Reverse Budgeting: How to Pay Yourself First

Are you tired of feeling overwhelmed by your expenses, unsure where your money is going, and struggling to grow your savings? In an article earlier this month on avoiding lifestyle inflation, I briefly described one strategy called “reverse budgeting” and how we’ve found it to be a helpful way for families to gain control over their finances.

What is reverse budgeting?

Reverse budgeting, also known as “pay yourself first” budgeting, is a financial planning strategy that prioritizes savings and investments. Unlike traditional budgeting, where you allocate funds for expenses first and then save what’s left, reverse budgeting involves setting aside a predetermined amount for savings before spending on anything else. By prioritizing your financial goals, you can reduce stress and increase your chances of achieving long-term financial success.

What are the steps to reverse budgeting?

1. Outline your financial goals – whether it is being financially independent at a specific age, or buying a vacation house in five years, knowing and defining what you are trying to achieve is the first step in determining the monthly savings you will need to set aside.
2. Calculate what you need to save to get there – say you want to have $100,000 in five years to go towards the downpayment on a vacation home. If your savings account pays 4% interest annually, you will need to save about $1,500 per month to meet this goal.
3. Automate your savings and investments – once you have defined your goals and calculated how much you need to save, you will want to set up automatic monthly transfers to the appropriate accounts. Using the example above, you would create a monthly transfer of $1,500 to your high-yield bank account. For a retirement goal that is further down the road, say 15-20 years, you likely want your monthly savings to automatically be routed to a diversified portfolio of stocks and bonds that could be in an Individual Retirement Account (IRA) or a nonqualified investment account.
4. Calculate your savings percentage – now that you have your savings automatically going to the appropriate, goal-specific accounts, it’s a good idea to make sure your total savings are at least 15-20% of your income. As an example, if your income is $200,000 annually, a good rule of thumb for how much you should be saving is between $2,500 and $3,500 per month. Don’t forget to include anything you are saving directly from your paycheck, such as a 401(k), 403(b), or another retirement plan through your employer.
5. Spend the remaining 80% – now that you are “paying yourself first” and saving everything needed for your financial goals, you are free to spend any income left over on whatever is important to you. Whether it’s expenses related to your home, dining out, new clothes, or traveling, you shouldn’t feel guilty about spending since you have prioritized your savings. If you need help with how much to spend in each area, there are rules of thumb, such as spending no more than 30% of your income on housing costs, etc. that can help.

That’s it! Prioritizing your savings and investments first allows you to live stress-free while spending on what truly matters to you. Embrace this simple and effective strategy to build a better financial future and experience the freedom of knowing your finances are in order.