=Intro bookend=

Hi. 

In this video, we will discuss some more gruesome details of income and spending, looking into paychecks, personal spending patterns, and budgets.

=Learning objectives=

After this lesson, I hope you will be able to do the following:

* Describe major items on a paycheck
* Classify types of paycheck deductions
* Identify major spending categories

and 

* Explain the basic budgeting process

=Money flows=

Previously, we discussed that in the grand scheme of things, you have inflows or income, you have outflows or spending, and you hope you have some left over.

Let's first focus on the inflows side, by looking at a sample paycheck, and how much of your paycheck you get to keep after various deductions.

Later in this lesson, we'll look at the outflows side, and talk about spending and budgeting.

=Sample paycheck=

Let's take a look at a sample pay stub, and dig into numbers a bit.

The precise format of your pay stub may differ of course, so just focus on the main ideas here.

At the top, we have the pay date and the pay period covered. 

Then we have a convenient summary section, giving us the current period and year to date sums for this year. 
Let's examine the 'current period' column.
The salient point here is that for this two week pay period, the employee earned 44 hundred and 72 dollars, but after all the deductions, which amounted to 1761, he only gets to go home with 27 hundred or so. In addition, the employer made its own contributions toward certain deductions and benefits.

The second column, YTD amount, just shows the totals for all pay periods throughout the year so far. This being an October pay slip, most of the year has already passed by.

The Earnings section doesn't give us any new information that we care about at the moment. If you are an hourly employee, you might see here the number of hours worked, including overtime hours. Let's keep scrolling. 

Benefits, deductions and taxes section is the meatiest part of the pay stub.
The first column has the names of all the items. The Employee and Employee YTD columns show current period and year to date contributions by employee to each line item, and the next two show the same for Employer contributions.

First, we have some pre-tax deductions - this means we get to subtract some items from our income before calculating taxes due. We will discuss the structure of income taxation in the United States in some later video, for now, don't worry too much about this detail.
We pay for a dental insurance plan, for health insurance, and a 401k. You will notice that on these items, there is both an employee contribution, as well as an employer contribution, which means that in addition to paying his own money for this, the employer throws in some of its own money. This is a nice benefit, essentially equivalent to extra compensation by the employer.

Health and dental insurance are mechanisms to limit total potential expenditure on health maintenance. We will talk at greater length about insurance in future lessons.

The 401k is an interesting beast. The great news is that this is not an expense, but rather a savings account, where the employee puts away some amount of his current income for the future. This particular employer seems to offer a generous matching contribution to the 401k savings plan. So by making a contribution to the savings account, the employee gets some more free money from the employer. Nice. We will discuss retirement savings in a future lesson. For the moment, I will just say that if your employer offers a match for 401k contributions, max it out, otherwise you are leaving free money on the table.

Now come the bad news, the taxes. We have some federal items, the income tax, the medicare tax, and the social security tax. We also have a bunch of state level taxes, in this case for New Jersey. Just the taxes alone, add up to about 13 hundred dollars, and explain the majority of the deductions from the paycheck.

In the last section, we see that this person has arranged for the net amount of the paycheck to be automatically deposited into his checking account at the bank. Generally a good idea to do this, so you don't have to deal with the paper check yourself.

As you can see, there is a lot of outflows that happen even before you get your hands on your money. Just the taxes here have eaten up about 30 percent of the gross earnings (1300 out of 4472).

=Spending=

Now let's move further downstream, and look at discretionary spending. 

What are the main categories of stuff that people spend their money on? There is a lot of different stuff out there, but we can get a handle on it by looking at how government surveys break it down.

We are going to take a look at the data from the Bureau of Labor Statistics Consumer Expenditure Survey. The first link is the main site for this survey, and the second is a PDF report for the year 2013, which is where the numbers in this lesson will be coming from. The last link is the glossary of terms, describing the details of each spending category used in the report.

The average household in the U.S. has 2.5 persons in it, and this is what it looks like as far as income and spending.

First, let's look at the top. The average pre-tax income is about 64 thousand, and after taxes of 7.5 thousand, the household is left with about 56 thousand dollars. 
But this tax amount is understated, since social security and medicare taxes are actually binned into the insurance and pensions item, down here. 
However, though in theory social security and medicare taxes are used for future pension outlays, this money is used for /other people's/ pensions, not yours. You have absolutely no access to this money once it leaves your hand. You can certainly hope that once you reach retirement age, the social security system is still in operation, but hope doesn't pay the bills. With the employee portion of social security and medicare taxes being about 7.5 percent, this comes out to about 4500 bucks. So our total average tax burden, then, is 7.5 thousand plus 4.5 thousand = 12 thousand bucks, or just under 20% of income.

Now, let's consider our after tax income, 56 thousand, with our total expenses, 51 thousand. This means that the average household saves about 5 thousand dollars per year, which is about 10% of after-tax income.  Somewhat encouraging, but not very much, all things considered.

Next we have our major expense categories. The Bureau of Labor Statistics report breaks some of these down into finer categories - for instance, see the total Food expense composed of home cooked food and eating out. If you want to dig deeper, check out that PDF I linked you to earlier.

The third column, expresses the spending amounts as percent of total spending.

If you are a fan of raw numbers, feel free to pause the video here and examine the numbers at your leisure. 

Let's check out the major expense categories sorted by size. You can easily see that housing is the biggest expense, followed by transportation, then food, and so on. Remember to mentally subtract 4500 bucks from insurance and pensions and move it to the tax category, because you have no control over this part.

The point of looking at all this is to understand the ways people spend money, and help us analyze what our own spending looks like in various categories. 

Spending money is easy - really easy - without even realizing how much you are spending. The world is chock full of messages trying to entice you to spend money on everything under the sun. It takes both awareness, and discipline, to control your spending. Building an explicit budget for yourself is a tool that helps on both fronts.

=Quiz 1=

Here's a question for you - if you are saving 10% of your after-tax income, and thus consuming the other 90%, how many years will it take you to save up for one year's worth of expenses? Pause and think about it for a bit.

The answer is, 9 years. 
Imagine this bar represents your entire after tax income. You save 1/10th of it, and you spend the other 9/10ths. 
So you need to think, how many of these green saving chunks do you need to accumulate, in order to cover your entire spending needs? Since your spending is 9 times as big as your saving, it'll take 9 years of saving.

What this implies is that saving only 10% of your after-tax income is not a very fast way to accumulate productive assets.

Bonus question - what if you save 25%, or 1/4th of your after-tax income? How long does it take then? How about 1/3rd? How about one half?

=Effective budgeting=

So let's talk about the basics of budgeting.

Before anything else, we need to build awareness of what our spending picture looks like, so the first step is to gather information. Collect your bank statements, credit card statements, ATM receipts, anything that gives you a record of what you spent over the past few months. Add up your monthly spending, and categorize it using your favorite classification scheme. Maybe base it on the Consumer Expenditure Survey categories, and tweak it to your needs.

If you tend to spend a lot of cash without recording what you spent it on, you should spend a month or two noting down every time you spend cash, in order to have a more accurate picture of your spending.

Once you know what your spending looks like, relative to your income, create a written budget, with desired spending amounts in each category. Keep things realistic - it would be nice to spend 0 dollars on food, but probably not likely to happen. Based on your review of past data, think about where you could cut your spending to increase your savings rate.

Stay organized - keep ongoing track of your spending looking forward rather than backward. If you only look backward at the end of the month, it's too late to do anything about it if you blow your budget.

Finally, if you find your spending categories or amounts do not suit your life, change them around to make them work for you. Budgeting is a continuous process  and it's ok to tweak things around as the need arises.

=Additional reading=

I hope you enjoyed this look into the details of where your money goes, from your initial earning inflows, to food in your belly and roof over your head. We have also had a brief look at budgeting, an effective tool to build awareness of your spending habits and help you maintain financial discipline.
In future lessons, we will touch on spending and saving, and discuss all the reasons why it is important to spend less than you earn and build up a base of productive assets.

Check out the link above. The website of financial literacy and education commission has many personal finance resources, among them some helpful budgeting and planning tools.

=Attributions=