Intro to the reverse budget

When you start your first “real” job in medicine, income increases multiple-fold. It’s a huge responsibility to figure out a budget, or spending plan, that covers fixed expenses while saving for the future. With so many potential competing interests, it helps to have a plan for your money, whether you follow a traditional budget, or an approach like ours. To give you an example of what “paying yourself first” looks like in practice, read on. We follow a strategy called reverse budgeting. 

The aim of reverse budgeting is to set aggressive goals, which get paid automatically. This leaves you to spend the rest as you wish. If things are tight, there is less “fun money” around to spend. When times are good, your big goals are funded in the background, while you feel free to spend what’s left. 

This approach works during the lean years of medical school, to the relatively flush years of residency, when you finally get a salary. If you embrace this strategy early, it’ll be really powerful when you’re income increases.

Benefits of the reverse budgeting approach:

Once you’ve paid yourself first, there’s no guilt about spending what’s left.

Drawbacks of reverse budgeting: 

There’s less wiggle room in the bank accounts. With this approach, bank balances aren’t allowed to swell into purposeless slush funds. Budgeting takes a bit of discipline, compared to not budgeting at all. On the other hand, knowing you’re always getting closer to your big goals decreases long term financial stress. Ease your mind, Friend!

Step 1: Automate everything

All my 1099 (gross) pay first gets automatically deposited by the company I work for into a business account. This account is owned by my S-corporation, and I am the authorized user. From this account, I pay myself a salary using a payroll service. This means that the business account handles larger sums of money compared to the others. It is the account from which my business credit card charges are automatically paid each month (deductible expenses). From this account, I make lump sum contributions to my solo 401k (administered free at Etrade) and my health savings account (I use HSAbank). 

Note on the solo 401k:

Maxing out this tax deferred account is among my largest financial goals each year. Part of reducing our taxable income as much as possible is contributing the full allowed amount, which periodically adjusts upward for inflation. The max contribution is $56,000 for 2019. I accomplish this by contributing five to twenty thousand dollars at a time. Since the 401k is administered online, I can transfer money at any time, even between cases at work. You must contribute the total amount by the end of December to maximize your pre-tax contribution during a given tax year. For more on 401k investing as a W2 employee versus a 1099 earner, you can read my guest post on it at WealthyMomMD.

Depending who administers your 401k, you can choose from a number of investment options. My solo 401k is invested aggressively, in a Vanguard total stock market exchange traded fund (ETF) and some shares of Google, since I don’t plan to use that money any time soon.

Note on the family HSA:

The maximum HSA contribution for a family in 2019 is $7000. This year, I maxed out the contribution early. Making the contribution early in the year is tax-neutral, but allows more time for invested money in the account to grow. Our HSA funds are invested in a Vanguard real estate investment trust (REIT), to further diversify our investments.

My payroll company takes the money it gets from my business account and deducts things like payroll taxes and contributions to a dependent care flexible spending account (I talked about this benefit in a recent childcare post here). The net pay is divided into two bank accounts: one at a bank that services our mortgage, and one at Bank of America, where our household bills are paid. 

Step 2: Stabilize cash flow (the family account)

Get clear on the largest deposits and bills coming and going from your accounts each month, before tightening down on the balances like we do. For example, my credit card bill can run $2000-$5000 each month, depending on large purchases like a medical license renewal, travel to conferences, and so on. Mid month, there is an automatic draft to an investment account for $4500. 

Other expenses coming out of the family account are smaller: childcare, gardener, water, electricity, garbage, and so on. So I setup payroll to deposit the amount needed to the family account: not more. When I keep that account hovering around $10,000, it’s not too much, and not too little. I don’t want the balance to creep too high, or psychologically, we will feel that money is there for spending. 

When your expenses are relatively stable each month, you can figure out a comfortable balance level that works for you. A good level is one that gives adequate cushion for monthly fluctuation, without the headaches of an overdraft event. 

Step 3: Optimize paying for the roof over your head

The rest of my paycheck goes into the mortgage account. 

Our mortgage payment comes out of its dedicated bank account each month. Opening that account got me a quarter percent discount on the mortgage rate, if I put the loan on auto-pay (which saves $32,000 over a 30 year mortgage). Since our bill includes an escrow payment, our homeowner’s insurance premiums and property tax are included (yay for more automation)!

Step 4: Reverse budgeting uses separate accounts for separate goals

When we purchased a duplex, our first rental property, we opened a dedicated bank account for it. I collect rent by Venmo, then transfer to the dedicated account. That money covers bills, repairs, and other expenses. I aim to build that account’s value to plan for future capital expenses, like expanding the lower unit, and one day, new windows. That money is earmarked for the property, a real asset that makes us money. Over time, improving the property will allow us to provide more value to our tenants, and one day, more monthly rent (yay for cash flow)! 

My aim is to keep some tension in the budget. I want our money to be working on aggressive goals by design. We live a relatively frugal, wonderful existence on the rest.  

Step 5: Where’s the emergency fund?

Our emergency fund doesn’t sit in one account, it’s spread over multiple accounts. Several months ago, when it got too big, I used it to help buy a rental property, a goal I’d had my eye on for a while.

There is always some extra cash in the family account, the mortgage account, and the business account. If a plumbing tragedy were to befall us, we could scrape together thousands on the spot from our reserves. With a good understanding of credit cards, we could temporarily use credit, paying the balance in full, of course.

The HSA account is an excellent account for investing, but we could use it as part of the emergency fund, if we really needed to. Since we have plenty of medical receipts, we could redeem money in the account without a tax penalty.

My approach to reverse budgeting isn’t perfect, but it works for us. Each month, I see incremental progress. I hope the concept of reverse budgeting helps you think about your own strategy, and how you can tackle some of your own big financial goals.

Let me know what works (or doesn’t work) for your budget in the comments below!