UPDATED: April 22, 2022
Financial planning is mapping out income, expenses, healthcare, taxes, etc., to help make informed investment and financial decisions. The main elements of a financial plan include a retirement strategy, a risk management plan, a long-term investment plan, a tax reduction strategy, and an estate plan.
The expression, “Life is a journey, not a destination” certainly applies to financial planning. Achieving short- and long-term plans is impossible without proper planning. A recent study by Charles Schwab (PDF) found that 59% of Americans are living paycheck to paycheck and only 38% have built an emergency fund.
Financial plans usually begin with a thorough evaluation of an individual's current financial state and future expectations. This often includes a budget which organizes an individual's finances and sometimes includes a series of steps or specific goals for spending and saving in the future. The plan allocates future income to various types of expenses, such as mortgages or utilities, and also reserves some income for short-term and long-term savings.
Understanding the Financial Plan
The first step in the creation of a financial plan involves assembling information, or more likely these days, cutting and pasting numbers from various web-based accounts into a document or spreadsheet.
Calculating Net Worth
- Assets: This may include a home, car, cash in the bank, money invested in a 401(k) plan, IRAs, investment properties, and anything else of value.
- Liabilities: These may include credit card debt, student loans, an outstanding mortgage and/or car loans.
Assets - Liabilities = Net Worth
It’s hardly a stretch to proclaim many individuals do not have a handle on their finances. In a recent survey of advisors by Financial Planner magazine, respondents reported that almost one-third of their clients are not financially literate, meaning they do not have sufficient knowledge and skills to make informed decisions about their monetary lives.
That is why a financial plan also must begin with a sense of monthly cash flow, i.e., what’s coming in and what’s going out by examining checking accounts and credit card statements. An accurate picture is key to creating a financial plan, and can reveal ways to direct more to savings or debt pay-down.
Itemizing expenses will help clarify how much is required every month for necessities, how much might be left for saving and investing, and items that can be trimmed or eliminated.
Document how much was spent over a year in basic housing expenses like rent or mortgage payments, utilities, credit card interest and home furnishings. Add categories for food, clothing, transportation, home maintenance, insurance and non-covered medical expenses.
Make sure to account for variable or discretionary spending on entertainment, dining out and vacation travel. Don't overlook cash withdrawals if that’s part of your spending plan.
Tallying up all these numbers for a year and then dividing by 12 will determine average monthly expenses.
Outline Your Financial Priorities
Next it is crucial to determine all possible short and long-term goals and objectives. These might include placing a down payment on a house, paying off student loans, buying a new car, starting a business, retiring, or leaving a legacy.
Because all finances are connected, it’s best not to focus on just one aspect. For example, when it comes to family planning, a couple may want to think about starting a college savings fund while saving for a down payment on a house.
How a person prioritizes these goals depends on the individual or family. A professional financial planner may be able to help select a detailed savings plan and specific investments that will help tick them off, one by one.
Constructing a Comprehensive Financial Plan
The next step is developing the actionable steps of a financial plan. Most likely, this will include saving money for retirement, an emergency fund, or a big purchase. Investing will also likely play a prominent role in a financial plan. Over the long term, investing in the stock market is considered a great way to passively grow your wealth.
Determining how to invest depends on individual preferences and appetite for risk. If an individual is working with a financial advisor, he or she can help decide the best asset allocation between large and small-cap stocks, bonds, cash, and alternative investments.
Emergencies Don't Become Disasters
The bedrock of any financial plan is cash for emergency expenses. The savings can start small: $500 is sufficient to cover small emergencies and repairs so that an unexpected bill doesn’t lead to credit card debt. The next goal could be $1,000, then one month of basic living expenses, and so on.
Building credit is another way to shock-proof a budget. Good credit provides greater access to lower rate loans. It can also boost one’s budget by helping to obtain cheaper rates on insurance.
Tackling High-Interest Debt
A crucial step in any financial plan: Pay down “toxic” high-interest debt, such as credit card balances, payday loans, title loans and rent-to-own payments. Interest rates on some of these may be so high that the borrowers typically end up repaying two or three times what was borrowed.
Investing and Retirement Planning
Retirement is coming for all of us. And it's never too early to prepare. The financial plan should include a retirement savings goal and how much is necessary to save each month to get there.
The best advice regarding retirement planning is to get started right now. There are several ways to do it—a self-directed path using index funds, robo-advisers, or working with a financial advisor.
Regardless of the method, it is crucial to get started as soon as possible. The earlier one begins to invest, the more time for compound interest to work its magic.
According to Financial Planning’s survey of advisors, one quarter of the advisors’ clients did not have any health insurance, and 34% had only minimal coverage.
“The increasing cost of health care in this country is an emerging need that more clients need to understand for their financial wellness,” according to one wealth manager who responded to the survey.
Health-care costs are a large and growing piece of people’s financial lives. The average 65-year-old couple retiring in 2019 will spend an estimated $285,000 on that category over the rest of their lives, according to Fidelity Investments.
That figure excludes expenses related to long-term care, help with daily activities such as bathing and dressing, which financial advisors typically calculate separately. The concern is well-founded. For example, the median annual cost of a home health aide is almost $50,000, according to a recent study by Genworth Financial, and the annual cost of a private room in an assisted living facility is close to $100,000.
Those costs are expected to increase to $66,000 and $131,000, respectively by 2027, Genworth estimates.
Yet, like many other expenses in retirement, healthcare spending occurs over many years, if not decades, which means it generally should be factored into cash flow and retirement planning.
Creating an Estate Plan
Estate planning is simply thinking about what will happen to assets after you die and how your family will be protected.
One of the first estate planning questions to answer is "Do I need life insurance?" People who have dependents who rely on their income, the answer is probably yes.
Beyond life insurance, most families will want to have a will as well.
For some people, a life insurance policy and a will may be all they need. Individuals who have a complicated family situation or a very large estate, an estate planning attorney may be necessary.
Obtaining Help with Creating a Financial Plan
Individuals who are struggling with budgeting and debt, may want to consider meeting with a certified counselor from the National Foundation for Credit Counseling. For those looking for investing advice, talking to a human financial adviser may be worthwhile.
Alternatively, you could use a robo-adviser service that uses algorithms to build portfolios to match an investor’s risk profile. Generally, the fees are lower with a robo-adviser than a human adviser.
Finally, for people looking for someone who can help develop a comprehensive plan from A to Z, a certified financial planner (CFP) may be the right option. CFPs are well-versed in a wide variety of financial topics, including investing, insurance, tax planning, estate planning, and more.
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