The first step in getting your finances in order is a budget. It is absolutely impossible to have sound finances and investments if you are spending more than you earn. For this page, we will assume that you have already done that. Once the only debt you owe is your house (and maybe school loans), should you begin investing.
Step 1: Identify your expenses
This is easier said than done. If you use financial software such as Quicken or Microsoft Money, it is substantially easier. Make a list of everything you spend in a month and then put the expenditures into categories. Common categories might be:
- Cell phone
- School loans
- Car payment
- Car insurance
Then think of expenses that you did not have this month that are regularly occurring, such as your nursing license renewal, car registration, etc. Add those together and divide by the number of months before they recur (to get a monthly average). Add all of your monthly expenses together. This number represents how much money you must make each month after taxes just to break even.
Identify your revenue sources and estimate your taxes
You need to be able to calculate approximately how much money you will make on a yearly basis (for your taxes) and monthly basis (for your budget). Generally speaking, if you take your hourly pay, multiply it by 2 and put a thousand at the end, you will get a rough estimate of your yearly pay. For example, a graduate who expects to make $20/hour (40 hours a week, 50 weeks a year) would make 20x40x50 = 40,000.
Once you know your yearly salary, you can estimate your taxes. The most important thing to understand in estimating your taxes is the difference between gross income and taxable income. Taxable income is your gross income minus any 401(k) and IRA contributions minus your eligible deductions. There are two ways to figure out your deductions (standard deduction and itemized); for the purpose of budgeting, just use the standard deduction.
Go to the IRS website and look up last year’s tax table (in one of the 1040 instruction booklets). For example, the 2009 tax tables start on page 77 of the form 1040. Subtract the standard and personal deductions from your gross income to estimate your taxable income. Now look up your estimated tax in the tables. Take that number and divide it by 12 to come up with how much tax you will be paying per month.
But wait! There’s more! You also have to pay Medicare and Social Security tax. These taxes are paid on your gross income. Social security is a flat 6.2% on all income up to $106,000. And Medicare is 1.45% on all income for a total of 7.65%. (The tax is actually 15.3%, but by law, your employer can’t show their “matching contribution” on your pay stub because you might revolt at seeing how much of your paycheck is
stolen taxed.) Oh and the income cap of $106,000 automatically goes up with inflation, so last year, the cap was $94,000, and in 2000 it was $76,000. (See, even the government knows inflation is stealing wealth.)
Calculate your cash flow and make adjustments
Now that you know your estimated taxes, add the monthly tax to your expenses. Now subtract all your expenses from your income to come up with your estimated cash flow. At this point, if you are like most Americans, you’ll find that you do not make enough money to cover your expenses. You now have two choices: 1) Seek more income, or 2) reduce your expenses— or a diabolically clever combination of the two.
It’s all about control
The purpose of this exercise is to put you in control of your finances. You wouldn’t drive your car with eyes shut, and you shouldn’t spend money without a budget.
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