Do you know your annual salary? You probably do. Do you know your after-tax income? Assuming your payroll withholdings are reasonably accurate, you can check your recent paychecks to get this information. Do you know your annual living expenses? What you think might be your annual living expenses could be inaccurate. To find out why, read on!
Why do we need to know our living expenses anyways? Well, this information is the basis of all long-term financial planning. Your spending determines how much money you have left to save for future financial goals. It also helps you to estimate your living expenses in retirement, which allows you to estimate how much you need to save during your working years to meet your retirement goals. Finally, I believe that knowing our cash flow helps us to make better everyday financial decisions.
You might say, “I track every penny that I spend in Quicken, and I can just print a spending report for the last year.” Well, that is a great first step, but you are probably not accounting for some recurring expenses that do not occur every year. For example, say you always pay cash for your cars and do not take out auto loans. Then, you are probably not accounting for automobile replacement costs. What about home maintenance, such as roof repair or major appliance replacements?
So, how do you estimate your living expenses while properly accounting for all recurring spending? First, you need to estimate your spending on expenses that do recur at least annually. If you track every penny in Quicken or another computer program, than you are done with this step. If not, then I suggest this method. First, track all of your spending for a few months using a notebook or spreadsheet. This should cover regular monthly expenses, such as rent or mortgage payments, utilities, groceries, etc. Then, look over your bank and credit card statements or registers over the past year and make a list of any other expenses that you are missing, such as insurance premiums, property taxes, birthday and Christmas gifts, automobile maintenance costs, etc. Finally, put everything together in a spreadsheet and express all spending on an annual basis. Let’s say that you go through this exercise and find that your total annual spending is $50,000.
After you have finished the first step of accounting for all of your yearly recurring expenses, you need to account for recurring expenses that occur less frequently than annually. Here is how. Say you normally spend $20,000 to buy a car and you replace your car every ten years on average. Let’s assume that the salvage value is negligible after ten years. Then, you want to add $2,000 ($20,000 divided by 10 years) to your annual spending. That was not too difficult. If you own a home, what about home maintenance costs? Well, that is trickier. Think of it this way. Take a look at your home. Eventually, almost every part of your home will need to be repaired or replaced – the roof, the paint, the plumbing, the carpet, furniture, major appliances, etc. Home maintenance costs vary depending on the type of home and local costs. One rule of thumb that I have seen is 1% of the home value per year. So, if your home is worth $300,000, you would estimate home maintenance costs at $3,000 per year. Let’s say that your estimated annual spending on expense items that do not occur every year totals $5,000. Then, your fully amortized total annual spending would be $55,000 ($50,000 from the first step plus $5,000).
Now that you have the magic number, what do you do with it? First, compare your fully amortized total annual spending to your after-tax annual income. Which is higher? If you find that your fully amortized spending is higher than your take-home pay, than you have a problem. Consider ways to reduce your spending so that you can save for your future. Second, you can use this information to help forecast and analyze your future finances.