How to Reverse Engineer an Annual Spending Plan

Whenever I hear or read about budgeting, I always cringe a little bit inside. As someone with very little self-will, the act of budgeting always strikes me as a crash diet that will quickly fizzle out a few weeks in. Nothing sounds worse than agonizing over every transaction, wondering whether or not I exceeded my monthly spending limits across ten different categories.  

​When I started getting more serious about my finances though, I wanted to get a better understanding of my expenditures and how they were impacting my long-term savings and accumulation of capital. Getting to a place of financial independence became more important as I looked towards new chapters down the road.

​But I wanted to approach the act of managing expenses in a less anxiety-provoking way that didn’t significantly alter my current lifestyle. What I needed was a financial wellness plan.
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Financial Crash Diet vs. Wellness Plan

The decision to start budgeting doesn’t usually occur in a vacuum. Maybe you feel the need to cut back due to a life event or change in income. Or perhaps you are looking to boost your savings for future goals down the road. 
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Jumping in cold turkey though can put a serious damper on your quality of life if you don’t have the right tools to bridge the gaps. If you typically spend $800 a month on food and decide to cut back to a $500 budget without a clear strategy in mind, your attempts towards saving more money will likely take a toll on your mental health along the way.
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Instead, your goals should be to:
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• Understand your regular spending habits and expenses over time, relative to your incoming cash flows.
• Identify ways to optimize your current expenses while minimizing the impact to your quality of life.
• Plan for acceptable trade-offs to reach more significant or aggressive savings goals.

To do this, you’ll need to establish a baseline and begin collecting some data. Since we have a few more months to go until the end of the year, this is a great time start and get into gear for 2021. 

Ditch the Monthly Budget

It’s time to ditch the “B” word now and create a spending plan instead. A spending plan helps map out future income and expenditures based on your current cash flows and spending habits/obligations so that you can strategize and adapt to any necessary adjustments over time. It is an iterative process that allows you to make incremental changes and develop long-lasting habits. 

I like to look at my financial picture annually because we all have different needs and routines throughout the year. Unless you are a robot, chances are there are some natural variations to your monthly spending habits. You may spend more during the holidays and spend less during the first few months of the year. Or if you live in Texas like me, you may find yourself with a whopping AC bill in the summer after 24 straight days of 100 degree weather.

​Using the same monthly thresholds from traditional budgeting methods can quickly lose its value when the natural ebb and flow of expenditures cannot easily be accounted for.  Instead, you want to create a framework that provides more time and space to tune into both your short and longer-term habits and identify changes that can be applied during different time frames.    
If an annual plan feels too broad, opt for a semi-annual or quarterly plan instead.

How to Reverse Engineer an Annual Spending Plan

​Now let’s get down to the nitty-gritty details of creating an annual spending plan. I've outlined what I've done consistently over the past two years to keep track of my income and expenses and forecast my future earnings and spend. 

For the first few months, you will be establishing your baseline by gathering data on your current income and expenses. You want to get a clear picture of what your life looks like now before attempting to make any changes. 

To help you get organized, I’ve shared the following Google spreadsheet that I use to log my monthly cash flows and expenses. ​

Make sure to download the file or make a copy first. 

Annual Spending Plan

​During the first few months, start with the following:

• Estimate your annual discretionary and non-discretionary expenses
• Track your total monthly, after-tax income
• Track your total monthly expenses
• Track your current net worth (optional)

​Since you will need to keep track of your transactions to calculate your monthly expenses, I also recommend using an online resource that captures and aggregate transaction-level data in real-time. My favorite tools are Mint and Personal Capital.

​I particularly like Mint’s features around spending categories as well, which you can begin to dig into when you start brainstorming potential changes to your current expense habits. They offer some great graphical representations that quickly show your spending habits over time. See a sample screenshot of their "Trends" report below. 

​Sample screenshot of my favorite feature in Mint, the "Trends" report. You can view all of your expenses in one place, broken down by category. 

Below are steps on how to begin this process:

 1. List out all of your estimated discretionary & non-discretionary expenses

First off, list out all of your estimated regular discretionary and non-discretionary expenses for the year. Discretionary expenses are any expenses that are necessary for daily living such as rent/mortgage, utilities, and insurance. Non-discretionary expenses are the “nice to have” items that are not essential for daily living. Subscriptions, memberships, and services are examples of non-discretionary expenses. 

The categories and amounts that you enter should be what you realistically think (or know) you spend, not what you want or think you should be spending. If you are unsure of how much you typically spend on an expense category, start with your best guess. These projections can be updated as you collect more data on your actual transactions and expense categories over time. 
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Enter these expenses under the Expenses tab in the Annual Spending Workbook (see Instructions tab in workbook for further details).

​Once you enter in these expenses, you will see the 'Monthly Expenses (Planned)' row populate with your estimated and annual expenses  in the Spending Plan tab.

​2. Track your monthly cash flows (after-tax income)

​Next, you will start gathering actual data. Each month, take inventory of all of your after-tax income sources such as your paycheck, side hustles, and investment income.

​I personally omit any income that is automatically going towards retirement, FSA, ESPP, or any other savings/investments vehicles automatically through direct deposits. This way I can better understand my disposable income. 

​Enter the total income earned in the corresponding month of the Annual Spending Plan workbook (see Instructions tab for further details).

3. Track your monthly expenses

​Next, you will track your total expenses on a monthly basis. This is where an app like Mint can come in handy by helping you log and consolidate each of your monthly transactions. 

Optional
Large purchases or expenses like travel or one-off items during the course of the year can easily throw your numbers off during the course of a year. I personally like to make note of these items and track them separately so that I can differentiate them from my regular expenses.

​To do this, enter your total, one-off, and travel expenses for the corresponding month in the Annual Spending Plan workbook.

4. Calculate your net worth (optional)

​Tracking your current net worth in conjunction with your monthly income and expenses can help you determine your desired savings rate based on your current savings, investments, and other assets (more on that below).

​I highly recommend using Personal Capital which aggregates all of your assets and liabilities and tracks your net worth in real-time. However, if you prefer to minimize your use of online platforms, you can use the Net Worth tab in the Annual Spending Plan workbook. ​
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Putting it All Together

Once you have gathered at least a few months of data, you can begin to ask yourself the following:
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• Are you achieving your savings goals over time given your current savings rate and net worth?
• If you are exceeding your target savings rate, could these excess funds be put to better use?
• Where are the gaps between your actual and estimated spend? 

*Tip: Use the expense categories in Mint or Personal Capital to help you understand your actual spending and how this compares to your estimated expenses.

From there, you can use this same spreadsheet or your own version of this plan to forecast your future annual income, spend and savings for the upcoming year. As you create this plan, think about the following: 
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• Are there ways you can optimize your income and spend over the course of the year that minimizes the impact to your quality of life?
• What are acceptable trade-offs throughout the year that you can take to achieve more significant savings?

Update your annual estimated expenses in the Expenses tab for the upcoming year based on these changes.

​Then, continue to use this spending plan to track your income and spend against your target expenses throughout the year.

​Here are a few scenarios where an annual spending plan and help guide your actions:

You want to increase your savings

​Your annual spending plan shows that you are currently netting an average of $100 in excess cash per month (or $1,200 per year), but you would like to save closer to $4,000 per year.

You look at your estimated expenses via the Expenses tab in the Annual Spending Plan workbook or your actual expenses broken down by expense category in an online tool like Mint or Personal Capital and strategize ideas on how to reduce your current expenses for the upcoming year. 

Your food expenses and debt obligations make up the majority of your expenses so you brainstorm how you can get more efficient with these expenses. Perhaps you start purchasing non-perishable items in bulk and plan more of your meals ahead of time to reduce food waste or impulse purchases at the store. Or maybe you decide to restructure your debt to reduce your monthly loan payments. 

All of these options have the potential to improve your savings rate without significantly impacting your day-to-day routine.

You want to better utilize your excess cash

​You realize you have netted an extra $500 in cash for the year after covering all of your expenses and other savings/investment accounts. Since you have no immediate needs for this cash, you decide to invest it in a diversified portfolio using a robo-advisor.

You need to reduce your expenses

​You find out that your expenses over time are exceeding your income which is putting you at risk of getting into high-interest debt or dipping into your savings. You identify a few subscriptions and memberships that you can cancel due to limited use but this still does not close the gap. 

You are paying $2,000 rent in a pricey neighborhood to reduce your commute time to work. However, if you move 20 minutes away, you could easily reduce your rent to $1,500. Now that your company has allowed a work from home policy, you can lower your rental payments by $500 per month without sacrificing a nice apartment.

Don’t Wait for Motivation

​Getting a true picture of your spending habits and cash flows takes time, and creating that space is crucial to cultivating long-lasting change. Therefore, the best time to think about managing your expenses is prior to any motivation to actually create one. If you are feeling pretty good about your circumstances today, it’s probably time to jump start the process of creating a plan now before life throws you a curveball. 

Setting up the tools and a process that works for you to manage your spending can take a little upfront work, but the effort to maintain it from there is fairly minimal. I spend about 30 minutes to an hour updating my income and expenses each month. 

As with any wellness plan, consistency is key. If you routinely check in with your finances each month, you are more likely to understand your regular habits, identify where change is needed ahead of time, and make incremental adjustments accordingly. 

With close to 40% of Americans unable to cover an unexpected $400 expense prior to the COVID-19 pandemic, there is certainly a need to pay closer attention to where our dollars are going, even when things look OK at face value. 

Gaining back control of your finances is a great way to reduce unwanted stress. Before you indulge in pricey self-care practices to take the edge off, try creating a spending plan instead!
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