Ready to create a budget, but don’t know where to start? The first step to budgeting is to understand your income. Your expenses are important when budgeting, but your income is the cornerstone of your budget.
Budgeting your income is simple, but often an overlooked piece of budgeting. For most people your income is a set amount every month. There’s a lot to understand with your income like your deductions, benefits, and taxes. Plus, now-a-days it’s common for your income to vary from side hustles, freelance work, or bonuses.
This is part three of the series: Create Your 2022 Budget with Me.
Catch up on the series here:
- Part 1: Five Reasons Why you NEED to Budget One-Year in Advance
- Part 2: How to Create a Back of the Napkin Annual Budget in Minutes
Stay tuned to learn next how to budget your expenses.
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Budgeting 101: Understand Your Income
Why it’s important to understand your income
Personal finance can be simplified to one formula: Income > Expenses.
It’s common sense to keep your income greater than your expenses, yet it’s challenging. Debt (especially credit card debt) is the result of having expenses greater than your income. If you keep your income greater than your expenses, then you can reach your money goals.
Here are a few examples of what you can do when you understand your income:
- Save for an emergency fund
- Invest and retire early
- Save for a down payment on a home
- Make large purchases without going in debt (like pay for pay for vacations)
How to create budget and understand your income
1. Find out your gross income
First to understand your income get familiar with your gross income This is your total income before taxes or benefits are deducted.
You can do this by grabbing a pay stub.
For example, Average Joe’s gross income is $56,160 a year. His pay stub shows gross pay of $2,160 for each pay period (every other week). Most months his gross pay is $4,320, but some months he’ll get three paychecks or have a gross pay of $6,480.
2. Get familiar with your pre-tax deductions
Familiarize yourself with company benefits deducted from your pay before you’re taxed. These reduce your tax bill.
Some companies offer a 401 (k) or 403 (B) plan, where you can select a percentage of your pay to automatically go towards your retirement. You build your nest egg, and your current tax bill goes down (it’s a win, win).
When setting up your budget for the upcoming year, check-in on how much you’re contributing to your retirement plan.
Often health, vision, dental, and group life insurance are provided as a company benefit and can be deducted from your pay to reduce what you pay in taxes.
You can take advantage of a Health Savings Account (HSA) or a Flexible Spending Account (FSA) to pay for out-of-pocket health care costs.
3. View your taxable income
Your gross income minus the total of your pre-tax benefits is what you pay taxes on (your taxable income).
For example, Average Joe’s has a pretax deduction of $160 for health insurance and contributes 5% of his gross pay ($108) to his 401(k). Instead of paying taxes on his gross income of $2,160, he pays taxes on $1,892 ($2,160-$160-$108).
4. Your taxes each paycheck
After deductions you pay taxes for Social Security (6.2%), Medicare (1.45%), and federal income taxes. Depending on where you live you might also have state and local income tax.
5. Post-tax deductions
Depending on your employer, you may have other after-tax deductions. Examples of post-tax deductions are disability insurance, wage garnishments for unpaid debt, automatic giving, Roth accounts, or other savings in non-retirement accounts, etc.
Other company perks like your cell phone, internet, or company car may be deducted too.
6. Take- Home Pay
This is what you bring home to live off after all deductions and taxes. Your take-home pay is the number you’ll use to create your budget and pay for your personal expenses like rent, car insurance, cell phone, groceries, vacations, etc.
7. Budgeting when your income varies
If you’re self-employed or a freelancer, it’s even more important to budget and have a plan for your income. It’s difficult if you don’t know what exactly you’ll earn. Start by figuring out what your desired income is. Then reverse engineer what it takes to reach your target take-home pay.
Look at your past income, clients, and hours needed to earn your desired income. Factor in a buffer (around 20% of what you earn) to pay taxes. Open a separate business account and pay yourself a set amount. This helps take the guess work out when your income fluctuates.
8. Know your sources of income
Lastly when budgeting income you’ll add together all your income including:
- Starting Balance– how much you started with your account at the beginning of the month
- Paychecks– take-home pay after taxes and deductions like health insurance and 401(k) contributions
- Bonus/Overtime- performance bonuses, overtime pay, or tips
- Additional Income- child support, alimony, side-hustle income, rental income (this can be if you own a home and rent out a room), or investment income
- Returns- money back or reimbursements
- Split bills- utilities, internet. etc. split with roommates
Related Post: How to Manage Money When Your Income Fluctuates
Start creating your budget by understanding your income!
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