Zero Based Budgeting was essentially created in the 1960s and applied to government and business budgeting. It has been imported to personal finance and is now suggested by some of the celebrity financial advisers out there. In my opinion, the value in a Zero Based Budget is that it is kind of a basic in the budgeting process and it forces you to allocate remaining monthly income to a useful purpose rather than just blowing it.
A Zero Based Budget is a method of budgeting that allocated every dollar in your budget. In that sense, it is kind of a bookkeeping method. It does not mean that you have zero dollars in your bank account at the end of the week or month. It is simply a reference to allocating your money. You can allocate to the things you really love. You can allocate to debt payments. You can allocate to necessities. But the key is that all the money is allocated. And it's near the end of the Zero Based Budget process that you see where you have extra money and decide where it goes.
So how do you do it? Easy as 1, 2, 3.
Estimate your monthly income after taxes. We'll assume you are contributing the amount to your 401k that gets matched. So after that and after Uncle Sam takes a piece, you have a certain dollar amount. That is the goal of Step One. Find that number.
We are going to start allocating that money. There is a special order that I believe you should use when allocating your income. Start with your home and allocate income for your rent/mortgage, electricity, cell phone, water, gas, cable, and internet. Next address your transportation and allocate for car payment, bus/Uber/subway fees, tolls, and gas. After you have allocated towards transportation, allocate your income to insurance, including home insurance, health insurance, life insurance, and car insurance. If life or health insurance comes out of your paycheck or your home insurance comes out of your home payment, leave these blank. Next you can allocate towards food, so groceries and dining out. After addressing food costs, you can allocate to loans. This includes student loans, personal loans, and credit cards. Then you can address entertainment, which includes any non-food based night out. After entertainment, you should allocate towards emergency savings a retirement account, and miscellaneous required costs.
Here is what it looks like in list form:
1) Home (rent/mortgage, clothing, electricity, cell phone, water, gas, cable, internet)
2) Transportation (car payment, gas, transportation fees, tolls,
3) Insurance (home insurance, car insurance, life insurance, health insurance)
4) Food (groceries, dining out)
5) Entertainment (Netflix, movies out, life shows, alcohol)
6) Loans (student loans, personal loans, credit cards)
7) Savings (emergency fund, retirement)
8) Miscellaneous (kid's clothes, tithing, gym membership, etc)
If you are going into the red, meaning you don't have enough income to cover expenses, then you have to start cutting, or you need another job. You want there to be a surplus if possible.
#3 DIRECT THE SURPLUS
Like we stated above, you want a surplus after you have allocated income to your expenses. Here is where it BECOMES a Zero Based Budget. We will take any surplus leftover, and we are going to allocate it all, bringing our balance to zero.
So for example, let's say that you started the month with $5000 of after tax income. And after allocating it to your monthly expenses, you have $450 left. To get to a Zero Based Budget, we need to have that $450 accounted for. In our case, we may put an extra $200 to student loans, $100 to dining out, and $150 to our retirement fund.
This does one thing well. It forces us to use any unaccounted for money conscientiously. So if we were not using this budgeting method, it would be easy to piss away a little of that money every day on extra food, drink, or clothes. By allocating it in advance and sticking to the plan, we have thoughtfully deployed the money, avoiding our primal consuming urges to waste it.
So there you have it. Zero Based Budgeting is simply a method for allocating every dollar thoughtfully. It doesn't prevent you from spending on things your like. It is just a method that helps prevent you from spending on wasteful things. This is a fundamental concept in financial planning and budgeting.
Stay tuned. I think my next post will be a review of the book Essentialism by Greg McKeown. I think there are many useful suggestions in the book that are transferable to budgeting and personal finance.
I wanted to take a moment to talk about something that comes up with entrepreneur financial planning clients. You see, for an entrepreneur, every penny and every day are typically spent trying to build their business. This presents some issues that other people like attending physicians do not have, since employed people just have to worry about how to allocate their paycheck and manage their 401ks and other retirement accounts. The entrepreneurs have to manage their personal finances and retirements, and also manage business finances. Hopefully I can provide a little extra insight because their are some legal aspects thrown in here and I have a background in that space too (this isn't legal advice, nor financial advice, and should not be taken as such). So let's get into it.
Founder of a fee-only, ethical investing firm. We specialize in assisting millennials tired of traditional financial advisers.