Reverse Budgeting: Creating A Budget That Actually Works

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 Peter Lazaroff By: Peter Lazaroff

Creating a budget and sticking to it is difficult for most people because the process is time consuming and restrictive. Traditional budgeting forces you to make every decision as if you live in a spreadsheet. But guess what? You don’t live in a spreadsheet.

Rather than focusing on expenses, it is better to focus on savings through a process I like to call “reverse budgeting.”

Reverse budgeting simply figures out how much you need to save, makes those savings automatic and then you spend the remaining amount of money as you please.

If you have spent your budgeted amount on restaurants, but something very important comes up unexpectedly that requires you to dine out, then you can shift spending elsewhere to fall in line with your priorities and values. 

BECAUSE REVERSE BUDGETING FOCUSES ON SAVING, YOU CAN’T SPEND WHAT YOU DON’T HAVE.

Increasing the amount you save naturally reduces the amount you spend, but it also forces you to prioritize your expenditures.

This is important because most people find that gradually saving more allows them to cut spending that doesn’t really fit with their values.

Best of all, reverse budgeting requires very little maintenance. A traditional budget requires weekly or monthly reconciliation of financial transactions. Once a reverse budget is set up, the entire thing can be automated.

The lack of ongoing time commitment makes it much more likely you will stick to reverse budget.

Here is how to set up a reverse budget in three easy steps:

1. Add up the amount per month that you need to save to reach your goals short-term goals.

Writing down a goal with an estimated date and expected cost dramatically increases your likelihood for success. It also allows for you to understand the things that are most important to you.

Start by writing short-term goals (five years or fewer), the date of desired completion and the expected cost.

If you add up the expected cost of all your goals, then you can determine how much you need to save on a monthly basis to make this happen. Once this is completed, then number the goals according to your priorities – now you know where to begin directing your monthly savings.

To give you an idea of how this works, below are short-term goals from our Goals Planning Worksheet from a hypothetical newlywed couple in January 2021.

Priority

Short-Term Goals (5 years or less)

Completion Date Expected Cost
1

Max out IRAs and Andrew's 401(k) each year

$31,500 per year $157,500
2

Build emergency fund

July 2026 $30,000
3

Pay off student loans

December 2023 $15,500
4

Save for "big" 5-year anniversary vacation

June 2025 $12,000
5

Buy Casey a new car

October 2024 $35,000

Total Expected Cost Over 5 Years

$240,000

Required Monthly Savings

$4,000

 

Short-term goals change from year to year, so perhaps Casey will get access to a 401(k) when she finishes graduate school. And once they have children, I suspect they will add news goals such as saving for college or finishing their basement.

They are also likely to increase the size of their emergency fund goal to accommodate the higher living expenses that successful professionals inevitably take on.

Once your short-term goals are in place, do the same exercise for intermediate-term goals (five to 15 years) as well as long-term goals (15 years or more).

It may be difficult to assign an expected cost to your long-term goals, but that’s OK, the benefit of this exercise is thinking about it.

If you can’t meet the monthly savings required to meet your short-term goals, then you can try to escalate your savings over time (see step three), but it also probably means that you need to evaluate what is most important to you and adjust your goals accordingly.

2. Set up a monthly automatic withdrawal from your checking account to a separate savings account. 

Automating your finances is the easiest way to maintain your reverse budget.

Start by opening an online savings account that pays a little higher interest rate than a traditional brick and mortar bank. In addition, online savings accounts serve as a barrier to impulsive spending since the money takes more time to access.

Next, set up an automatic monthly withdrawal from your checking account to the online savings account to meet the amount you reverse budgeted in step one.

Then you are done – simply spend the leftover money in your checking account as you see fit.

3. Escalate your automatic savings over time.

This step is really powerful for both people wanting to supercharge their savings as well as those that can’t save the required monthly amount to meet their short-term goals.

Let’s return to our short-term goals example from step one. That example requires a 20% savings rate for someone with a $240,000 income. For someone that hasn’t been saving much prior to this exercise, removing $4,000 per month from their lifestyle can be challenging.

Escalating your savings is a way to slowly advance towards your ideal monthly savings.

Start by setting up several automatic withdrawals from your checking and deposit into your online savings account.

The first three months should withdraw $100 per month. The second set should withdraw $150 in the next three months, then $200 in the next, and so on.

If you are already meeting your short-term monthly savings target, then escalating savings over time is a great way to begin addressing those intermediate- and long-term goals.

Next Steps:

Reverse budgeting is just one strategy to build your wealth. If you want more simple systems you can use in your finances here are a few more options:

Disclosure:

This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.

 

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Peter Lazaroff, Chief Investment Officer, first took an interest in investing when his grandmother gave him a single share of Nike stock for his 13th birthday. Today, nearly 20 years later, his investment insights are highly sought after by local and national media. More »