

Net Paycheck

As discussed in my previous article, your net paycheck is the amount remaining after taxes and employee benefit deductions are subtracted. When building your spending plan, it’s easiest to use your net paycheck as your income source. This is straightforward for those with a fixed annual salary, as your paycheck remains consistent. For those with variable income, such as commissions or hourly wages, you can use an average based on your previous paychecks.

For spending plan purposes, it’s best to focus on steady, predictable income sources like paychecks or rental income. One-time payouts, dividends, and interest payments are less predictable and may be more difficult to project.

Fixed Expenses

After entering your income, you’ll need to allocate your expenses. While budget tools may not categorize expenses as fixed or variable, understanding the difference is helpful. Fixed expenses remain relatively constant throughout the year, while variable expenses can fluctuate.

Examples of fixed expenses include:

• Mortgage or rent
• Insurance premiums
• Subscriptions or memberships
• Cell phone or internet
• Debt payments

Fixed expenses are easy to track and should be straightforward to include in your spending plan. When determining your spending plan, it’s helpful to understand which expenses you can control and which you cannot.

Some fixed expenses, like subscriptions, can be controlled and evaluated based on your needs and preferences. However, other fixed expenses, such as mortgages, debt payments, and insurance costs, are necessary and may have limited flexibility.

When establishing your spending plan, prioritize necessary fixed expenses before allocating resources to less essential expenses.

Variable Expenses

As the name suggests, variable expenses fluctuate in amount and are less consistent than fixed expenses. These expenses are often based on consumption, reflecting your spending habits.

Examples of variable expenses include:

• Groceries or dining out
• Clothing or accessories
• Entertainment
• Utilities
• Gas
• Travel

Variable expenses are more difficult to project in a spending plan due to their fluctuating nature and cyclicality. Some months your variable expenses may spike (e.g., Christmas gifts or travel), while others may decline (e.g., winter months when you stay home). To estimate these irregular expenses, you can average your past spending.

Variable expenses are often referred to as discretionary expenses, as they are triggered by your voluntary choices. You have the ability to control the level of your spending and ensure it aligns with your available resources.

Similar to fixed expenses, some variable expenses can be controlled, while others cannot. Additionally, some are necessary for survival, while others are less essential.

Examples of controllable variable expenses include:

• Groceries
• Dining out
• Travel
• Entertainment
• Clothing

For groceries, you can control where you shop and what you buy, although prices may fluctuate. You can also control how much you eat out, how much you travel, your entertainment choices, and your wardrobe updates.

Whether controllable variable expenses are necessary depends on your available resources and personal values. I don’t advocate for eliminating all discretionary expenses, but I encourage you to evaluate whether they bring you joy and are worth the cost.

Variable expenses you might not have control include:

• Gas
• Utilities

Gas and auto-related costs depend on your driving habits (i.e. commuting to work or school and other errands), while utility costs are influenced by your usage. While you can be mindful of your consumption, your control is limited, as many people commute and need basic utilities.

When establishing your spending plan, prioritize necessary variable expenses over less essential ones.

Saving

In addition to expenses, it’s important to prioritize saving. While many employees participate in retirement accounts, these shouldn’t be the only savings vehicles. Consider dedicating a portion of your paycheck to other savings avenues beyond your 401(k) or workplace retirement plan.

Examples of savings (outside your employer provided retirement account) include:

• High-Yield Savings Account
• Roth IRA (if eligible)
• Brokerage Account
• 529 Plan

When advising clients, I often recommend a fixed savings plan. A long-term systematic fixed savings plan is an effective way to build wealth over time. This involves contributing a specific amount of money to a savings vehicle at predetermined intervals, such as $500 per month to your Roth IRA.

I prefer fixed savings because it can be automated, reducing the need for manual effort. Many employers allow you to set up direct deposit to automatically transfer funds to your chosen savings accounts. This out-of-sight, out-of-mind approach allows your savings to grow while you adjust to living on the remaining income. For example, if you receive a $3,000 paycheck and can afford to contribute $500 monthly to your Roth IRA, you can designate $2,750 for your checking account and $250 for your Roth IRA. The maximum contribution to a Roth IRA for tax year 2024 is $7,000 for those under the age of 50 and $8,000 for those age 50 or older as they are entitled to a $1,000 catch-up contribution.

The amount you should save and where to save depends on your individual financial situation and goals. As far as savings guidelines, contributing 10-15% of your salary to your employer provided retirement plan (401(k), etc.) is generally known as financially prudent. The maximum contribution to a 401(k) plan for 2024 is $23,000 for those under the age of 50. Those that are age 50 or older are entitled to a $7,500 catch-up, for a maximum contribution of $30,500.

A rule of thumb for your emergency fund is 3-6 months’ worth of your average expenses. As a result, if you spend about $4,000 a month, you could think of your emergency fund goal to be at least $12,000. From a savings standpoint, you can calculate how much you need to save each paycheck to meet your emergency fund goal (if you haven’t achieved it already). Your savings strategy should align with your current financial circumstances and future aspirations. A financial planner can help you develop a personalized savings plan.

Remember, saving should be balanced with spending. It’s essential to invest for your future while also enjoying your hard-earned money and spending on things that bring you joy.

Tracking

The frequency of tracking your spending plan depends on the method you use. Spreadsheet or manual tracking methods may require monthly reviews, while budgeting tools often provide real-time data. Regardless, we recommend reviewing your spending plan at least once a month. This can be done at the beginning of each month to assess the previous month’s income and expenses.

Reviewing your income and expenses each month helps you understand where your money is going and whether you’re over or under budget. While occasional overspending is acceptable, the goal is to spend less than you earn.

Your fixed expenses and savings determine how much you can spend on variable (discretionary) expenses. The formula is simple: Income – Fixed Expenses – Savings – Discretionary Expenses = Remaining Money. You can track this by comparing your checking account balance at the beginning and end of each month. A decrease indicates you spent more than you earned, while an increase means you spent less.

For those living within their means, their bank accounts should grow each month. Once you have sufficient funds in your checking account, consider transferring some money to savings for interest.

Budgeting tools effectively track your monthly cash flow. In addition to monthly reviews, a year-end review is beneficial. At the beginning of the new year, review your previous year’s income and expenses to assess your annual cash flow. Remember to subtract your savings, as it’s an investment, not an expense.

Defining Your Financial Goals

Once you’ve established your spending plan, the next step is to define your financial goals. Financial goals are typically significant expenses that you plan and save for, aiming to achieve them in the future.

Examples of financial goals include:

• Retirement
• House
• Car
• Family
• College
• Charitable Giving
• Home Repairs/Remodeling
• Legacy
• Family Support
• Wedding
• Travel

Financial goals vary based on individual circumstances, financial situations, and life stages. For example, younger professionals may prioritize buying a house, starting a family, getting married, and saving for their children’s college education. In contrast, those nearing retirement may focus on retirement itself, leaving a legacy, and supporting family members. However, some goals, such as traveling, buying a car, or giving to charity, can apply to all life stages.

When you’re ready to take action on your financial goals, follow this four-step process:

1. Identify the goal
2. Construct a timeline
3. Estimate a cost
4. Determine the savings plan

Step 1: Identify the goal

Begin by identifying the financial goals you want to achieve. We recommend focusing on at least two goals that you can commit to saving for. Retirement is a common goal, often achieved through your employer-sponsored retirement plan. Think about additional goals that you’re willing to devote money to.

Step 2: Construct a timeline

Set a timeline for achieving your goals. A specific target date can motivate you to stay on track and accountable. While the timeframe doesn’t need to be exact, aiming for a particular year can be helpful.

Step 3: Estimate a cost

Estimate the cost of your goals. Some goals have more predictable costs than others. For goals like buying a home or car, consider the down payment as the cost. Research can help you estimate costs more accurately.

Step 4: Determine the savings plan

Calculate the savings needed to achieve your goals within your desired timeframe.

Example:

For a $24,000 new car goal over two years with bi-monthly paychecks (24 times a year), you’d need to save $500 per paycheck ($500 x 24 x 2).

While this example doesn’t account for interest or market fluctuations, it demonstrates the calculation process.

When working towards financial goals, it’s important to consistently allocate money to them based on the goal, timeline, and estimated cost. This systematic approach increases your chances of achieving your goals.

Knowing Your Individual Financial Situation

When allocating your resources, it’s crucial to fully understand your unique financial situation. Your resources should align with your current financial position, not with your peers’ circumstances.

Many people fall into the trap of “keeping up with the Joneses,” a common phrase that highlights our desire to spend money on new, expensive items, technology, and experiences. If your neighbor shows off a nice car, you may feel pressured to do the same, even if you can’t afford it. Remember, just because others flaunt their wealth doesn’t mean you need to follow suit. Your spending decisions should align with your own values and available resources.

The desire to avoid disappointing friends or appearing less wealthy can lead some people to spend beyond their means. While this can be uncomfortable, it’s essential to resist the temptation to spend to appear wealthy if you don’t have the financial resources.

If a purchase scares you or you doubt your ability to afford it, it’s likely not a prudent financial choice. Your individual financial situation will determine what you can reasonably spend on. Avoid the trap of trying to keep up with others.

Conclusion

When managing your paycheck and allocating your money, prioritize wise decision-making. Establish a spending and savings plan, define your financial goals, and understand your individual financial situation.

Employees should allocate their money thoughtfully, considering their current resources, anticipated earnings, known expenses, defined savings, and financial goals. Avoid the temptation to keep up with the Joneses and pay attention to your expenses. By developing a systematic savings plan, you can improve your financial condition and achieve your goals.

At Anchor Bay, we guide our clients in thoughtfully allocating their resources. You’ve worked hard for your money; now is the time to spend, save, or give it away wisely.