Financial Planning: What It Is – What It Isn’t

To tell you what financial planning is, first let me tell you what it isn’t.  It isn’t just stocks, bonds and mutual funds.  In fact, investments are just a part of financial planning; a tool to get where you want to be.

I will also tell you what a financial planner isn’t.  He/she isn’t a stockbroker or mutual fund salesman or an insurance salesman.  She/he is exactly what the title says; someone who helps you plan the financial portion of your life so that you achieve your life goals.

For example, you may have young children that you want to have the opportunity to attend college. A financial planner will look at all aspects of college planning; what colleges are being considered and their costs, how long until the children are ready to attend, how to apply for financial aid, what scholarships may be available, and what alternatives should be considered.  Your financial planner will show you how to get to the point where your children will be able to attend college and graduate with little or no debt.

Obviously, money plays a part, but the financial planner will develop the strategy, taking note of your resources, your children’s ages and any other variables so that you can arrive at an objective, reasoned decision.  The seller of financial products will sell you a product that is predicted to grow to an amount commensurate with the cost of college without necessarily considering the other variables.

Financial planning is an ongoing process that continues to be refined as the years pass and should be tweaked annually as long term goals get closer.

So what is a financial plan?  It is a plan that looks at your life from today until the day you leave.  Given that many of us are living into our 90’s, I suggest planning through age 99, something to consider when you start to think about when you want to retire.

A financial plan consists of six distinct parts:

1.  Your current financial situation: Your net worth and your cash flow.

2.  Risk management:  Your insurance needs compared to your insurance coverage.

3.  Wealth accumulation:  Accumulating money for intermediate and long term financial goals; for instance, buying a house, planning a wedding, or funding college.

4. Retirement planning:  Assuring that you continue, or improve, your lifestyle after retirement.

5. Tax planning:  Minimizing your tax burden so that you are able to keep more of what you have worked for.

6. Estate planning:  Planning for the efficient distribution of your accumulated assets after your death.

We will look at each distinctive part, one by one.

 

1. Your Current Financial Situation:  Your Net Worth

The best way to begin your financial plan is to know what you are worth – your net worth.  Calculating your net worth is relatively simple – add up everything you own, calculate its worth and then add up everything you owe and subtract.  Hopefully, you will come up with a positive number.  If you have recently finished college with a lot of student debt, that number may be negative, but you have a lot of time to turn it around.

For most of us, the most valuable thing we own is our home and our car.  To figure your net worth take the market value of your home and subtract the mortgage balance.  Likewise, get the value of your car and subtract any loan balance.  These two figures will likely reflect much of your net worth.

Next, add savings and investments.  Include the money in your retirement accounts that would be available to you if you left the job tomorrow. If you have accumulated cash in a permanent life insurance policy, add that in also.

After that add in the value of your stuff that has value. Include jewelry, any collections (coins, stamps, guns, etc.) Don’t include stuff that depreciates rapidly.  Unless you have antique furniture, I would ignore furniture, computers and old text books.  Do look in your garage, attic, and any other place you use for storage.  Do look on your walls for art work that may have value.

Do you own land other than your home?  Rental property?  Interest in a small business?  If you do, calculate the value and add it to the plus side.  When calculating the value of a business, don’t forget the value of good will.

To arrive at your current net worth, add in the positive value of your home, car, stuff, and anything else of value.  That number will serve as the baseline to track your progress toward your financial goals.  Compute it annually.  I recommend you do this when you do your taxes.  Realize that the value of your car will decrease, but the value of your home and savings and investments should increase.  If your net worth does not increase every year, take a close look at your cash flow and resolve to make adjustments in the coming year.

Cash Flow: Money In, Money Out

Cash flow is what you earn minus what you spend.  For many of us, there is too much month left at the end of our money.  How often have we looked back at the end of the month and cannot figure out where our money went?  We were going to take everything left over at the end of the month and put it in savings, but nothing is left.  What’s worse is that there is a week before we get paid and we are out of money.  Sound familiar?  I hope it doesn’t.  But for many of us there is nothing left at the end of the month to put into savings.  What to do?

First; keep close track of the money you spend – I mean every nickel. Get receipts from everyone; that includes fast food, gas pumps, grocery stores and especially that restaurant where you have lunch. Any money you spend that doesn’t produce a receipt should be recorded somewhere, either on your phone or the back of an envelope. At the end of the day empty your pockets, or handbag, and log in those receipts. I am reluctant to recommend spending money, but investing in a money management program will save you money over time.   I have used Quicken for years – cost is about $30, but there is any number of money management apps for your smart phone.  What is important is to understand that the small amount of money you spend for extras every day, particularly food, is what interferes with saving and investing.

I recommend either buying software or creating a budget to forecast your cash flow over the month, or go online to any number of sites that will offer it for free.  I find it a lot easier to pay the $30 and avoid the pop-up ads and the other solicitations that come with “free”.

Make sure every dollar is accounted for.  The only way that works is to do your accounting at the end of every day. Take a few minutes and pull out those receipts and notes.  Log them in whatever system you have that works for you. If you gave $5 to some homeless person, log it in.  If you bought a lottery ticket, log it in. Do this faithfully for at least three months and develop your budget.  Hopefully your income is more than your expenses.

Set a goal for savings, and then pay yourself first.  Put money into savings before paying any other bill.  Then pay your mortgage or rent, utilities, car loan and plan for food, and gas for the car(s). Then if there is no money left at the end of the month, at least you will already have set aside money in savings. If there is any money left at the end of the month, give yourself a treat, and eat out.  Bon appetit.

 

 2. Risk Management – Do I Need It If I Don’t Do Anything Risky?

Risk Management in the context of financial planning refers to transferring risk away from us to a third party. To answer the question in the title, life is risky. Risk is unavoidable but is manageable.

Referring to the picture above, since we do not maintain firefighting equipment in our homes, other than a fire extinguisher in the kitchen, we have transferred the risk of putting out a fire to the local fire department, and hopefully, when there is a request for a donation, we will be generous – especially to the volunteer fire departments that rely on us for support.

But what about the fire damage to our home?  We should have transferred that risk to an insurance company – one who might “be there” or “be on your side” or assure us that we “are in good hands”. Whichever one you choose, you want to be sure that they will be there when you need them.

There are many other risks we need to consider transferring to an insurance company.  Some insurance to consider:  Life Insurance to provide an income stream to those who are dependent on us for support if we die while they still need our financial support.  Property Insurance to repair or replace our home, car or other expensive thing we own that we can’t repair or replace without taking a big financial hit.  Liability Insurance that pays others for damage we caused, or the court said we caused.  Disability Insurance that continues our income when we cannot work due to injury or illness. Health Insurance that will pay most of your doctor and hospital bills. Long Term Care Insurance that will provide the money to care for us when we become too frail in body, and maybe in mind, to care for ourselves.

There are many other coverages available if you have a boat, an airplane or any number of things that would be expensive to replace.

3. Wealth Accumulation – Keep Some Of What You’ve Earned

Wealth Accumulation is just what is says, saving enough money to meet a specific goal or goals.  Note that there should be definite goals. For instance, if your goal is saving to buy a house, you will want to set a time for when you want this house.  You will want to plan how much you need to put down – preferably 20% to avoid the added expense of mortgage insurance. You will want to know how much of a monthly mortgage payment you can afford, not forgetting that taxes and insurance will be added into the monthly payment and that the taxes and insurance may increase every year.

When you have these numbers then you need to look at how long you want the mortgage to run.  The shorter the length of time, the sooner the house will be paid for, but the monthly payments will be higher.  Don’t forget that even when the mortgage is paid, you still will be paying for property taxes and insurance, and that these costs will most likely increase every year.

What other goals might you consider?  Well, college for the kids; a new car, a boat, a vacation, or maybe just a “nest-egg” to supplement your retirement.

College for the kids would be the next biggest expense, and at the rate costs are increasing, it could be more than your home.  What you will need to consider:  how long before your child (children) start school; how expensive is the school today then increase that by 7% a year.  Add in an estimate for the other charges and books, and room and board.

How to make all these calculations without help?  Glad you asked.  One of the great purchases you can make, that will pay for itself many times over, is a financial calculator.  A financial calculator will show the Time Value of Money and can compute loan payments, interest rates and length of time to pay off a loan.  One financial calculator I can recommend is the Texas Instruments BA II at a cost of $30 – $35.  They offer a more expensive model, but this is all you will need.  If you decide to shop for a financial calculator make sure it has these five keys:

N which is the number of periods, usually months.

 i which is interest for the time period (months or years).

PV which is the present value of the loan, or investment.

PMT which is the monthly payment to pay the loan, or accumulate wealth.

FV which is future value.  For a loan that number would be zero.

For example. You are purchasing a new car and are financing $24,000 at an interest rate of 6% annually. You want to decide whether to pay it over four, five or six years. Do these calculations.

N = 48 (4 years), 60 (5 years) or 72 (6 years)

I = 6%/12 = 0.5% per month

PV = $24,000

FV = 0 (the loan is paid off)

Compute PMT: For 4 years monthly payments are $560 per month. 5 years is $462 per month and six years is $396 per month..

If you are investing, for example how much money  will you have in 20 years if you invest $200 a month at 10% annually.

N = 240 (20 years x 12 months)

I = 0.833 (10%/12 months = 0.833 month)

PV =$ 0 (you are starting now)

PMT = $200 per month

Compute FV = $153,140 which is how much wealth you will have accumulated in 20 years.

That is just a sample of what a financial calculator can do for you. Be sure to completely understand the instructions and do all time value of money exercises.

4. Retirement Planning – Getting To Easy Street The Easy Way

People who do not believe in Santa Claus, the Easter Bunny or the Tooth Fairy do seem to believe in the Retirement Fairy. The Retirement Fairy appears when you arrive at that magic age around 65 and decide to retire.  The Retirement Fairy spreads his (her) magic fairy dust so that you are able to live on less than half of what you lived on the day before you retired.  You have the same house, car(s) and the need for food and, unless you were very smart and paid off your mortgage, car(s) and all other debts, your overall expenses are the same as when you were working. Even if your mortgage is paid, you still owe property taxes and insurance, both of which will continue to rise year after year.  If you rent, you know from experience that your rent will increase almost every time you renew your lease.

Believing that you can live on much less after you retire is a BIG MISTAKE that you should not make. When you are retired every day is Saturday, except Sunday.  Now you get to do all those things you never got around to.  Those things you will get around to doing will cost money.  Life can, and probably will, get more expensive.  There are trips to take, maybe grandchildren to spoil, children who need a hand.  You may live into your 90s and as you age, your body, like your aging home and car, will require more maintenance.

If you believe that you will be able to get by on Social Security, take a good look at your Social Security statement and compare it to your pay.  Now from that Social Security figure realize Medicare premiums will be deducted.  And, Medicare will not pay for all of your medical expenses.  You will still need supplemental medical insurance to pay for what Medicare doesn’t cover. Realize also that Social Security payments are not necessarily tax-free.  If you do continue to earn money you could be liable for income taxes on your Social Security payments.

So what can you do?  Glad you asked!  Start saving and investing for retirement tomorrow.  Pay yourself first – that means that you set aside money to save before you pay any other bills.  If your employer has a retirement plan, buy into it, especially if there is a match to your contribution.  Invest in stock mutual funds – do not listen to those who broadcast that the stock market is the same as a Las Vegas casino, or that investing in stock mutual funds is the same as gambling, or that the stock market will crash and you will lose everything. Those salesmen want to sell you a “safe” investment product that will not provide the growth you need, but may provide the seller a large commission.

Now comes the tough love.  Set a realistic retirement goal – enough so that it will last you from retirement through age 99.  How about a goal of one million dollars?  That would provide you with $4,200 a month for 30 years. At age 35 you would have to invest $600 a month for 30 years.  Look at those numbers – you put aside $600 a month and then pay yourself $4,200 a month. That is the value of compounding. To get there from here put aside at least 15% of your gross pay.  If you can’t get there yet, put aside at least 5%.  When you get a raise, put it into your investments and keep doing that until you get to 15%.

I know the argument, “I can’t afford to save and invest.” You can’t afford not to. If you are under age 40, the million dollar goal is doable.  Over 40, it becomes a stretch.  Find the money.  Cut expenses. Work part time.  If pizza delivery really pays $16 per hour, 10 hours a week will let you put away $640 a month. And, if you only get to $500,000, that will still get you $2,100 a month until you reach 100. Better than just Social Security.

Start tomorrow.  Every month you delay is a month of compounding you have lost. Get going while you have the energy.  You won’t have it in your 70s, 80s and 90s.

5. Managing Income Taxes: Death or Taxes – Not Sure What I Fear Most

The best advice I can give to anyone who wants to lessen their tax burden is to “Do Your Own Taxes.” I have no wish to take business away from Jackson Hewitt, H & R Block, Liberty or your accountant, but most of us, given the tax preparation software available, can easily do our own taxes.

By doing your own taxes you will better understand the tax regulations, and how to pay as little as the law allows.  Remember the difference between tax avoidance and tax evasion.  Tax avoidance is legal and will give you lower taxes.  Tax evasion is illegal and will give you up to ten years.

The simplest way to do your own taxes is to buy tax preparation software.  I have used both Turbo Tax and H&R Block software with good results.  The greatest advantage, besides being much cheaper than paying someone else, is the insight you gain from walking through the many questions asked that you probably never thought of.  For instance, if you’ve given something to a charity, the software will suggest the amount of the deduction.  Until I used this feature, I deducted much less than the amounts suggested.

And who knows your situation better than you?  A tax preparer will input what is provided.  Doing your taxes at home, you can go look for something that you had forgotten earlier.  You can do your taxes at your own pace, over days or even weeks, and when you are finished, the software will help you file electronically and will help you track the progress of your return so that you know when it was received and accepted. If you are due a refund, you can track that also.

But tax planning is a year round task.  Track every expense that may be deductible.  Are you putting money aside in a tax deferred account?  Do you support someone who may not live with you but is dependent on you?  Tax credits come and go – maybe you qualify for a tax credit this year. There are a number of credits associated with children and saving energy.  Check them all out.

There is nothing patriotic about paying more taxes than your obligation. Nor is there anything shady about taking advantage of credits and deductions.  So called “loopholes” were put there by your government for a reason whether we agree with them or not.  Use every “loophole” you can.  Increase your income by avoiding as much tax as possible – just do it legally, avoid not evade.

One last comment.  Many planners and advisers (I used to be one of them) will advise you to avoid a large refund by adjusting your withholding as close as possible to what your expected taxes will be at the end of the year.  Our argument was that you are giving the government an “interest-free loan.”  I have changed my position.  I believe it is better to withhold too much and get a refund than to risk owing taxes at the end of the year.  Besides, for many people a tax refund represents a way of forced savings.  I can live with giving the government an “interest-free loan” if it allows me to put a lump sum towards my retirement that I otherwise might have just spent on lunch.

6. Estate Planning – Plan For What To Do Before You Can’t Plan Anymore

“You can’t take it with you.”  Most of us have heard that quote at some point, usually when someone is encouraging us to spend money we may not want to spend.  But it is true.  We should make some kind of arrangement as to what happens to our money and our stuff when we die.The best way I know how to prepare is to put those close to you through the process while you are still here.  What do I mean?  Glad you asked.  Who in your family, or anyone close to you, really knows what to expect when you die.  Tell them. Don’t rely on your will for everything.  A will is read after your funeral.  What if you wanted to be cremated and didn’t tell anyone, but put it in your will?  Can you imagine digging you up to be cremated.  Everybody would be traumatized except maybe the funeral home owner.

Of course make out a will.  Depending on your relationship with family and those close to you, you may want to discuss it before or as you make it out.  Be as specific as possible to avoid any confusion and bad feelings when the will is read.  But also let your wishes be known. Do you want to be cremated, buried in a cemetery or buried at sea?  What kind of service do you want?  What do you want in your obituary?  Do you have any great pearls of wisdom that you want to be read?  Is there anything you don’t want found or revealed?  Get rid of it now.

Consider a living will.  Who will make decisions for you when you are no longer able?  Designate that person now when you are fully capable. A springing power of attorney will allow someone you trust to make decisions for you when you are deemed no longer able. Do you want efforts made to keep you alive at all costs, or will you give permission to “pull the plug.”  Put everything in writing now.  No telling what will happen tomorrow.

Do you think you need a trust which will let you have a say in how your money is dispersed after you are dead?  Perhaps you have a spendthrift child who would do better with an allowance from a trust rather than receiving a lump sum of cash.  Or maybe you want to hold money until your child has reached some milestone – attaining a certain age or graduating from college.  A trust will give you that control.

Be aware that some assets will pass outside of a will and consequently outside of probate.  Your retirement funds should have a beneficiary.  Is the beneficiary current and does the beneficiary know she/he is the beneficiary?  Is your home, car and any other property title jointly so that it passes with a minimum of bureaucracy?  Do you own real estate other than your home?  Is the property in another state? How is it titled?