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Create Your Own Personal Financial Plan
A question we've heard countless times over the years is "What's the most common mistake people make when managing their finances?" Our answer: making spending and investment decisions apart from a personalized financial plan. No matter how good your investing choices are, if they're made outside the framework of a larger plan, you're inviting trouble.
Imagine that you're preparing to build your dream home. Over the years, you've accumulated scores of ideas that you'd like to see incorporated into it. Before construction begins, you sit down with your builder to review your design goals. You ask him how long before the blueprints will be ready, but to your surprise, he tells you he doesn't work that way. Rather than planning everything ahead of time, he prefers to develop the design as he goes along. He'll keep your ideas in mind, but "blueprints are so restricting," he says—he wants to have the freedom to be spontaneously creative as the house is being built.
Most of us would be reluctant to hire a builder like that! When building a house, we recognize it's a good thing to have a carefully considered blueprint for action before taking on a challenging task. In fact, the more important the project (e.g., having open heart surgery), the more emphasis we place on careful planning.
Unfortunately, too many people use the "we'll work out the details as we go along" approach when it comes to one of the most important projects they'll ever take on—building a secure financial future.
Yet, in much the same way that we live in a physical home, we each "live" in a financial home as well, one that has been created by our past decisions. Just as our dream house could end up poorly designed due to a lack of planning, many people reach retirement and find their financial home isn't what they've always hoped for. That's usually what results from a lifetime of making financial decisions independent of a master blueprint.
The good news is this doesn't have to happen to you. Make this the year you set aside time to create a personalized financial plan that's designed to build the kind of future financial home you'll enjoy living in.
In a moment, we'll look at typical planning situations for people at three various stages of life. But before we do, let's examine two basics common to every financial plan. The first is the necessity of developing a clearly defined set of God-given goals. Clearly defined goals establish your financial priorities.
In his book Storm Shelter, Ron Blue lists the following five steps for setting good goals: List your goals, consolidate and refine them, prioritize them, make them measurable, and keep them visible. The monthly surplus established by your budget (which I'll get to in a moment) is the wind in your sails, but your goals are the compass you navigate with. Set good goals and keep them in front of you—you'll be surprised at how much more productive and focused you'll feel as you start living with a clearer purpose.
The second common denominator of all good financial plans is a spending plan (i.e., budget). You may not like it, but it's an absolutely essential tool for everyone who hasn't yet received a seven figure inheritance. Without a spending plan, you can't intelligently implement saving and investing strategies because you don't know if you have any extra money to save or invest.
Even if you seem to have extra money left over each month, without a budget you won't know if that money should be saved for those once-a-year items (such as insurance premiums and summer vacations) or if it truly represents a surplus. Also, it's unlikely you'll be in a position to give generously to God's work if you don't plan for it.
As you work through your goal-setting and spending plan, remember that this is a spiritual endeavor, not merely a mental one. Your personal financial goals and budget will reflect how you view and use money. Since as Christians we are managers rather than owners, it's vital that you allow God to speak to you regarding your plans for His money.
Married couples should absolutely make these planning decisions together, not just because it ensures "buy-in" from both parties, but because it establishes you as a team rather than opponents. One-half of marriages end in divorce, and 80% of those are due, in part, to money problems. Jointly establishing a financial plan may have farther reaching implications than you think.
While there are no "one-size-fits-all" financial plans, certain experiences are common to particular phases of life. As you read the following scenarios, don't get discouraged if you feel "behind." The point is not to provide benchmarks of how far along you should be, but rather to provide guardrails to keep you on track and to help you think through issues common to each phase. Your situation will probably differ somewhat from what's here, so make sure to personalize these to your individual circumstances.
THE YOUNG PERSON/COUPLE
For many young people these days, youth translates financially into "easy credit and lots of debt." More than likely, the first decade out of school is spent paying off school loans, car loans, and credit card bills. Outfitting an apartment or first home can really pack on the debt, especially if you aren't following a spending plan in those early years. Throw in trying to save for a wedding, the down payment on a first home, building a savings reserve, and paying for the arrival and growing up of your little bundle(s) of joy. And just about the time your education is paid off, it's time to start saving for college for the kids.
Sound bleak? It doesn't have to be. Unfortunately, many young couples waste the most productive financial years they'll have for a while: those early marriage years when both spouses are likely working and there are no kids in the picture yet. This is a golden opportunity to make serious headway financially, but all too often it isn't seized due to lack of planning (and because there's so much fun stuff to buy!). The sense of urgency that arrives with those two exciting words—"I'm pregnant"— often comes too late. Here's what's needed:
1. Make a budget, relying on your current spending to establish realistic initial estimates in each category. Usually this requires a period of tracking your expenses carefully to ensure your budget is using realistic figures. Establish your short- and medium-term financial goals. Then look at your budget again. Does your available surplus put you in position to realize your goals? If not, it's not unusual to go through several rounds of belt-tightening before finally settling on a workable budget. Consider these to be normal growing pains—chances are, it's your first experience setting and living on a serious budget.
2. Attack your debt, while avoiding further debt. This is tougher than it sounds, since most young people have yet to establish a savings reserve from which to absorb unexpected expenses. Couples considering having children are wise to attempt budgeting all living expenses from one income, while applying the other entirely to debt reduction and saving. Sure, that may reduce the money you have for "fun stuff" now, but you'll appreciate the flexibility later when your expenses soar and income potentially drops in half.
List all of your debts, including balances and interest rates. There are two main debt-payment strategies to choose between. If you are highly disciplined, you will save the most money in interest expense by paying off your highest interest rate debts first. But a more motivating strategy for many is the “debt snowball” approach, in which you pay off the debt with the lowest balance first, then the next lowest, and so forth. Don't underestimate the value of this psychologically; if seeing your debts fall one after another keeps you motivated, it's worth paying a little extra interest.
3. Start building your emergency fund by opening a money market account and having money automatically deposited into it each month. For most people, it's a good idea to start saving a small amount even before they've finished paying off their debt. Some of this depends on the interest rate of your loans, but having a small savings account will help keep you from slipping back to your credit cards when unexpected expenses arise. A savings account balance of three to six months living expenses is routinely recommended by financial planners. That may seem like a lot, but you'll have plenty of use for it if buying a house or having children are on the horizon.
4. Take advantage of free money at work by contributing to your retirement plan up to the amount your company matches. This is slightly controversial if you are in a deep debt hole, in which case you should skip this step for now. But if your debt is manageable, meaning you have a clear plan to pay it off reasonably soon, take advantage of employer matching in your 401(k) or other retirement plan if it's available. Beyond the amount matched, additional contributions take a lower priority.
5. Fund a Roth IRA. A Roth IRA, funded in your twenties or thirties, is an incredible deal. You'll get 30+ years of compound growth, then get to take that money out tax-free! Roths can also double as college savings accounts, or even last-resort emergency savings vehicles. Because they are so potent yet flexible, you should make a serious effort to start funneling money into one as soon as you get your debt under control and emergency savings up to a reasonable level.
5. Choose your investing strategy. Whether you're investing at work or in a Roth IRA, you need a clearly-defined strategy. Sound Mind Investing offers two primary strategies to follow: Just-the-Basics, and Upgrading. Both are founded on core principles that should be a part of any investing plan, and each can be adapted to your situation.
Once you get your long-term strategy up and running, continue to follow it no matter what the markets may be doing. In other words, don't let current events (and the emotions surrounding them) interrupt your monthly contributions.
6. Start a college savings account. If you already have a child, the clock is ticking on their education saving. There is definitely a right way and a wrong way to do this, so educate yourself. It's easier than it seems: use a Section 529 plan, Coverdell Education Account (formerly known as Ed IRAs), or even a Roth IRA. Avoid the old tools you've heard about: EE bonds, custodial accounts, and so on. And don't buy into the idea that you need to save a gazillion dollars for college either. Worst case, there will likely be loans or part-time jobs available to make sure Junior can still go to college. Don't be paralyzed by the huge numbers you read about; just start saving what you can.
THE MIDDLE-AGE COUPLE
As bittersweet as having the kids leave home may be, for most couples it marks a financial turning point from peak spending years to peak saving years. Coinciding with the decline in child-related expenses are the highest earning years for most workers, and in some rare cases, paying off the mortgage. At any rate, there's probably more surplus money available now than ever before, and it's a good thing. The day-to-day expenses of child-rearing have likely left you feeling a little behind regarding your retirement plan. It's catch-up time now. Your priority list includes:
1. Revise your budget to reflect your new level of income and expenses. This budget revision should be an annual event anyway, but I'll include it in case you haven't adjusted your budget in a while. Take a new look at your short and medium term goals as well. It's getting down to crunch time, so if you're serious about meeting those goals, you don't have as much of a time cushion as you once did. Use that as motivation rather than letting it discourage you.
2. Take a financial inventory of your household. What debt do you have outstanding? What needs are coming up—additional school payments, cars that need replacing, home repairs you've put off? At this stage of life, debt should be pared back to bare minimums. If you haven't already done so, pay off those credit card balances, car loans, and other consumer debts. You likely have the cash flow now that you can eliminate or reduce interest expense on big-ticket items, like car purchases, through advance planning and saving. If it's not there yet, build your emergency saving account balance up to where it should be.
3. Get realistic estimates of how much money you'll need to retire. SMI's Retirement Planning Worksheet Calculator can help you with this task, as can many of the other good calculators available at other financial websites. Having specific figures in mind will help motivate you if you need to start saving more, or potentially keep you off the austerity budget if you're doing better than you thought.
4. Review your investing strategy. For many people, this will have already happened years ago as a result of managing retirement plan money at work or IRAs they've established. But how you divide your money between stocks and bonds (which affects your risk level) changes as you move closer to retirement, so it's important to make sure your allocations are still appropriate. See point #5 for young couples for more on this.
5. Maximize your retirement plan at work. Your 401(k) or other retirement plan at work probably represents your best opportunity to quickly save large amounts for retirement. The tax advantages of such an account, which usually include pre-tax contributions, coupled with employer matching or other contributions, make it tough to beat. This isn't true in every case though, so investigate the details of your plan, as well as the investment options offered within it. Most 401(k) plans will allow you to save as much as $15,500 in 2007, and an additional $5,000 if you're at least 50 years old.
6. Take advantage of IRA opportunities. If you're married and your gross income is over $103,000, you probably won't gain an immediate tax benefit from contributing to an IRA. But that doesn't mean it's not worth doing so anyway. Or you may qualify for a Roth IRA, which can provide years of valuable tax-free growth. Remember, your time horizon isn't just until you retire, it's through your retirement, which these days often extends 20-30 years. So if you've maxed out your retirement plans at work, definitely consider an IRA. For 2007, the maximum investment amount is $4,000, and if you're at least 50 years old you can add an additional $1,000 per year.
THE RETIREMENT COUPLE
The big day has finally arrived! Freedom! But with the freedom from your job comes the unsettling loss of that familiar friend: the regular paycheck. That loss of steady income makes many retirees feel like they're at the mercy of the financial markets to a much greater extent than they prefer. Don't panic, you can have peace of mind despite this adjustment. But it's definitely time to make sure your personal financial plan reflects these major changes. Here are the key points:
1. Decide whether to take your company retirement plan money in a lump sum or an annuity. This is an extremely important decision and should be made with great care. If you'll be making this decision soon, schedule an appointment with a CPA or financial planner to talk about which is a better option for you.
2. Re-create your budget to reflect the realities of your retirement income. This doesn't just mean the changing amounts; it means the change in the timing of these payments as well. Match your living expenses to the amount and timing of your income, obviously remembering to include things such as social security income, pension benefits you receive, and so on.
3. Determine your strategy for withdrawing money from your retirement plans. This is a major decision, one you should make with a firm grasp of your income needs (from your newly revised budget). Let's review a few popular options:
- Taking a fixed amount out at regular intervals is simple enough, but it exposes you to market declines and increases your risk of outliving your money more than other methods.
- A slight variation involves taking out a fixed percentage at regular intervals. This improves your odds of not outliving your money, as you take less out if your account balance declines. As long as you are still able to meet your expenses, this can work well.
- Another option that greatly insulates you from market fluctuations is to set aside 3-5 years of living expenses in a money market fund account, and pay all current expenses from that account rather than your investments. History shows that over five-year periods, the stock market has made money an overwhelming percentage of the time. This is a good way to extend your time horizon, allowing you to be slightly more aggressive in your asset allocation, by insuring that you won't be taking money out of your plan disproportionately during down markets.
4. Consider the implications of which accounts you withdraw from when. Traditional IRAs, including IRAs you may have rolled over from your company retirement plan, have mandatory distribution rules that require you to start withdrawing from these accounts at age 70.5 . Roth IRAs, by contrast, have no mandatory distribution rules, and in fact, get favorable treatment should you die and leave them to your heirs. While this decision requires some individualized number crunching and thought, taking money out of your traditional IRAs rather than your Roth IRAs early in retirement will generally leave you with more flexibility in your later years than vice versa (due to the smaller mandatory distributions you'll incur).
An even more aggressive way to leverage this difference in the IRA rules is to consider delaying the start of your Social Security benefits initially when you retire. You'll have an extremely low taxable income as a result, which you can use to your advantage by converting chunks of your Traditional IRA into a Roth at rock-bottom tax rates. Having more Roth and less Traditional IRA assets will increase the flexibility of your future withdrawals, perhaps lower the overall tax rate paid on those IRA assets, and boost the amount of your monthly Social Security payments once they do begin. This sort of maneuver is complex enough that it's likely wise to enlist the help of a good CPA to evaluate its effectiveness in your specific situation.
5. Reconsider your asset allocation and risk threshold. Retirement is a time to reduce risk, taking only as much as is necessary to meet your financial needs. Even if you've been an "all stocks, all the time" investor throughout your life, it's foolish to take that added risk if you can live comfortably on the income provided from less aggressive investments. So look closely at what your specific income needs are, and throttle down your risk if you're able. The new SMI Managed Volatility Fund
may be a useful tool for the stock allocation of those at this stage, since it attempts to offer some downside protection while still pursuing the Upgrading strategy.
I've merely touched on some of the most important aspects of creating your personal financial plan: identifying your season of life and risk temperament, determining your ideal asset allocation, applying our model portfolios, and so on. But all of this information is explained in detail in our bonus reports for new readers: the SMI New Reader Guide, and Jumpstart to Successful Investing.
While these lists aren't comprehensive, they do highlight key items to address in your personal financial plan at each stage of life. Ultimately, your financial priorities and plan of attack can only be decided by one person, and that's you. But having a step-by-step financial plan can help you stay on track when the inevitable financial temptations grab your eye.
Your goals are worth sacrificing to achieve, and taking the time to establish a comprehensive plan is the first step. This year, replace your good intentions with action by creating—and faithfully following—a personal financial plan. When it comes time to move into the financial home you've built for yourself, you'll be glad you did.
In our Sound Mind Investing newsletter, we try to regularly emphasize why we are here serving you in this way: We want to help you to have more so you can give more to share the good news of Christ's love with the world.
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