Budgeting Rules of Thumb

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Budgeting Rules of Thumb

When trying to set a budget and economize, one is limited by one’s future earnings. If expenses continually exceed earnings, one has to borrow money to pay expenses. Eventually, one reaches a point when it becomes impossible to eliminate debt, which may lead to bankruptcy. A few rules of thumb can be used as guidelines in cash-flow management to help formulate your goals and priorities.

Taxes

Many people would like to avoid taxes. However, evading taxes is illegal. Doing so can ruin your budget and really mess up your goals when you are caught. So let’s plan to pay taxes, yet strive to pay the least amount allowable by law. This means taking advantage of all the legal opportunities available to reduce taxes, such as participation in employer-sponsored retirement and benefits plans, as well as funding your own individual retirement accounts (IRAs). Federal and state income taxes, Social Security, and Medicare taxes generally will reduce your gross earnings from work by 25–35%. Since these taxes are deducted before you get a paycheck, plan your budget on the net amount. That is, if you earn $50,000 per year, don’t plan to spend more than about $32,000.

Inflation

The prices of goods and services tend to increase over time. This is called inflation. While it is quite impossible to predict future inflation rates, historically they have ranged between 0% and 10% per year in the United States. Under current US fiscal policy, the Federal Reserve is trying to manage inflation between 2% and 4% per year. To predict the future costs of goods and services due to inflation, the rule of 72 might be helpful.

Rule of 72

The rule of 72 can tell us how long it will take for the price of something to double, if we know the rate of inflation. Dividing 72 by the inflation rate equals the number of years it will take for the cost to double. You must use a whole number as the rate, rather than a decimal or percentage. That means that if inflation is 3%, use 3, not 0.03. For example, if you want to know how long it will take for the price of bread to double at 3% inflation, you will proceed as follows: 72/3 = 24 years. Those of you who passed algebra also see that this formula is useful in determining what rate of return is required, in order for an investment to double in a fixed number of years. Using a hypothetical example, in order for an investment to double in 12 years, the investment return must be 6% (72/12 years = 6% return). And the rest of you thought algebra was a waste of time! You can see that using the rule of 72 allows you to predict future costs, income, and savings without using a fancy financial calculator or computer. But remember, it is only a rough estimate.

This illustration does not reflect any actual investment, and investment values will fluctuate. It demonstrates mathematical principles only and should not be regarded as absolute. Furthermore, the periodic declines in markets will diminish the rule’s effective application.