Recently, my family moved to an envelope budgeting system whereby we spend only cash for basic household categories such as food, entertainment and a few others. We place cash in budget envelopes and spend accordingly. When the envelope is empty, we’re finished shopping for that particular month.

Listed below are the steps we took to implement our envelope budgeting:

• Determine categories for your envelope budget. Not everything in your household budget can fit into an envelope, literally. Things like utilities, subscriptions, and other recurring monthly bills are typically paid online or via bank draft. The real spending categories we are interested in are discretionary spending categories. For our family the typical categories making up our envelope budget are food, household products, gifts, entertainment, and clothing. In the beginning we also included gasoline, but the pay-at-the-pump feature is just too convenient to pass up on a cold, rainy day, so we still use our debit card at the pump. Who wants to carry kids into a convenience store to pay for $30 worth of gas in cash?

• Use past spending to establish initial budget amount. Review your previous month’s spending record to indentify transactions that belong into each spending category you have budgeted. In our case, a $50 Target store transaction may break down accordingly: $25 on groceries, $10 on clothing, $15 on household products. Using your best estimate come up with an average monthly expenditure for each envelope budget category.

• Create a budget envelope for each spending category identified in the previous step. Record the category and monthly amount on each budget envelope. If you are paid twice a month, plan to fill the envelopes on payday, rather than the first of the month. If you have enough cash on hand to fill the first month up front, try a monthly budget plan right off the bat.

• Stop spending for a particular category when budget envelope reaches zero. To guarantee the success of an envelope budgeting plan you have to stick to this rule. When you run out of money in your “Entertainment” budget envelope, you cannot take $20 from “Food” to cover a movie. You have to have the discipline to skip a night out.

The envelope budget is a great way to get a quick handle on your finances. However, I’m not sure it is something that can be sustained long term, simply because of the amount of tracking and planning it requires. If you are in need of a quick budgeting plan, and are currently lacking the discipline to use a debit or credit card, I would definitely give envelope budgeting a long look.

How much money do you spend each year on ice cream? Seems like a strange question, I know. But the purpose of it is to get you to start thinking in terms of annualized expenses. This is the first step towards putting together a budget in early retirement.

First, you must determine how much you spend now on all household expenses. Some of these categories will likely go away or be reduced significantly in retirement (i.e. commuting costs, eating out, etc.), but for now list everything you spend money on each month and multiply by 12. A quick look at my own budget might go something like this (with monthly amounts listed first, and the annual costs listed second):

Grand’s Family Budget (Sample):

• Mortgage: $1,200 ($14,400)
• Food: $500 ($6,000)
• Electricity: $200 ($2,400)
• Cell Phones: $100 ($1,200)
• Car Insurance: $60 ($720)
• Cable: $45 ($540)
• Netflix: $15 ($180)
• Ice Cream: $10 ($120)

My family likes ice cream, and we can easily go through a half gallon a week at roughly $2.50. That means we spend $120 a year on ice cream. Yikes! If you carry out this exercise further and apply the “multiply by 25” rule we would need a $3,000 nest egg to pay for ice cream for the rest of our lives. Toss in our Netflix membership and we would need about $7,500 to generate enough interest to pay for our weekly ice cream/movie nights.

I did not provide an exhaustive list of our monthly budget, but you get the idea. Ice cream was a very small example budget category, so just imagine how much savings would be required to generate the interest to cover your utilities and your food bill? In case you are wondering, about $60,000 and $125,000, respectively.

This exercise reinforces to main ideas. First, it’s important to whittle down as much debt as possible, and live as frugally as possible when planning for an early retirement. The larger your budget categories are the larger the nest egg you need to save to generate the interest to pay for those things. This is assuming you do not want to scramble the golden egg by drawing down the balance during retirement.

My homework assignment: Create a full, annual budget of our regular, monthly expenses. Apply the “multiply by 25″ rule to establish a ballpark figure of the nest egg I would need to save to live off the interest indefinitely. This figure will represent the top end of my “number.” Over time I will bring that number down by reducing expenses and determining a safe withdrawal rate.

Photo by lilvanili