Zero-based budgeting is a money management technique that entails assigning a purpose to every dollar you earn. The objective is to end each month having used every dollar wisely. In other words, you should have $0 left to spend discretionarily.
Keep reading to learn more about zero-based budgeting, its benefits, and the steps involved in practicing it.
Zero-based budgeting example
Let’s say you earn $5,000 (net) every month. A zero-based budget might look like this:
- Housing: $2,000
- Food: $1,000
- Transportation: $500
- Entertainment: $500
- Investment account contributions: $1,000
If you sum these expenses and subtract them from your net monthly earnings, you’ll arrive at $0 (hence the name “zero-based budgeting”).
Note: What separates the aforementioned budget from living paycheck to paycheck is the fact it entails building wealth (see the $1,000 investment account contribution line item). The point of zero-based budgeting is not for you to live paycheck to paycheck. Rather, it’s for you to comfortably cover expenses and assign whatever’s left to productive activities (such as investing).
Benefits of zero-based budgeting
Here are a few reasons many people (including myself) swear by zero-based budgeting.
Manage money more intentionally
With zero-based budgeting, every dollar you earn has a predetermined purpose. That leaves less room for reckless spending. It’s equivalent to planning a trip ahead of time by plotting its course on a map as opposed to figuring it out along the way.
Learn exactly where your money is going
This budgeting technique leaves virtually no room for guesswork in regards to where your money goes. It forces you to identify, ahead of time, which categories you’ll be spending money in each month. If you overspend (which would leave your budget in the negative at the end of the month), you’ll have to do a retrospective and figure out which category’s transactions were to blame.
Live within your means
With zero-based budgeting, you aren’t allowed to spend a penny more than you earn within a given month. In other words, this budgeting technique forces you to live within your means.
Prioritize your financial goals
As I mentioned in the previous section, a key advantage of zero-based budgeting is that it forces you to plan not only for your expenses but for building wealth as well. If saving for retirement is important to you, for example, build monthly 401k or Roth IRA account contributions into your zero-based budget.
Downsides of zero-based budgeting
No budgeting technique is perfect or right for everyone. Here are some downsides of zero-based budgeting you should be aware of.
Difficult to manage on an unpredictable income
People who earn irregular incomes (i.e. contractors, gig workers, etc) often find zero-based budgeting difficult. After all, you can’t give every dollar a purpose if you don’t know how many dollars will be coming in.
One modification that might help in this regard is budgeting to spend last month’s earnings as opposed to forecasting. In December, for example, you’d budget to spend whatever you earned in November. This requires discipline, though; you can’t touch the current month’s earnings.
Doesn’t account for irregular expenses
In its purest form, a zero-based budget assumes you spend the same amount of money every month. This isn’t the case for most people; you’ll likely spend more money than usual around the holidays in December, for instance. That can blow up your zero-based budget if you haven’t planned properly.
The solution? Plan properly. Setting up sinking funds is a very convenient strategy. It entails setting money aside each month until you have enough to cover some big future expense. Plan on spending $1,200 this Christmas, for example? Set $100 aside each month starting in January and you’ll have enough.
Zero-based budgeting can be stressful in its rigidity. It leaves virtually no room for error, meaning any lapse in judgment could put you over budget.
Keep in mind, however, you can build slack in by over-allocating as needed. If you’d like to spend $500 per month on entertainment but also want to account for the possibility you might party a little harder than usual one night, for example, perhaps budget $600 instead. You can always save the extra $100 if you don’t spend it.
How to create a zero-based budget
Next, let’s dive into the steps required to create a zero-based budget from scratch.
Step 1: Calculate your net income
How much money do you bring home each month? If you’re traditionally employed, this should be easy to figure out by looking at your pay stubs.
Again, if you earn an irregular income, refer to my note in the previous section regarding how to approach that.
Step 2: See where your money is currently going
Next, analyze your credit card and bank statements to see where you’re currently spending money. This will help you determine which budget categories to focus on in the next step.
Step 3: Identify your budget categories (and appropriate amounts for each one)
Next, decide which categories you’d like to keep in your budget – and how much money you should spend on each one monthly.
Be sure to include some form of wealth-building category in your budget. Whether it’s eliminating high-interest debt, adding to your retirement savings, building an emergency fund, or all of the above, make sure you’re doing more than just paying bills with your zero-based budget.
Step 4: Ensure you have some means of tracking your progress throughout the month
Speaking from experience, this next step is essential to succeeding at zero-based budgeting. Implement some means of tracking your expenses throughout the month to ensure you’re on track. I recommend an application called Mint, which connects to your bank and credit card accounts, helping you track expenses in one convenient location. Check out this article, where I share tips on getting set up to track expenses through Mint.
There are loads of other great zero-based budgeting applications out there, too. You Need a Budget (YNAB) is another example. It’s actually built around the concept of zero-based budgeting and makes it very easy to understand and approach.
Step 5: Review your progress on a monthly basis
Lastly, it’s important to check in on your zero-based budget and adjust as needed. I recommend doing this every month. Look at your spending and ensure you haven’t gone over the limit in any category. If you have, evaluate whether that was a lapse on your part or indicative of you not having allocated enough money to that category.
Additional tips to help you succeed at zero-based budgeting
Don’t feel bad if it doesn’t work for you
No budgeting technique is right for everyone. In fact, you may need to try a few before finding one that meets your needs. You may even find there is no single budgeting strategy that meets your needs and you instead need to use various strategies.
Check out my blog posts on the topic of spending for some general tips.
Consider the 50/30/20 rule when setting your zero-based budget categories
The 50/30/20 rule entails spending 50% of your income on needs, 30% on wants, and 20% on savings. It’s by no means a blanket rule but can be helpful if you aren’t sure where to start when setting your budget categories.
Not sure how to define needs vs. wants? I’ve got you covered – check out this blog post I wrote on that very topic.
Choose your savings and investment accounts wisely
Where you choose to keep the wealth-building portion of your zero-based budget may play a major role in determining whether you succeed. If you’re an impulsive spender, be sure to keep that portion in an account you’re unlikely to withdraw from for short-term wants. For example, I keep my long-term savings in accounts completely separate from my day-to-day checking funds.
Additionally, be sure to choose account types that match your goals. If you’re saving for retirement, for example, consider a dedicated retirement savings account. If you live in the United States, check out this article I wrote containing a list of the various investment account options available there.
Zero-based budgeting: Conclusion
I hope this article has helped you understand zero-based budgeting, its benefits, and how to get started. Click here for more of my articles on the topic of spending money wisely.