This post, like many others, started off as a mailbag question and wound up taking more space to explain and discuss the idea than could reasonably be included in a mailbag post. Kevin writes in with a great question:
Have you ever heard of 70-10-10-10? Is it a good idea?
70-10-10-10 is a budgeting strategy popularized by the late Jim Rohn. The idea is really simple on the surface. You simply take all of the after-tax money you bring home and split them into four groups.
The first group is the “70” part of 70-10-10-10. It suggests that you use 70% of your take home money to live on. If you bring home a $1,000 paycheck, $700 of it goes to living expenses. Easy enough, right?
The second group is the first “10” of 70-10-10-10. It suggests that you use 10% of your take home money for “active investing.” You put it in your savings account or somewhere else where it’s easily available and use it to invest in things that you observe in your day to day life. I’ll get into the specifics of this later.
The third group is the second “10” of 70-10-10-10. It suggests that you use 10% of your take home money for “passive investing.” This means that you’re putting money into your 401(k), putting it into a Roth IRA, or something like that. This is money that you just put aside and don’t think about, knowing that it will build over time into a nice nest egg for you.
The fourth group is the final “10” of 70-10-10-10. It suggests that you use 10% of your take home money to make your community or the world at large a better place through some form of giving.
I think this is a good, solid budgeting strategy for most people. Having said that, I think there are a few issues worth discussing in detail.
The “70” Requires Lifestyle Changes for Most People
Before we dig in here, it’s worth noting that for the average American, the ratio they live by is something like 91-3-3-3. In other words, most Americans only put aside around 6% of their income for the future and donate around 3% of their income.
For people to make the switch to 70-10-10-10 means that they have to inflate their savings from 6% to 20% and their charitable giving from 3% to 10%. That money has to come from somewhere, and it comes from living expenses.
In other words, the big challenge for people interested in a 70-10-10-10 model is that they will have to cut their living expenses from an average of around 91% of their income to around 70% of their income. In other words, they’ll have to trim about 23% of household spending to be able to pull this off.
Now, there is good news: that 23% in household spending is the bottom 23%, the 23% that’s least important to you in your daily life. It encompasses the things you spend money on that don’t really bring you any value whatsoever.
It’s still a healthy dose of spending, and it’s going to require some changes to what you’re doing.
I recommend starting with these eight big financial steps, which are:
+ Moving to a smaller home or apartment
+ Moving closer to work
+ Commuting via bike or mass transit
+ Eliminating cable or satellite television
+ Shopping around for all bills
+ Preparing meals exclusively at home, except for special occasions
+ Switching (almost) exclusively to store brands
Doing a few of them will likely get you close to that 23% mark. If you couple that with tightening the belt a little on your incidental spending, you’re going to be getting pretty close to that target.
The issue with such changes is that while they’re easy to suggest on paper, what actually matters is taking action on making those changes. If you just think that you’re really going to cut spending but don’t actively work to change much of your lifestyle, you’re not actually going to cut much spending. You’re not going to cut your spending from 91% of your paycheck to 70% of your paycheck.
This is the foundation. You have to make the spending changes before you can do the other pieces of the equation. If you don’t change your spending first, this budgeting “strategy” becomes 91-10-10-10, which adds up to 121. Where’s that other 21% coming from? Debt. If you immediately hop on board with the three 10s without adjusting your spending first, you’re going to end up financing your lifestyle with debt, which means that while your investments and savings might creep up a little, your debt total is going to go up even faster.
This needs to come first. Change your lifestyle and the other changes will follow.
What’s the 10% for “Active Investing” For?
Over the years, Jim Rohn waffled a little on the purpose of the first 10%. He often referred to it as “active investing,” but also referred to it as “savings.”
In general, Rohn’s idea was that you could keep some of your money in a savings account for easy access for two main purposes.
First, it serves as an emergency fund. You could treat it as a “bank” from which you can take out a 0% loan in an emergency and then pay it back on your own terms. His idea of an emergency fund was one that you repaid when you took the money out.
Second, it serves as something of an “opportunity fund.” An opportunity fund is a stash of money you have set aside in case life hands you an exceptional opportunity. For example, you might find someone selling a piece of equipment that you’d really love to have for $300 cash. Without an “opportunity fund,” it might be hard to instantly cough up that much cash; with one, it’s a matter of hitting the bank or an ATM for a moment.
Often, “opportunity funds” are used to flip things, like when you’re buying something for $100 when you know you can sell it again for $500 if you put a little time into it. It might also be used for special life opportunities, like being able to go on an unplanned trip. In either case, you’d eventually repay the money you took out of the fund and, if you profited, you could use that for other investments or to further bolster the fund.
Personally, I have an emergency/opportunity fund that I’m constantly funding via automatic transfer from my checking account to my savings account. I don’t refill it when I need to tap it, but I do sometimes take some of the excess out (“excess” being money in excess of three months of living expenses) and use that excess to make an extra contribution to my passive investments (see below). I find that this automated approach makes it very easy to keep stocking my emergency/opportunity fund.
Speaking of which…
Is the 10% for Passive Investing / Retirement Enough?
Another plank of Rohn’s 70-10-10-10 plan is that you put aside 10% of your take home pay into passive investments for your long term future, namely retirement. There will come a time where you no longer want to work for a living or you want to make a radical career change, and that money is there for you when you reach that crossroads.
It’s worth noting that Rohn was largely suggesting this in an era before 401(k) plans became prevalent. He was mostly suggesting that people open up normal accounts at investing houses and put that money into mutual funds.
Today, things are a little different. Many workplaces offer a 401(k) plan, which takes money out of your paycheck before taxes. Some workplaces offer a Roth 401(k) variant, which uses after-tax money.
What does that mean? With a normal 401(k), you pay taxes when you take the money out in retirement. With a Roth 401(k), you pay taxes now and then can take out money in retirement without paying taxes on it.
To stick with the 70-10-10-10 rule, you should be contributing about 13% to a normal 401(k) (which will drop your take-home pay about 10%) or 10% to a Roth 401(k). (A similar rule of thumb is true for a 403(b) or TSP).
What about a Roth IRA? That’s a good option in some cases, particularly where your workplace doesn’t have any kind of retirement plan. A Roth IRA is something you can open yourself by talking to an investment house of your choice (I use Vanguard for mine). You’d sign up for automatic contributions from your checking account, so you’d want to set it up to scoop out 10% of your take home pay. Remember, the annual contribution limit for a Roth IRA is $5,500, so if you’re bringing home more than $55,000 a year, you’ll want to keep an eye on it.
As with the “opportunity fund,” you’ll want to automate this kind of savings. Turn on automatic workplace contributions with your 401(k) or sign up for a Roth IRA and turn on automatic contributions from your checking account. That way, you don’t have to think about it – it just happens.
The big question, though, is whether or not this is “enough.” Is 10% of your income enough to build a healthy retirement?
For the most part, I would say “yes,” but it depends on a few things.
First and foremost, how much are you going to be cutting your spending in retirement? Most people do spend less in retirement simply because they’re not working and they’re simply not going to restaurants or commercial establishments as often because they’re not going out of the house to work every day. Often, people spend about 80% of their pre-retirement spending once they retire if they’re not consciously making cuts. If they’re intentionally cutting back, it can be much lower – for example, if you intend to move to less expensive housing when you retire, the decline in spending will be even sharper. You’ll also have access to Social Security and Medicare, though you will likely see an increase in medical costs.
So, the more you’re willing to trim back in retirement, the more likely it is that 10% will work for you.
Second, how old are you when you start saving adequately for retirement? If you’re in your twenties when you start saving and you sock away 10% of your annual income all the way through, you’ll be in good shape. If you’re 45 and just now starting, it might be a lot tougher to get there and you may want to save more than 10%. In general, if you’re under 30, you’re fine with 10%, and if you’re in your thirties, you’re probably fine with it if you don’t harbor illusions of retiring early.
Finally, when do you plan on retiring? If you want to walk out the door at age 60 as compared to age 70, not only are you going to need ten more years of living expenses, you’re also going to have ten fewer years to save. In other words, the younger you want to retire, the more you need to push beyond that 10% level.
So, if you’re younger, don’t intend to retire super early, and plan to be reasonable in terms of spending in retirement, 10% is a great number.
If you’re starting when you’re older or want to retire super early or want to have a cushy retirement, you should aim for more than 10%, the more the merrier.
The Question of Giving
The final “10” in this plan is charitable giving. The idea behind it is that you simply give 10% of your take-home income to something that makes your community or the world around you a better place, and that’s up to your own judgment. What can you do with your money that will make your community a better place? What can you do that will make the world a better place?
As I noted earlier, the average American gives only 3% of their income to charitable giving, so bumping that up to 10% is a pretty significant change for most people. Plus, there’s the tension that exists between maximizing your financial situation and giving away some of your money.
I can’t really answer those dilemmas in any meaningful way other than to talk about our own charitable giving.
For the most part, Sarah and I give locally. Most of our giving is done to organizations and groups in our community. These contributions benefit us indirectly – in some cases, they go to help community programs that we enjoy, while other donations (like the local clothing pantry or food pantry) help out those in need in our community.
We give a small amount to national and international charities, but we’re really careful about such donations because it’s really hard to see those dollars at work. We have to trust sites like Charity Navigator and other tools when we donate because we actually can’t be sure that the dollars are really going to those causes. We do give to larger charities, but it’s with pretty extreme care.
We give a little bit occasionally to political campaigns, but this is very infrequent.
Our philosophy is that if we give locally, we can see the dollars at work actually making lives better, and those lives go on to do bigger and better things in the world, creating a positive ripple effect where we can see some of the initial ripples. Those ripples indirectly affect us as well, as it improves the community we live in and our children live in. It’s hard for us to see those dollars at work if we give to charities that take the money far away from us, so we’re very careful with that kind of giving.
I can’t tell you how much to give or where to give, as that’s a very personal decision. All I can say is this: Sarah and I don’t regret a dime of our charitable giving. For us, being able to witness some of the impact of it has been incredibly life affirming.
The 70-10-10-10 budgeting model is a solid framework for people to use if they’re uncertain about how exactly to proportion their money. While it does require some significant personal spending cutbacks, it prescribes a level that most people can actually pull off while also adding long term security and the flexibility to take advantage of opportunities and handle emergencies.
I tend to look at models like 70-10-10-10 as starting points for people who are trying to figure out what really works for them. If you line your finances up with this model, over time you’ll start to notice that some elements really click for you while other elements are challenging or rub you the wrong way. That’s when it might be time to make some adjustments, like going to 60-15-15-10 or 80-5-10-5, depending on what your goals are and your life is like.