How to make a financial plan

One of the interesting things I’ve noticed during my chats with clients is how often folks approach their finances with no clear outline of where they are going.  While most people would acknowledge that they probably need a financial plan, I think there is a lot of mystery about what one consists of.  My goal this month is to really explain what the components of a good financial plan are.

What is a financial plan?

Two important notes before we move forward with our discussion.  First, we need to mention what a financial plan is not.  Many large brokerage companies like Edward Jones and Vanguard have advisers that take a quick couple of numbers from their potential clients and do a simple forecast of their investment return over time.  These are boiler plate templates, and only a very minor component of an overall plan.  They are a sales product not a financial plan. This leads us to our next point.  Financial plans are comprehensive.  They should include all the following:  investment strategy and allocation, tax-planning and forecasting, budgeting, liquidity and cash flow analysis, debt repayment strategies, contribution plans for IRA’s, 401k’s and taxable accounts, social security and Medicare strategies, estate planning, and assessment of insurance needs (life, disability, long-term care, auto etc.). 

Goals

The most important component of a financial plan is your (and your families) goals for the future.  The overall purpose of the plan is to tell you if you’re on track to reach those goals, and what you need to do to get yourself on track to meet those goals.  Here are some examples of goals that I would ask my clients about:

-Retirement Age

-Money longevity (will I have enough money if I live to 90?)

-Having a certain income or investment balance by a certain date

-House purchases

-Travel plans

-Paying for college, weddings, or other large events

-Leaving behind some type of legacy to your beneficiaries or to charity

-Property and business investments

-Career changes

Savings/Contributions

Another important component of your plan is your savings rate.  This would include items like how much to contribute each month to your 401k and your IRA, can you afford to invest additional funds into a taxable account, and how much cash should you have on hand for emergencies?  Many people seemingly decide to randomly put money into the market, but most would benefit from regular contributions based on their budget and cash flow.  Other considerations include:  What is your 401k match?  Roth or Traditional IRA?  How much of an emergency fund do I need if I Iose my job?  What are the fees in these accounts? What are the tax implications of my savings strategy?

Investment Strategy/Allocation

Your investment strategy has the potential to completely make or break your overall plan.  Even slight changes in your overall allocation can have massive impacts that lead to hundreds of thousands of dollars of losses or gains over your lifetime.  Your investment strategy should include a detailed analysis of your risk tolerance (how much loss can you handle?) and your time horizon.  The shorter your time horizon, or the more immediate your need for income, the less risk you should take.  Also central to your investment strategy is your asset and sector allocation.  What is an ideal ratio of stocks to bonds?  Government bonds, treasuries, corporate, or mortgage backed bonds?  Should I own real estate?  How much technology stock should I own compared to healthcare or energy?  Large or small companies?  Do I need monthly income from these investments?  How much of my portfolio should I have in international (non-U.S.) companies?

Debt Repayment and Budgeting

Debt repayment and budgeting plans will help your family control their monthly spending, and ultimately conquer high-interest debt in the most efficient way possible.  For example, there is a movement by Dave Ramsey and other “financial entertainers” to push the “debt snowball” repayment plan on their readers.  The debt snowball consists of paying off your smallest debts first, and your larger debts last.  It doesn’t take a rocket scientist to realize that the most important component of debt repayment is the interest rate, not the account size.  Why would you pay off a $5,000 school loan with a 3% interest rate, if you also had a $22,000 auto loan with a 7.5% interest rate?  Following that advice would lose you thousands of dollars for no reason.  Debt repayment and budgeting is a short-term component of your overall plan, but proper planning can open free cash that can be used to invest later down the road for greater impact.

Taxes & Drawdown

The final component of your financial plan is your tax strategy and your plan for drawing down your accounts in retirement.  Throughout your entire plan, there are a series of tax considerations that need to be properly handled or you risk overpaying the IRS for no reason.  For example, what order do I take contributions from my IRA’s and taxable accounts?  How do I spread out my RMD’s (required minimum distributions) to best keep my taxes low each year?  What are the tax implications of owning REIT’s (Real Estate Investment Trusts) or municipal bonds?  Should I be using tax-free or taxable bonds in my account?  Are ETF’s or mutual funds more tax efficient?

Other considerations include the tax implications of working while taking social security, or how your investment income integrates with your social security plans.