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5 Key Components of Financial Planning

We all have things we want to accomplish. And the first step is usually coming up with a plan. Unfortunately for many of us, we don’t have a plan for our finances.

A financial plan doesn’t have to be complicated. Use one to set some concrete financial goals and then make decisions to meet those goals.

While nothing can replace the expertise of a professional financial planner, we’ll give you an overview of why financial planning is important and what questions you should ask as you’re creating your financial plan.

What Is Personal Financial Planning and Why Is It Important?

A financial plan may not seem important. And depending on whether you loved Kate Bush’s “Running Up That Hill” when it first came out or while you were binging season four of “Stranger Things,” retirement might feel a long way away. 

But what if you learned that by failing to plan for your retirement you lost almost $25,000? You’d probably be freaking out, right? 

If you fail to plan, you are planning to fail.

Benjamin Franklin

But that’s exactly what you’re doing. Here’s an example:

Let’s say you’re 35, and you created a financial plan when you were 21. You decided that every month you would put $100 into an investment account that earns an average of 5% per year. Now, $100 a month may not sound like much, but after 14 years you would have $24,461 sitting in the account (that’s $16,800 in deposits and $7,561 in interest).

Now, let’s say you’re 35 and decide to start depositing $100 a month in the same account that earns 5% interest for the next 30 years. You’d earn $83,673. Not too shabby. 

But if you started when you were 21 and invested over those additional 14 years, you’d have $192,511 in the account.

What To Know Before Making a Financial Plan

There’s no one way to write a financial plan. You can do it yourself or consult a financial planner or investment advisor. But before you start, you need to know where you’re starting from. To do this, you’ll need to calculate your net worth and figure out your cash flow situation.

Calculate net worth

The formula to calculate your net worth is simple. You take your assets and deduct your liabilities.

Your assets include: 

  • Your home or other properties 
  • Your car
  • Money in the bank
  • Money invested in a 401(k) plan or other retirement accounts
  • Stocks, bonds and other investments
  • Other valuable assets like jewelry or art

Your liabilities include any outstanding debts:

  • Mortgage
  • Credit cards
  • Personal loans
  • Student loans
  • Auto loans

Once you know your assets and liabilities, you can take an honest look at your financial situation. If your assets exceed your liabilities, you may be in a good position to invest more for your future. 

On the other hand, if your liabilities outweigh your assets or you’re just breaking even and don’t have an emergency fund, it may be a sign you need to adjust your spending, look for ways to boost your income or come up with a plan to shrink your liabilities.

Determine cash flow

You’ll also need to determine your cash flow, which is a measure of how much money you bring in, how much you spend and how much you’re able to save.

First, estimate your monthly income. If you get a regular paycheck, this should be fairly easy to do. If your income is irregular, try to figure out an annual total then divide the total by 12 to figure out a monthly average.

Next, try to figure out your expenses. You can do this by looking at your checking and credit card statements. Your expenses may include:

  • Fixed monthly expenses: This may include your rent or mortgage payments, student loan payments, auto loan payments and minimum credit card payments. Your fixed expenses might also include recurring expenses like gym memberships, your cable or internet bill and streaming services.
  • Annual expenses: Some bills like property taxes and some insurance premiums aren’t paid every month. Take these expenses and divide them by 12 to get a monthly average.
  • Other expenses: This includes everything you buy that isn’t a fixed expense – from food, entertainment and clothing to gas and auto maintenance. If you can, try to figure out a monthly average.

What Are the 5 Key Steps of Financial Planning?

Financial planning includes five key steps: goal setting, budgeting, mitigating risk, building wealth and understanding how taxes affect retirement planning.

1. Setting goals

If you want to improve your physical fitness, you’ll need to set goals and put in the work to achieve them. The same philosophy applies to financial planning. Goals give you realistic objectives to work toward. If you meet them, great! If you don’t, you may need to adjust your plan. 

To be most effective, set up short-term, medium-term and long-term goals.

Short-term goals (1 – 10 years): 

  • Pay off all outstanding credit card debt
  • Pay off all student loan debt
  • Save enough for a 20% down payment on a home
  • Create an emergency fund that equals a full year’s income
  • Set up a retirement account and invest as much as you can comfortably afford each year

Medium-term goals (10 – 20 years): 

Long-term goals (20+ years):

  • Retire all outstanding debts
  • Pay off primary residence mortgage
  • Maximize savings for a comfortable retirement

Your goals and timeline will likely depend on where you are in life and your income. But once you’ve determined your goals, you can develop a plan to reach them. As a bonus, you may find achieving short-term goals, like settling debts and saving enough to buy a house, will make it easier to achieve your medium-term and long-term goals.

2. Calculating your budget

The next step in creating a financial plan is to create a budget. This is where all the information about your cash flow will come in handy. 

There are lots of ways to create a budget – from pen and paper to spreadsheets to cutting-edge apps that analyze your spending. What matters is striking the right balance between spending, saving and investing.

Experts recommend the 50/30/20 rule of budgeting.

  • 50% of your after-tax income covers needs like rent or mortgage, utilities, food and other daily expenses.
  • 30% of your after-tax income covers entertainment, new clothes or other items.
  • 20% of your after-tax income covers saving, investing and paying down debts.

The 50/30/20 rule isn’t a hard-and-fast rule. The ultimate goal is to create a sustainable balance between meeting your needs, enjoying life and saving for your future. 

3. Mitigating risk

Of course, things can – and will – go wrong. You may face setbacks like long-term job loss, an injury or an accident. 

To mitigate these risks, you hope for the best but prepare for the worst. 

  • Emergency fund: Try to set aside at least 6 – 12 months of income in an emergency fund. If something goes wrong, you have a financial cushion. Just remember to replenish the fund once you’re back on track.
  • Insurance: Make sure you have health insurance, homeowners or renters insurance and car insurance and make your payments in full and on time. You should review your coverage every few years or when you go through a major life change, like getting married or having a child.

    Depending on where you work, you may be eligible for free or low-cost disability insurance or life insurance coverage through your employer.
  • Estate planning: Death is a part of life and being prepared for it can help make your loss easier for family and friends. Creating a will can help prevent bitter disputes over who gets what and who is responsible for settling your affairs. If you’re unable to make decisions for any reason, putting a living will, health proxy and power of attorney in place can save your family the heartache of making difficult life-or-death decisions on your behalf. 

4. Building wealth

Who wouldn’t love to win the lottery, invest in the next big startup, buy a hot NFT or make a killing in cryptocurrencies? But these are high-risk investments. You can make or lose money in the short term, and they don’t guarantee wealth in the long run.

The beating heart of any good wealth-building plan is a commitment to make small, regular investments throughout your working life. Gradually building your wealth allows you to take advantage of the long-term benefits of compound interest, and it also helps protect you against fluctuations in the economy.

The key to any good investment strategy is working with a professional. You don’t need to “make bank” to hire a financial planner. Ask your family and trusted friends if they can recommend someone. You may be able to access financial planning services through your work, bank or credit union.

That doesn’t mean you can’t take some risks and do some investing on your own. These days you can invest in real estate through crowdfunding without spending a fortune. There are micro-investing apps that let you make small investments, sometimes by simply rounding up everyday purchases to the nearest dollar and taking the difference and investing it for you.

5. Retirement and taxes

If you’re contributing to a 401(k) plan or 403(b) plan through your job, congratulations! You’re already saving for retirement. If you don’t have an employer-sponsored plan, you can also invest in an individual retirement account. Both plans allow you to contribute a certain amount each year into an account that earns interest.

As a rule, retirement accounts use relatively safe investment vehicles like mutual funds, but you can usually select options that adjust your level of risk depending on where you are in your retirement planning journey.

One key issue with retirement planning is when your retirement accounts are taxed.

  • Employer contribution plans: With most 401(k) plans and other employer contribution plans, you’re allowed to make pretax contributions toward your retirement. That saves you on taxes now and helps keep your taxable income down. And your employer may match your contribution up to a certain percentage of your income. The catch? You’ll pay taxes on the income when you cash out in retirement.
  • Individual retirement accounts (IRAs): With an IRA or Roth IRA, you deposit money into an account using after-tax income. The plus side? There’s no tax bite when you cash out in retirement.

Having a Plan Makes It Easier To Pivot When Things Go Wrong

Building wealth is a marathon, not a sprint. If you don’t have a financial plan, don’t panic – but don’t wait too long either. Whether you do it yourself or work with a financial planner, the sooner you have a financial plan, the sooner you’ll be able to reap the rewards.

The Short Version

  • A financial plan doesn’t have to be complicated. Use one to set some concrete financial goals and then make decisions to meet those goals
  • Financial planning includes five key steps: goal setting, budgeting, mitigating risk, building wealth and understanding how taxes affect retirement planning
  • Whether you do it yourself or work with a financial planner, the sooner you have a financial plan, the sooner you’ll reap the rewards
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