Saving money makes sense, but it's tough to do if you don't have a plan in place. During Sound Ideas, Edgar Norton, Director of the Institute for Financial Planning and Analysis, said there are two primary approaches:
- Top Down
- Bottom Up
Norton said no matter which method you use, you should start now, and continue tweaking.
"It's better to start making decisions now, then adjust along the way, " Norton said.
The top down method works this way. It starts with that big number-- your monthly income. Then consider taxes, FICA and other deductions.
"Medicare and social security take out 7.65 percent. Then you have federal and state taxes. Before you know it, 80% of that gross pay is gone," Norton said.
Norton said the top down approach works best for people who have just experienced a major life change that results in an income change.
"If you're a new college graduate, or you are newly married. Or perhaps you've just been divorced.
As you could probably guess, the bottom up method is the opposite approach.
"This would be good for just about anyone who wants to assess their spending versus their income. It works especially well for people who are nearing retirement age," Norton added.
The bottom up method includes a math formula.
"First, examine your spending habits that have been established for your lifestyle, rent, mortgage payments, food expenses, etc. Add them up then divide by one, minus your average tax rate," Norton said. This amount is less than your marginal tax rate. To calculate it, examine your income amount on your most recent tax form. Also find your tax rate and divide that number by your total income and that will give you your average tax rate.
"For most people, the average tax rate is likely somewhere between 8 and 18 percent. Add a little more for state taxes," Norton said.
"This is when reality hits. Maybe you need to go through the practice again, and make spending adjustments to avoid going into greater debt," Norton said.