To budget effectively you need to start out with the following steps:

1. Calculate Monthly Income
2. Calculate Monthly Expenses
3. Balance Income Vs Expense
4. Analyze Expense and Income Categories
5. Align Budget with Financial Goals

Although this might seem straightforward, it is the critical first step to budgeting and to seize control of your personal finances. It is also critical to actually scrutinize this, as there are a lot of deductions that are done to our incomes (for ex: taxes, medical insurance) that reduce how much we are actually receiving every month. Moreover, everyone’s situation is different so for some it will be simpler to calculate but for others (for ex: if you have two sources of income) it will be more complex.

Taking into account that personal situations vary, we need to assess the following questions:

• Do I have multiple incomes?
• How are these categorized by the government?
• Am I single? Am I married? Am I head of household?
• If married, am I filing jointly with spouse or independently?
• Am I an employee, employer or both?
• How are these incomes taxed by the government?
• How much am I paying in taxes annually? Monthly?
• Am I paying a federal income tax?
• Am I paying a state income tax?
• How much is the state income tax for the state I reside in?
• Do I have a medical insurance plan? How
• Is it through my employer? 
• Is it pre-tax or after-tax?

*There might be more questions about income that are worth considering that we have not included here– please think thoroughly about your personal situation.

For the purpose of this article, we are going to use a story with the following characteristics to better visualize an example of how to calculate the monthly income of our made up character: Steve. 

• Steve is a 23 year old male, is 1 year out of college and graduated with a film and video production degree
• Steve lives in Los Angeles, CA 
• Steve is single
• Steve has 1 year work experience
• Steve works full time employee for an advertising agency
• Steve’s salary is a flat $65,000 a year salary
• Steve does not have any other sources of income
• Steve contributes 4% of his income pre-tax to his company’s 401K Plan
• Steve has medical insurance offered through his employer and pays pre-tax $100/month for his plan

Given Steve’s situation, we know the following: he is paying federal income tax and state income tax (CA is a state that charges state income tax. Please see here (link) to verify in which states you pay state income tax). We also know he contributes to 401K pretax– i.e., this is deducted before paying taxes and therefore Steve’s taxable income is reduced. This is the same for his medical insurance plan. 

Given all of this we have the following:

Steve’s Annual Income: $65,000

Steve’s 401K Pre-tax Contributions: 65,000 * 4% = $2,600

Steve’s Pre-tax Medical Insurance Annually: $100/month * 12 months = $1200

Now, it’s time for Steve to pay federal income taxes:

US Federal Income Tax: *It is important to note that Steve lives in the United States and in the US taxable income is taxed in brackets. To learn more about tax brackets and how they work please see this insightful article: https://www.bankrate.com/taxes/tax-brackets/

If you live in the United States, we have found a very cool and useful website that assists in calculating all of this for you. Please see: https://smartasset.com/taxes/income-taxes. 

Now, time for Steve to pay state income tax. To do this we have used the following website as above, using the California Tax calculator page, specific for Steve’s circumstances:

https://smartasset.com/taxes/california-tax-calculator#7ihUCBilhe

According to this site and Steve’s given circumstances, his take home pay is: $47,879.00. 

This means that on a monthly basis Steve’s real income is: $47,879/12 months = $3989.92. 

Now that we have calculated our monthly income as accurately as possible, then step 2 to budgeting is to calculate monthly expenses. Within monthly expenses, we need to take into account every possible expense we have consistently every month after the respective taxes (calculated on Step 1) have been paid. This will include the following:

• Rent
• Electricity bill
• Gas bill
• Water bill
• Phone bill
• Internet Bill
• Property Insurance
• Car Insurance (dependent on having a car)
• Car Payment (dependent on having a car)

These are what we call ‘fixed costs’. ‘Fixed costs’ in your monthly expenses are defined by the following traits:

1. They can not be eliminated completely 
2. You can’t reasonably control their magnitude
3. This means that you can’t reasonably reduce the cost of them, e.g., your internet bill will cost the same month after month, your rent will be the same month after month, etc. 
4. In the case of water/gas/electricity, we recognize that you can control their magnitude as they depend on usage. However, we are using the following principles for these to justify their qualification as fixed:
5. You are not being completely wasteful and therefore your bill is due to normal and adequate usage
6. That reducing these services to an exaggerated minimum (e.g., during winter freezing months you don’t use the heater to save a little bit more) is not worth the marginal savings gain
7. We have also left out food because it is our belief that, even though food is absolutely necessary, you can control the amount spent by a large degree. 

We then consider ‘variable costs’ for monthly expenses. We define ‘variable costs’ as those that have the following property:

1. You can control completely their magnitude

Under variable costs we will find the following:

• Subscriptions 
• Gym
• Streaming Services
• News
• Etc
• Groceries
• Eating out
• Social Activities
• Miscellaneous Expenses

When designing our financial life we need to be cognizant of our recently calculated real monthly income and always aim to have income exceed expenses. This is the basis for wealth. Therefore, we need to aim to reduce our variable costs as much as possible and simultaneously increase income aggressively. 

Going back to Steve’s story, his monthly expenses are the following:

• Rent: $900
• Electricity bill: $50
• Gas bill: $25
• Water bill: $25
• Phone bill: $100
• Internet Bill: $65
• Property Insurance: $20
• Car Insurance (dependent on having a car): $140
• Car Payment (dependent on having a car): $200
• Subscriptions 
• Gym: $50
• Streaming Services: $100
• News: $35
• Groceries: $600
• Eating out: $400
• Social Activities: $400
• Total: $3,110

After calculating monthly income and monthly expenses, we need to balance these out. By this we simply mean get your monthly real income and subtract your monthly expenses to it. This should give you the exact amount that remains. If you have a net positive then great, if net is zero then we have work to do and if the remaining balance is negative then we have serious work to do. 

It is our belief that in order to have a good financial footing and be able to realize your financial goals you should always aim to spend less than your income and thus save. Save with the purpose of achieving your financial goals. 

Going back to Steve’s Story:

Monthly Income (after taxes): $3989.20

Monthly Expenses: -$3110

Net Savings Per Month: $878.20

Savings Rate: $878.20/$3989.20 = 22% savings rate

Net Savings Per Year: $10,538.40

*Please note that these are Steve’s savings metrics without accounting for his 401K