I haven’t discussed my job in a while, but while talking with a new financial planner the other day I was reminded of a lesson I learned a long time ago. The conversation we were having had to do with the basic fact that most people do not have a clue what they spend. They wake up sometime around January 2 or 3, and think, “this is the year that I am going to get control of my finances” and then they start to try to build a cash flow model (or a simple budget). While the scary majority of people may not know it is pretty easy to create a ‘back of the napkin’ picture of someone’s cash flow.
When you take a rear view look at your spending there are only 3 places that your income could have gone:
That is it.
Cash Flow – Taxes
We all know the tired, cliche that there are only two things in life that are guaranteed. But I guess there is a reason something becomes a cliche, right? When dealing with your own cash flow, you can get as detailed or as high level as you want.
For most individuals, the easiest thing is to take their gross income subtract their 401(k)/IRA contributions and use an effective tax rate that is equal to their top marginal bracket. Is this completely accurate? Of course not! And this may not work for you if you are someone that has more than just two W2 earners in the household. Notwithstanding, using this method, at least provides a baseline to stat a real budgeting conversations. I usually round up the bracket.
This should be pretty easy to calculate. You have a cash emergency fund? Great, how much a month is going to it. Do you have a 401(k) at work? Great, how much per paycheck is going to it? Any non-retirement accounts? How much are going to them per month?
Sometimes, I’ll run into a situation where the person isn’t saving regularly, but it is 2018, it shouldn’t be too hard to figure out the inflows to a certain account.
If you didn’t send it to the government, and you don’t have it (in another account) – you spent it!
Maybe you spent it on rent/mortgage, maybe you spent it for past purchases (i.e. consumer debt or student loans), maybe you donated it to a church/non-profit, maybe you bought too many lattes, maybe you just bought some material shit you didn’t need, but either way the cash is gone.
Back of the Napkin Cash Flow Example
Let’s say we have two working spouses that each make $100,000/yr each saving $10,000/yr to their 401(k). They have never budgeted, and have zero clue what they spend. The husband has tried to figure it out a few times, but after looking at the 3rd visa bill his head is spinning. So, what can they do?
First, let’s figure out their income. They make $200,000/yr saving $20,000 leaving us with $180,000. Next we have to figure out their estimated taxes. $180,000 * 25% = $45,000 or so going to taxes. Yes, this is a simplification and over estimation, but it gives us a starting place that this couple spends at a minimum $135,000/yr or $11,250/mo after taxes.
- $200,000 – $20,000= $180,000
- $180,000 * 25% = $45,000
- $180,000 – $45,000 = $135,000
Invariably, people will argue that the math ‘can’t’ be right; they can’t possibly spend $11,250/mo after taxes. So I’ll do the exercise with them. What happens most of the time is that they get the tax part correct since it is easy enough to pull up their taxes last year, and the tax bill was lower than what I put which only means they spend even more then the number I originally provided!
For someone who diligently budgets this exercise may seem elementary, or even useless, but when you give this easy tool to someone who has no idea what their family spends it can serve as an eye opening experience.