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Pay Yourself First: Creating A Reverse Budget To Reach Your Goals

Find out “Pay Yourself First: Creating A Reverse Budget To Reach Your Goals” A recent study conducted by Fidelity is one of the most mind-blowing pieces of financial research I’ve come across in my 7+ years as a CFP®.

For the study, the company analyzed which 401(k) accounts performed the best. And there was one thing the top-performers all had in common: they were dead.

More specifically, they were owned by people who had forgotten they had an account — which often happens when someone has a small balance in a 401(K) to which they contributed in the past, such as from a short-term stint at a company.

Pay Yourself First: Creating A Reverse Budget To Reach Your Goals
Pay Yourself First: Creating A Reverse Budget To Reach Your Goals

Yes, it’s ironic. But there’s a big takeaway here, which is:

You don’t spend what you don’t see.

Americans paid 5.7 billion dollars in early withdrawal fees in 2019.

Can you guess who didn’t end up paying fees? The people who forget they had an investment account. And in the end, those are the people who enjoyed the best returns.

The concept of hiding money from yourself is a powerful one in personal finance, and it can be applied to your advantage in many ways.

One way to benefit from this strategy is referred to as “paying yourself first.” In other words, to automatically route a portion of your monthly income to designated financial goals immediately once it hits your account.

In fact, this is the strategy legendary financial columnist Jane Byrant Quinn says helped her start saving successfully:

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“To become a serious saver, start hiding money from yourself. It works every time — if you don’t see it, you won’t spend it. You won’t notice that it’s gone. Really, you won’t. I know, because hiding money started me on my first successful savings plan.”

In my opinion, the best way to implement a pay-yourself-first strategy is through a reverse budget.

What Is A Reverse Budget?

Reverse budgeting is paying yourself first to fund the most important goals you have in your life. Anything left over after funding your goals (and after you’ve taken care of your fixed-monthly expenses) is yours to spend as you please.

Traditional Budgeting Vs. Reverse Budgeting

Traditional budgeting is based on constantly tracking your income and expenses, with the hope that you’ll have enough money left at the end of the month to put towards your financial goals.

Reverse budgeting is the exact opposite; you put money towards your financial goals first, and then you spend whatever is left.

 

The Psychology Behind Paying Yourself First

There are a few behavior-based principles that help explain why paying yourself first works.

First is Parkinson’s Law, which states that “work expands so as to fill the time available for its completion.”

Time is a resource, and that same logic can be applied to any resource we have. When it comes to money, it tends to be the case that the more money we have available, the more of it we spend.

Paying yourself first counteracts the impulse to spend by limiting the amount you actually have available to you.

 

Second is The Paradox of Choice, which is the title of a book in which psychologist Barry Schwartz argues that an overabundance of choice increases anxiety and reduces the quality of our decisions.

Reverse budgeting counteracts this by reducing the number of financial decisions you’re tasked with making each month. You choose your goals upfront, pay towards those goals as soon as the money hits your bank account (ideally through automation), and then make sure to keep your variable expenses under a certain threshold.

With traditional budgeting, you might be balancing between different budgeting categories throughout the month, sorting dozens of transactions, and then finally deciding what goals you want to address (as well as specifically how much you can put towards those goals).

How To Create A Reverse Budget

Pay Yourself First: Creating A Reverse Budget To Reach Your Goals
Pay Yourself First: Creating A Reverse Budget To Reach Your Goals

There are four steps to creating a reverse budget:

  1. Determine your monthly expenses and income.
  2. Choose your financial goals.
  3. Automate your goals.
  4. Budget the rest.

I’ll cover the four steps in the next section. But the graphic below (designed for Pinterest) can help you visualize the flow of your money in a reverse budget.

Step #1: Determine Your Monthly Expenses And Income

In reverse budgeting, living expenses are broken down into your fixed and variable monthly expenses.

Fixed monthly expenses are ones that stay consistent from month to month. These are the bills that have to get paid, so money should be allocated to them.

The most common fixed monthly expenses are:

  • Mortgage or rent
  • Taxes (property, business income, etc.)
  • Utilities (cable, internet, electricity, trash, etc.)
  • Debt payments (auto, student loan payments, etc.)
  • Insurance (life, medical, auto, etc.)

Free personal finance tracking apps can help you easily obtain this data by downloading and importing your previous months’ financial statements.

 

Step #2: Choose Your Financial Goals

What are your most important financial goals right now?

You may have just one immediate goal, like getting out of high-interest credit card debt (which should be your top priority).

Other people may have more than one, like building their long-term retirement savings, saving for a down payment on a home, or setting up a six-month emergency fund.

So the first thing you need to do is identify the goals you want to start working on. Once you do, you’ll need to decide how much you’ll be paying yourself towards those goals.

As a starting point, subtract your total monthly expenses from your totally monthly take-home pay. The resulting number is what you can allocate to your goals.

For someone who has their emergency fund in place, this may look something like:

  • Dream vacation: $250 per month.
  • Saving for a down payment on a home: $500 per month.
  • Retirement account via a 401(K) + employee match: 6% of your paycheck.

If you’re struggling to choose your goals, a good framework to think about them is the baby steps. Specifically, make it a priority to pay off your existing high-interest debt and build a small emergency fund. Once you do have some cash in the bank, and your high-interest debt is paid off, more options to build wealth will open up.

Pro Tip: If there’s not a large gap between your total monthly expenses and income, it’s perfectly OK to start small. For example, the amount you pay yourself first may be just $100 this month. Challenge yourself and your finances with a difficult but manageable amount of money.

Step #3: Automate Your Savings Goals

Reverse budgeting isn’t just about limiting the number of decisions you have to make. It’s also about limiting your actions. That’s why, whenever possible, you should automate your savings (and even your expenses).

If your goal is to invest money into a Roth or traditional IRA, for example, this might require setting up an automatic transfer from your checking account into your IRA.

If your goal is to pay off a certain debt, you’ll not only want to set up automatic payments, but also pay yourself first by choosing to automatically pay additional principal towards that debt.

Set up your transactions so that once your direct deposit hits your bank account, the money is taken out as soon as possible.

Step #4: Budget The Rest

Here’s where you’ll experience the real simplicity behind reverse budgeting.

At this point in the process, your only goal is to stay below your “below the line budget.” There are no transactions to sort and categorize, and no guilt about spending money on luxuries. As long as you stay below your spending limit, all is well.

If you use a budgeting app, one common practice is to set automated rules that exclude certain expenses from your budget. By doing so, you can budget only for below-the-line (variable) expenses, which makes managing them much easier.

For example, say your salary is $5,000 a month and you’re applying $4,000 of that (80%) to financial goals and fixed-monthly expenses. You only have to worry about tracking and budgeting the remaining $1,000 of expenses.

Tips For Paying Yourself First

Pay Yourself First: Creating A Reverse Budget To Reach Your Goals
Pay Yourself First: Creating A Reverse Budget To Reach Your Goals

Here are a few things to keep in mind as you begin your reverse budgeting journey.

Expect To Fail

There are bound to be unexpected expenses along the way. This will throw your variable expense category off. And since you already “spent” that money, you’ll be left to wonder how to pay for these surprise expenses.

First things first: remember that this is going to happen. It doesn’t mean that you suck at budgeting. Instead, simply make a plan upfront for what you’ll do when this happens.

Here’s one such plan: Withdraw money from your emergency fund to help pay for the unexpected expenses during the month when they occur. Then, in the following month(s), make replenishing your emergency fund your top financial goal.

Yes, this may require you to reduce the amount you’re putting towards other goals, or even eliminate some of them for the time being. That’s OK — you’ll circle back to them once your emergency savings are back to full strength.

Remember The Big Three

Housing, food and transportation. If you’re struggling to stay under budget month after month, it’s likely because of one of these “big three” categories — not lattes or an occasional meal out with friends.

Percentages Vs. Dollar Amount

It’s important to know when saving with percentages is best, compared to when it’s best to save a specific dollar amount.

I like to use a percentage amount for long-term goals. For example, saving 10% of your income in a 401(K). For short-term goals, such as saving for a car, a down payment on a home or a vacation, I’d go with a specific dollar amount.

This way, if your income goes up, you’re not saving a lower percentage of your income over time.

What you’re trying to avoid is lifestyle creep, where variable expenses rise with income, and therefore, more luxurious expenses become necessities.

For example, very few people willingly fire their cleaning service or decide to buy an affordable car after driving a luxury model.

See How Far You Can Go With Incremental Increases

Supercharge your savings by challenging yourself with incremental increases towards your goals.

For example, every three months, increase your 401(K) savings rate by 1%. Then, see how far you can go — and whether you actually feel that 1% difference.

One year, one of my goals was to see if I could increase the amount I paid off my mortgage principal by $100 every month. It was a good challenge. And while I failed, it helped me reset my limits of what I thought was possible.

Reverse Budgeting FAQ

These are some of the questions people commonly ask about reverse budgeting.

Who coined the term “pay yourself first?” 

The phrase “pay yourself first” comes from the classic personal finance book The Richest Man in Babylon by George S. Classon. In the book, which distills financial lessons in a series of parables, Classon writes:

“A part of all you earn is yours to keep. It should be not less than a tenth no matter how little you earn. It can be as much more as you can afford. Pay yourself first. Do not buy from the clothes-maker and the sandal-maker more than you can pay out of the rest and still have enough for food and charity and penance to the gods.”

How do you pay yourself first in business?

If you have side hustle income or are self-employed, you can pay yourself first by regularly withdrawing a percentage of your gross income. Simultaneously, you’d also allocate profits to a savings account for taxes and operating expenses.

The book that best describes this method, which is what helped me get control of my business cash flow as a first-time entrepreneur, was Profit First by Mike Michalowicz.

How do you pay yourself first on a small income or when you’re in debt?

You can still use the “pay yourself” methodology while paying off debt.

One approach is to use the debt snowball method to determine which debt you pay off first. Then, at the start of the month (as soon as the money is in your account), put as much as you feel you can towards that debt.

To avoid overdraft fees, I’d switch to a bank that has none, such as one of my favorites Chime.

Final Thoughts On Paying Yourself First

Parkinson’s Law is not only one of the most important time management principles, but also a great framework for managing your money.

After all, if you walk into a car dealership with $10,000 in your checking account instead of $20,000, chances are you’re going to spend an amount closer to the smaller figure.

But just as important is the fact that, by using this approach, you no longer have to think month after month about what’s a priority. Instead, you can pick the right financial goals upfront and automate those transactions.

In my opinion, this gives you the highest chance of successfully completing them.

Have you tried reverse budgeting? Has it worked? What went wrong? I’d love to know in the comments.

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