NerdWallet's Smart Money Podcast - Questioning the 50/30/20 Budget and Company Stock

Episode Date: November 28, 2022

The 50/30/20 budget is a simple way to organize your finances. But as rent prices soar and inflation impacts everything from gas to groceries, does this budget still make sense? To start this episode, Sean and Liz discuss the merits — and limits — of the 50/30/20 budget. Then they answer a few listeners’ questions about navigating company stock. To send the Nerds your money questions, call or text the Nerd hotline at 901-730-6373 or email [e-mail]. Also, for a special end-of-year episode, we want to hear your financial rose, thorn and bud of 2022 — aka the best and worst thing that happened with your money this year, and what you’re most excited for in the new year. Leave us a message on the Nerd hotline, or email [e-mail].  Timestamps: This Week in Your Money segment: 0:00 - 8:28 Money Question segment: 8:29 - 27:14

Hey folks, Sean here. I hope you all had great Thanksgivings. Liz and I are off for the week, so please enjoy this episode from our archive. And before I go, one quick plug. For our special end of year episode, please send us your rose, thorn, and bud of 2022. Your rose is the best thing that happened to you this year. Your thorn is something that you struggled with. And your bud is what you are most excited for in 2023. You can send these to us on the Nerd Hotline by calling 901-730-6373 and leaving a voicemail. You can also email a voice memo to us at podcast at nerdwallet.com or just send us an email with it all written out.

All right, talk to you guys next week. ISOs, NSOs, and RSUs. Companies offer their workers an alphabet soup of stock, and regardless of whether they make you rich, all of them have tax consequences. Welcome to the NerdWallet Smart Money Podcast, where we answer your personal finance questions and help you feel a little smarter about what you do with your money. I'm Sean Piles. And I'm Liz Weston. To send the nerds your money questions, leave us a voicemail or text us on the nerd hotline at 901-730-6373. That's 901-730-NERD. You can also send your voice memos to podcast at nerdwallet.com. Follow us wherever you get your podcasts to get new episodes delivered to your feed every Monday. And if you like what you hear, please leave us a review and tell a friend.

In this episode, Sean and I answer some listeners questions about investing in your own company stock. But first in our This Week in Your Money segment, we're talking about the 50-30-20 budget and whether it still makes sense in a world of high housing costs and inflation. I think we should start by giving a quick rundown of the 50-30-20 budget. So in a nutshell, you take your after-tax income, and 50% goes to must-have expenses, things like shelter, food, transportation, minimum loan payments, insurance, etc. And then 30% goes to wants, that's clothes, eating out, vacations, travel with your friends. And then 20% is supposed to be allocated towards extra debt payments and savings. The way I usually think of must haves are the expenses that you can't put

off without having serious consequences. So wants are things you can put off without major problems, but if you don't pay your landlord, serious consequences are going to happen. So it's understandable with prices rising, with rents going through the roof, a lot of people have the question of, will this still work? Right. I mean, it makes sense because there's some information from the U.S. Census Bureau that shows just how expensive things are for a lot of folks out there. 23% of American renters spend more than half of their gross income on rent, and nearly half of renters are spending more than 30%, which officially qualifies them as cost burdened. That's according to the US

Department of Housing and Urban Development. HUD says that people who spend that much may have difficulty affording necessities such as food, clothing, transportation, and medical care. If so many people can't make the 50-30-20 budget work, does that mean that the budget is unworkable entirely? I hear that question a lot. And I think to answer it, we really need to go back to the genesis, where it came from. And people might not know that the 50-30-20 budget was actually created by Elizabeth Warren. So she is now a senator. She was a former presidential candidate. You've probably heard her name, but she and her daughter wrote a book called All Your Worth that describes this budget. And in her previous life, Warren led the consumer bankruptcy project at Harvard

University, and she researched how and why Americans were going broke, why they kept filing for bankruptcy. What she found was that rising living costs and stagnant incomes were causing people to stretch farther and farther to cover the basics. And that left them with too little leftover to save for the future or pay off debt. She also wrote about this in another book

called The Two Income Trap, where she noted that people were trying to get into good school districts and the housing in those districts were getting more and more expensive, on top of the fact that medical care and college educations were going through the roof as well. All these things used to be affordable on one income and now require two. With all those challenges, Warren thought that by limiting our must-haves, that will give us more wiggle room so that we can save, get out of debt, and enjoy our life simultaneously. And having the must-haves, your basic expenses limited to half of your income, also makes it easier if you lose your job. There's less of a nut to cover. Yeah. And a lot of folks can think of the 50-30-20 budget as prescriptive, as something that you have to follow. Otherwise,

you're not managing your money well. And in reality, for most people, it can be a really good guideline. But for some folks, it's just not realistic. Yes, it works on many incomes, but not every income. If you have a super low income, you may not even be able to cover the basics, you know, with 100% of your income. People with very high incomes may have basics that are well below 50%. And when I first came across this budget, our must haves were something like 80% of our income. It took a while to get it down to 50% and make all this work. So I understand that when people first encounter this, they may think, oh, there's no way that I can do this. The whole point though, is to try to get a budget that is

balanced, that isn't all one thing or all another, that doesn't cause you to go into debt every month. And it's something that you can work towards. You don't necessarily have to be exactly according to those guidelines all the time. And for me, I was just so delighted when I came across this because until that point, people kept asking me, well, what should I spend on X, Y, or Z? And the answer is it depends. Everybody's situation is so different, but this general guideline seems to work for a lot of people. I think a lot of people are in the situation you described when you first started using the 50-30-20 budget where you have a decent income coming in, but your expenses take up more than half of your income. How do you whittle that back? Because the approach of, oh, just move to a cheaper city. Oh, just find a less expensive apartment isn't easy or realistic for many people.

Yes, exactly. And it takes a lot of doing. I think the effort is worth it to get a more balanced budget. But for a lot of people, it's going to involve making more money. That's what happened with us. And that's not something that everybody can do. If you're on disability income, if you're not able to work, if you're in an area without a lot of possibilities, this can be really tough. But if you're in an area where the cost of living is way out of reach for you, it's going to continue to be like that. There is no budget that's going

to make it work. So making those big changes may be what's necessary for you to get a more balanced budget and a more balanced life. Right. And while the key to any budget is getting all of your expenses to add up to less than 100% of your income so that you do have money to save and pay off debt. Yeah, exactly. And you may be in a situation where you think, okay, I'm willing to do must haves that eat up 70 or 80% of my income for a while. And then down the road, we're going to be in a different situation where we don't have to do this. And I totally get that as well. Well, there are trade-offs in both directions. Like for a while, my partner and I lived in San Francisco and we did that when we were in our

early to mid twenties. And that helped us get on the professional tracks that we're on today. Then once we were established, we looked at our money and realized we can't sustain this and save money at all. So we moved to a less expensive area. And that's allowed us to get more balanced with our budget and actually save money and build our wealth over time. Yes. And that is an ideal way to approach this is to be realistic about where you are, what's

coming in and what's going out. And it goes back to the, you know, Ben Franklin era advice about how important it is to live below your means. It just means that you are going to have so much more flexibility to be able to deal with life. It's going to cause you a lot less stress and it really is worth it. Whatever budget you wind up using. Okay, well, let's get on to this week's money question. Let's do it.

This episode, we are answering a few questions about company stock and stock splits. And to help us talk through these topics, we are joined by investing nerd Alana Benson. Welcome back to Smart Money, Alana. Hey, guys. Thanks for having me. Great to have you on, as always. So before we get into these three money questions, I have a quick disclaimer, of course, and it is that we are not financial or investment

advisors and we will not tell you what to do with your money. This discussion is for general educational purposes only. And let me underline this. You really need to get personalized advice from a tax pro if you're dealing with this stuff. It's very complicated and there just aren't any one size fits all answers. And as you will hear with the first question, it is thorny and technical. So let's just dive right into it and see how it goes. Here's the first question, which came from a listener's email. For the first time in my life, and I'm 50 years old, I've joined a publicly traded company where they issue company stock as part of their annual bonus package. I understand that I invested gradually over a five-year period, but my understanding

stops there. What should I do with these RSUs as they are vested? And if I do anything with them, will I be taxed? Okay. So Alana, let's talk first about why companies issue stock as part of a compensation package. Employers use stock and stock options as a way to attract and retain their employees. Usually these packages only start becoming valuable after a certain amount of time. So you won't fully get the total value until after their vesting period. And that's where it comes in as a way of retaining employees. It's a promise of future money. Exactly. Potentially.

Potentially. It's a really big asterisk on that one. So we've all heard stories about people getting fabulously rich off of stock options or company stock. That's not really the norm, but getting a slice of equity can be a nice perk if the company does well. Yeah, which is another big if, if the company does well. So let's also talk about how vesting schedules work. Can you give us a rundown, Alana? It gets complicated. So if you don't understand

it right away, that's okay. It takes a couple of read-throughs or listen-throughs. But vesting is basically when you have the right to a benefit with incentive stock options or ISOs, you're earning the right to exercise and buy the stock over time. And if it's stocks or RSUs, it's when you actually get the stock. Just because you are maybe granted a schedule that says that you will get stock, that doesn't mean that day one when you start with a company, that stock is yours. Vesting schedules can have a lot of variation. So you really need to read your paperwork and make sure that you know the particulars of your own vesting schedule. One thing that some of them have in common is what's called a cliff,

and that's a length of time that a person has to work at the company before the vesting schedule starts. So maybe you have to work at your company for a full year before any of your stock actually starts to vest. And a lot of times this vesting only happens if you work for the company. So if you quit or get fired, a lot of times that equity is out the window and you likely won't get any of it. Which is how these can be great retention tools because the vesting schedule is often fairly gradual and you have to be a part of the company to be able to have your stock options, stocks, or RSUs actually vest. Exactly. A pretty common vesting schedule is vesting over four years with a one-year cliff. So that one-year cliff, again, means that you have

to wait a year before you get anything. After that first year, you'll get a chunk, say maybe 25%. Then you slowly earn the rest of the grant over time, usually at a rate of about 2% each month. You can start to see how this could be used as a retention tool where maybe someone's considering quitting, but then they say, oh, well, if I just wait until this date where I'll have more of my stock fast. And so that works over time. So far, we've been talking about stock options and RSUs, I think it would be helpful for us to give our listeners a quick explainer of each of these. Yes, there are several different kinds. So it does get complicated. The first one we're going to talk about is employee stock options. These allow you to buy

a certain number of company shares at a specified price during a specified time, and that's usually at a discount. There's different kinds. There's NSOs, which are non-statutory stock options, and ISOs, which are incentive stock options. And there's a couple of differences, but mainly ISOs are issued just to employees, whereas NSOs can be granted to outside service providers. Sometimes it's people on the board of directors or advisors, folks like that. ISOs have better tax treatment, and a lot of times those may be more favorable. But again, there's lots of smaller differences. Another more popular or becoming more popular kind of employee stock is restricted stock units or RSUs. These are similar to stock options, but you don't actually have to purchase them. With stock options, a lot of times

you're granted this ability to purchase them, but you still have to actually pay for them. With RSUs, they just become yours over time as they vest, which makes them a lot more attractive because you don't actually have to pay anything for them. Yeah, it streamlines the process in a way. And our listener is wondering about the tax implications of RSUs. What do you think they should know? With RSUs, you're typically taxed when you actually get the shares, which is almost always when they vest. The value of your shares is added to your taxable income, and you're paying ordinary income tax rates plus Social Security and Medicare taxes. And in a high tax state like California or New York, you could easily pay 40% or more when your

RSUs vest. Some employers offset those taxes and some don't. So again, you'll just have to look at the paperwork for your individual equity allowances. All right. Now our next question comes from a listener's email. It says, Hi, nerds. I work at a startup and I was granted 12,000 stock options on a four-year vesting schedule. I've been with the company about two years, which would mean I could execute up to half. My strike price is 30 cents, so I can afford to do it, but it's a significant expense. My company is still a few years away from a liquidity event where I would be able to sell this stock.

Is buying early a good tax strategy? I've been reading about the alternative minimum tax and getting taxed as long-term capital gains instead of income, but I'm not sure how it all works. I'm pretty personal finance savvy, but there's not a lot of info out there for startup employees. Would love to hear a podcast episode to help those of us who staked a lot working at a startup and might be risking a big tax bill in our futures. Thanks. Well, we are here to help you, dear listener.

So Alana, our listener, threw out a number of terms that folks might not be familiar with, including liquidity event and alternative minimum tax or AMT. Can you break down what these mean? Absolutely. But first, I just want to really reiterate what Liz was talking about, getting help from a tax professional. It sounds like this person is just wanting to know if this is a good tax strategy. And there's just so many other factors when it comes to each individual person's situation and whether exercising is going to be a good idea for them. If something is going to be a significant expense, what does that mean for each individual person? Are you not going to be able to pay certain bills or does it just mean that you're cutting into a vacation budget? I think that there's maybe not as much emphasis on those kinds of things as there should be. And so really, we cannot say this enough. If you have these questions, speaking with a tax professional may just be your best bet because they can get really deep into your own personal situation. Yeah. And often when it's

your first time thinking about company stock, if you have access to it, you don't know what you don't know, but a tax professional or a fiduciary financial planner will know what you don't know and will help guide you through this tricky area so that you can make the right financial decision for your own personal goals. Exactly. But let's get into those definitions. Remember that incentive stock options or ISOs give you the right to buy your company's stock at a discount. The strike price is what you're going to pay to buy the stock. And a liquidity event is when you can actually sell the shares. For example, an acquisition, a merger, initial public offering like an IPO, or any other action that allows founders and early investors in a company

to cash out some or all of their ownership shares. And now let's talk about the alternative minimum tax, which is, I think, peak jargon when it comes to company stock and all that goes into this. Can you give us a breakdown of what this is? Yeah, the alternative minimum tax is a tough one. It was designed to make sure that wealthier people couldn't completely escape taxation. But non-wealthy people can face the alternative minimum tax in some circumstances. And one of those is when they exercise incentive stock options or ISOs. The difference between the price you pay and what the stock is worth at the time you buy it is basically considered income

under the alternative minimum tax rules. People don't have to worry about alternative minimum tax if they exercise their options and then immediately sell the stock. It's only when they buy the stock and don't sell it in the same year that this tax comes into the picture. All right, why would anyone volunteer to pay the alternative minimum tax?

Because it could pay off in the long run if the stock really takes off. And that's because you can qualify for more favorable capital gains tax rates down the road if you've owned the stock for long enough. By long enough, I mean it's been at least two years from the grant date, which is when the options were given to you, and one year from the date that you exercised or bought the stock. So people may do this if they're in a high tax bracket and the stock is super cheap and they can tie up their money for a while. But there's a big risk because the stock could also tank. We've talked about buying the stock at a big discount, but there's no guarantee that these options will be worth anything. The stock price

could plummet either before you get a chance to buy it or afterwards. So you really do have to believe in the long-term prospects of the company and be willing to gamble a bit. Yeah. And given the way the stock market has behaved so far this year, I'm betting there are a number of folks who made such a gamble and are maybe regretting it a little bit. And I'm also going to say this is part of why we talk about investing for the long term and not investing money that you think you will need within five years because the stock could go down and then you might feel like you're out money. And if you are regretting that, or it hurts you financially, that might mean you invested money that you maybe

should have put toward an emergency fund, just a little thought there. But I also want to throw out that folks should realize that by working for a company, they are already invested in a pretty significant way by spending a lot of their waking hours working for that company. So some tax advisors might suggest that you think about diversifying your investments and not purchase a large amount of stock for the company that you work for. If you are heavily investing in one company, whether it's your own company or another company, then that might throw your portfolio out of the allocation that you would like it to have. If you want to be mostly invested in well-diversified, low-cost funds, then investing very, very heavily in

company stock might tilt you out of that allocation and might create more risk than you're comfortable with. It's good to think of your entire investment portfolio holistically and how adding this type of company stock will affect the rest of your balance. And again, your other alternative, if you don't want to buy the stock and hang on to it is simply wait for that liquidity event. That way you can buy the stock at that time and sell it immediately. You'll be subject to ordinary income tax rates, but that might be a better deal for you than locking up money. It all depends on your situation. Right. Okay. Well, now let's get on to our third and final question, which comes from a listener's text message. It is,

what is a stock split? How does it benefit people investing and customers? Should I invest before or after the stock split? All right, Alana, more jargon for you to decipher for us. Can you explain what a stock split is and why do companies do this? Stock splits are essentially the way that a company can increase the number of available shares while lowering its share price. This makes a higher cost stock more attractive to smaller investors, and it means they may actually be able to get in on it. So we're going to explain this using my favorite method, which is pizza. its stock starts trading and say there's like four slices because that math makes it easy for us. So if there's four slices, right, we're going to have a pizza stock split. And then all of those slices are going to get divided once again. We still have the same amount of pizza. And if you owned one slice or one quarter of that pizza,

now you own two slices. It's value for value, the same metric amount of pizza, but you're getting two for one. Okay. And what are the benefits of a stock split? Your portfolio could see a benefit if the stock continues to appreciate over time. Studies show that stocks that have split have gone on to outpace the broader market in the year following the split. But then again, past performance does not guarantee future performance. There's no saying that that will happen again. Stock splits can signal that a company thinks it's got a lot of growth in the future and it's trying to attract investors. So that could be a good sign. But does investing before or after the split make a difference? Stock splits don't necessarily make a company's shares any better than they were before the split,

but a stock may be more expensive before a split. So if investing before made things financially tight, after the split, it might make it more manageable. If a stock is $100 before a split and then it's $50 and $50 is an easier purchase for you than $100, then that makes a financial difference. I think it can be attractive to try and get in on as much company stock as you can. Because like you said, we've heard all these stories about people becoming billionaires because they invested in company stock. But there is a lot of risk involved, especially if you're putting money up for stock that maybe should be better spent in an emergency fund or going towards your necessities.

Right. All right, Alana, we just waded through three pretty complicated listener questions. Do you have any final thoughts around company stock or how people should think about the situation? I think one of the most important things to think about, like we've said, is your own financial situation and your faith in your company. If you really believe that your company can go the distance and become bigger and better and more profitable over time, you know, that's a really good indicator to you. But if you're at a company where you're saying, man, like, I don't like my team or my manager, I don't understand the strategy, there's no communication, those are all pretty good

indicators that that company may not be the healthiest. And so those are all things to keep in mind as well, because you're betting on the success of this company. So if you don't think it's going to do well, you should maybe listen to that instinct. We should also talk about the fact that we as human beings tend to value what we are familiar with. And it can be really tempting to think, oh, my company's got this great future. I'm going to go all in. But as Sean mentioned earlier, you've already got your livelihood hanging on this company. And you might not be privy to everything that's going on around you or in the company. And you can't predict what the future is going to be. If you are optimistic about your company, that's awesome. Just make sure that you

counterweight that with the understanding that you don't want to have all your eggs in one basket. And before you make any rash decisions, please do talk with a tax professional, because this stuff is complicated. Okay, well, Alana, thank you again for joining us. Thank you for having me. And with that, let's get on to our takeaway tips. Liz, will you start us off, please? Yes, absolutely. First, there are multiple different types of equity. Stock options you have to purchase, restricted stock units you don't. Second, don't make taxes an afterthought. If you are lucky enough to have equity,

figure out a plan. Exercising at the wrong time can trigger some costly tax consequences. Finally, equity can get complicated. Take your time, read the fine print, and enlist the help of a tax professional or financial advisor. And that is all we have for this episode. Do you have a money question of your own? Turn to the nerds and call or text us your questions at 901-730-6373. That's 901-730-NERD. You can also email us at podcast at nerdwallet.com and visit nerdwallet.com slash podcast for more info on this episode. And remember to follow, rate, and review us wherever you're getting this podcast. This episode was produced by Sean Piles and myself. Our audio was edited by Kaylee Monaghan.

Here's our brief disclaimer, thoughtfully crafted by NerdWallet's legal team. Your questions are answered by knowledgeable and talented finance writers, but we are not financial or investment advisors. This nerdy info is provided for general educational and entertainment purposes and may not apply to your specific circumstances.

And with that said, until next time, turn to the nerds.