Here’s how it works and how it compares with the 50/30/20 plan.
What Is the 80/20 Rule of Thumb?
The 80/20 rule of thumb is a simple approach to budgeting. It looks at your take-home income, which reflects your income after taxes, health insurance premiums, and any other expenses that are taken out of your paycheck. You put 20% of your take-home pay into savings. The remaining 80% goes toward your expenses. Ideally, you put 20% into savings as soon as you’re paid. The goal of the budget is to ensure you always pay yourself first.
Where Does the 80/20 Rule of Thumb Come From?
The 80/20 plan is a spinoff of the 50/30/20 plan. The 50/30/20 budget was proposed by Sen. Elizabeth Warren (then a Harvard law professor) and her daughter, Amelia Warren Tyagi. The plan states that 50% of that take-home income should go toward necessities like housing, electricity, gasoline, groceries, and the water bill. An further 30% can go to discretionary items like restaurant dining or getting tickets to a sports game. Finally, 20% should go toward savings or debt repayment.
How to Use the 80/20 Rule of Thumb
The 80/20 rule of thumb aims for simplicity. To use it, multiply your take-home pay times 0.2. The result is how much you should put into savings. For example, if your take-home pay is $800, you would put $160 in savings as soon as you’re paid. That leaves you with $640 for your expenses, including needs and wants. The 80/20 rule helps you pay yourself first. To ensure you do this, you could establish an automatic withdrawal from your checking account. Plan the withdrawals to happen a day or two after every paycheck, and send the money to a savings account. This way, the money that hits your checking account is yours to spend. Your savings are automatically stashed away. Not all the savings have to go into a traditional savings account. You can redirect some of the money into a brokerage account or a retirement savings account such as a Roth IRA. In fact, those following an 80/20 plan may be better off directing the majority of their savings toward retirement once they have an emergency fund established. The recommended amount for an emergency fund is three to six months of expenses. Once you have an emergency cushion, experts advise saving between 10% to 20% of your income for retirement, depending on the age at which you start to save. Fidelity, for example, recommends that someone who starts saving at age 25 should put 15% of their paychecks into retirement accounts. If you wait until your 30s or later, you may need to save more to have enough by the time you retire.
Why the 80/20 Rule of Thumb Generally Works
The 80/20 rule of thumb generally works because it’s easy to stick to and maintain. It might be a good fit if you’re new to budgeting and don’t want to adopt something complicated. It might also be a good fit if you have trouble with or find it stressful to stick to a more structured budget. This budget has a lot of flexibility, so if you find that your spending patterns vary, the 80/20 rule also could work well for you.
80/20 Rule of Thumb vs. 50/30/20 Rule of Thumb
The 50/30/20 plan is sound advice, but it can be tough to discern what’s a want and what’s a need. For example, there are some clothing items you need. You might need specific clothes for work and you need essential items to wear day-to-day. Some clothes are also wants, like trendy items that you’ll only wear a few times. Everyone is going to define those differently. Even if you know things like ice cream are a “want” and other foods are a “need,” it still takes time to go through your grocery receipt and separate the costs on a line-item basis. Some people don’t want to classify and track their spending as closely as the 50/30/20 plan requires. The 80/20 budget plan is essentially a simplified version of the 50/30/20 plan. You don’t have to do any expense tracking and you don’t have to discern between “wants” and “needs.” You simply take your savings off the top and spend the rest. Some might find that the 80/20 rule of thumb leaves too much wiggle room for discretionary spending. If you prefer structure, the 50/30/20 rule of thumb could be a better fit.
Grain of Salt
The 80/20 budget plan is a great starting point, but it should be viewed as the minimum you should save. The more you can save, the better. Once you achieve 80/20, push yourself toward a 70/30 savings rate, then 60/40. As your savings grow, so does your flexibility and opportunity. The savings don’t all have to be in a retirement account. You can put those funds in accounts that are easier to access, so they can be used to buy a rental property, start a small business, take a career risk, or enjoy extra vacations. Keep in mind that the 80/20 rule of thumb is a general rule. Your results will vary, and you may have financial priorities that don’t fit this guideline. Like all rules of thumb, it’s a starting point, and you can adjust it to meet your individual needs.
