Dedicating time to financial planning can help you protect the assets you have now and increase your wealth in the future.  The basic elements of financial planning are:

  • Examining Your Current Financial Situation and Setting Goal
  • Investing
  • Tax Planning

Examining Your Current Financial Situation - The first step toward planning your financial future is understanding where you are today.

  • Cash Flow: Paying bills on time, saving, and avoiding reliance on credit cards or credit is only possible if you spend less than you earn. (Okay, spending a little more one month won’t kill you, but if it happens on a regular basis, it will be hard to avoid financial problems.)   Use a ledger to list and track your income and expenses.  (Don’t forget to include savings.) To the most accurate figures as possible, you may want to track your daily spending.  If your income is irregular, it is a good idea to track that too.  If you have a negative cash flow (i.e., your expenses exceed your income) or you would like to save more than you are currently able to, you’ll need to evaluate where you can cut back on expenses or generate more income.  Can you get a part-time job, rent out a room in your house and even cut back on dining out? Skip the daily $4 mocha latte.  Get a cheaper cable package or cut your land-line phone and find a better utility rate. Increasing income can be difficult, but most people have some expenses they can trim. Honestly assess what is a necessity and what isn’t.
  • Net Worth: Your net worth is the value of your assets (things you own, like a house or car) minus your liabilities (monetary obligations to others, such as a mortgage or car loan).  Tally up your “net worth” to see where you stand financially. Your net worth should be positive (meaning you own more than you owe) and it should increase over time.  One simple way to increase your net worth is to pay down your debt. You can also build your net worth by putting your money in assets that typically increase over time (or at the very least hold their value) and minimizing spending and borrowing for assets that decrease in value.  If you put $5,000 in a savings account, at the end of the year, you will have more than that because you are paid interest. On the other hand, if you buy a $20,000 car, it will probably be worth less at the end of the year because most cars depreciate in value as soon as you leave the lot. If you borrowed money to purchase the car, the amount owed on the loan could be greater than the car’s value.

Setting Goals - Identifying clear, achievable goals is a crucial part of anyone’s financial plan.  A financial goal is the amount of money needed for a specific purchase or service at a definite date.  Making goals precise allows you to determine how much you need to set aside each month and track your progress.

There are three types of goals: short-term, mid-term, and long-term.  Short-term goals are achieved in under a year, mid-term in one to five years, and long-term in five years or more. Emergency savings, vacations, and electronics are typical short-term goals.  A down payment for a house is a common mid-term goal. Long-term goals may include saving for retirement or your child’s higher education.

You can make a goal chart to help you determine a timeline for your goals and the amount of money you’ll need to regularly set aside in order to reach them.  You may find the numbers daunting or not realistic based on your current financial situation. As mentioned above, you may be able to make adjustments to your income and/or expenses to free up cash for savings.  If not, determine your priorities and save for the most important goals first.

Investing - Now that you have determined what you want to save for, you may be wondering where you should put your money. There are three basic types of investment classes:

  • Stocks: A share of stock represents a percentage of ownership in a corporation.  In other words, if a company is divided into a million shares and you buy one share, you would own one millionth of that company.  You can make money from receiving dividend payments and selling the stock for more than you bought it for.  Historically, stocks have provided the greatest return (earnings) long term.
  • Bonds: A bond is a loan to a company or government, with you, the bondholder, as the lender.  Generally, you receive the principal, called the par value, at maturity of the bond and interest periodically while you are holding the bond.  Depending on the market, you may purchase a bond below, at, or above its par value. In general, bonds are between stocks and cash equivalents in regard to risk and return.
  • Cash equivalents: Cash equivalents are assets that can be readily converted into cash, such as savings and checking accounts, certificates of deposit, money market deposit accounts, and U.S. Treasury bills.  They tend to be low-risk, so there is little or no danger that you will lose the money you deposit. As a result, cash equivalents provide a lower return.

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It is best to keep money for short-term goals in cash equivalents.  Because you will be using the money soon, your primary concern is that you not lose any of your principal investment.  If you put your money that you need in six months in stocks, there is a decent chance the stocks will be worth less when you sell.  For emergency savings in particular, you want to make sure you can immediately access the money when you need it.  For long-term goals, the value of your investment in six months is less of a concern than inflation, which is the general rise in the price of goods and services over time.  The return on cash equivalents is very often less than the rate of inflation, meaning if you keep your money there, its value will be essentially decreasing over time.  That is why it is a good idea to put a large chunk of the money you are saving for long-term goals in stocks and bonds, which, on average, have a higher return than cash equivalents.  There is a risk that the value of your investments will decrease, but the risk is lower the longer your investment period is.  Inflation can be a concern for mid-term goals, but since the timeframe is shorter, you may want to be more conservative with your investment choices.

A good way to reduce the risk of losing money when you invest is to diversify.  A well-balanced portfolio has a mixture of stocks, bonds, and cash equivalents. It is also a good idea to diversify within each type of investment class.  For example, you can purchase stocks from manufacturing companies, technology-oriented companies, and financial services companies.  A simple way to get diversity is to purchase shares in a mutual fund. In a mutual fund, money from several investors is pooled to buy different stocks, bonds, and/or cash equivalents.

Tax Planning - Smart tax planning is not just claiming all of the deductions and credits you are entitled to on your tax return so that you can get a bigger refund.  It also involves thinking about and engaging in legal methods to lower your tax burden throughout the year.  The following are items that can give you a break on your taxes:

  • Employer-sponsored retirement plan: Most employers offer a defined-contribution retirement plan (typically a 401(k) or 403(b)).  It gets its name from the fact that your contributions are defined but not the benefits that you receive in retirement.  That is dependent on how much is put into the plan and how well your investments perform.  The money that you contribute to a defined-contribution plan is deducted from your paycheck pre-tax, meaning you don’t have to pay income taxes on it.  While your money is invested in the plan, you don’t have to pay taxes on the earnings either. You only have to pay taxes on the withdrawals you make.
  • Individual Retirement Account (IRA): IRAs are not tied to the employer – you can open one at a variety of financial institutions.  In order to contribute to an IRA, you or your spouse must have earned income.  The annual contribution limit is higher for employer-sponsored retirement plans, but the investment choices are typically greater for IRAs (and you don’t have to worry about what to do with the plan when you leave your job).  With a Traditional IRA, your contributions are tax-deductible, and your earnings while in the plan are untaxed as well. With a Roth IRA, your contributions are not tax-deductible, but your earnings and withdrawals are not taxed.

These top 3 categories of financial planning will help you get started evaluating your finances as well as your future goals.  It is always good to plan ahead and avoid being unprepared.  It is also good to have a vision and direction of where you want yourself to be 10 years down the road. For newly married couples or first-time home buyers this is an essential step.