Financial planning is a process that helps you achieve your goals and dreams by enabling you to better manage your finances. The end product of the process, a written financial plan, typically covers the key financial issues most people face — budgeting and saving, investing and insurance coverage, as well as tax and retirement planning.
A good financial plan is a work in progress that is updated periodically as conditions change and can be referred to regularly as a resource for the financial aspects of daily living and as a guide to preparing for the future.
Understanding financial planning and its importance
Becoming aware of the possibility and desirability of having a financial plan — and awareness that the field of financial planning even exists — typically takes place in young adulthood. After someone has worked for a while, started to manage their finances and perhaps thought about having a family and a permanent home, they often feel the need to take the money-related aspects of life more seriously.
Another time many people’s thoughts turn to financial planning is when they start to consider retirement or are about to enter retirement. They often have questions about the adequacy of their savings, how much income they will have in retirement and how they might be able to leave a legacy.
Whether younger or older, having a financial plan can be very helpful in setting and achieving your goals, providing peace of mind and preventing you from making costly mistakes.
6 steps for developing a financial plan
1. Set financial goals
The first step in any financial plan is setting clear, specific goals with specific time frames. For example, one goal may be to save enough money over the next five years to make the down payment on a house. Another might be to pay off student loans in 10 years. Attaching a time frame to a goal makes it more real and more attainable because, by working backward from the goal to create action steps that bring you closer to your goal, you will gain a sense of accomplishment and create a positive feedback loop that will encourage you to stick to your plan.
2. Create a budget
Even if having a budget sounds restrictive, knowing your expenses and making sure they don’t exceed income is one of the most liberating aspects of having a financial plan. Most regular expenses — rent or mortgage payments, utility bills and car payments, for example — are easy to track and plan for. But life’s smaller expenses often go unrecorded, which leads many people to underestimate their total spending. Creating and sticking to a budget can help eliminate the high cost of borrowing money to cover spending.
3. Establish an emergency fund
In addition, unexpected major expenses, like car repairs, can be harder to handle without a budget that sets aside money for such emergencies.
That’s why establishing an emergency fund — a stash of cash kept in a bank savings account and earmarked for emergency use only — is a valuable component of a financial plan. It can help you weather a job loss or an unexpected expense without turning your life upside down. A cash cushion that covers at least three months of living expenses is a good starting point. Even better is a six-month emergency fund. Consider creating an emergency fund before addressing other savings goals.
4. Make sure you’re covered
A comprehensive financial plan will include an assessment of the insurance protection needed to cover you and your family for a variety of risks. Life insurance, property and casualty insurance, auto insurance and health insurance are some of the categories of insurance typically included in sound financial plans.
5. Develop investment strategies for future goals
The key to reaching long-term financial goals is developing a proper investment strategy, which can be implemented after establishing a budget and squirreling away emergency funds. The time-tested method of “paying yourself first,” or setting aside a fixed amount from each paycheck for saving or investing before you do anything else with the money, is a way to start.
Financial services giant Fidelity Investments suggests the 50/15/5 rule: “Aim to allocate no more than 50% of take-home pay to essential expenses, save 15% of pretax income for retirement savings, and keep 5% of take-home pay for short-term savings.”
Don’t forget, too, that workplace savings programs, such as traditional 401(k) or 403(b) plans, can be extremely useful savings/investment vehicles since your annual contributions lower your taxable income and the funds invested grow without being taxed until you retire. What’s more, many companies make matching plan contributions, which means that if you don’t participate, you miss out on a “free” contribution to your retirement fund.
6. Consider taxes and retirement
Finally, there is the need to consider the impact of taxes as well as take steps to ensure that one’s post-working years are comfortable. As one’s income and savings rise, tax planning becomes increasingly important. For example, in addition to workplace savings programs, there are other tax-advantaged investment vehicles, such as traditional and Roth individual retirement accounts (IRAs) that may be considered as part of a financial plan. Health savings accounts (HSAs) and state-run education savings plans known as 529 plans also can provide significant tax advantages.
For those approaching retirement, a financial plan will typically consider various Social Security claiming strategies as well as other ways to maximize retirement income, minimize taxes and leave a financial legacy for heirs.
Types of financial planning help
If you have the time, discipline and knowledge — or the willingness to learn — you can tackle the financial planning process on your own. There are many free resources online that can help, including the financial planning tools offered by the US Securities and Exchange Commission (SEC). Some major financial services providers, such as Fidelity and Charles Schwab, also offer complimentary financial planning tools for customers.
For help that is more comprehensive yet still mostly do-it-yourself, there are several financial planning software tools designed for individuals, including MaxiFi, Mint, Personal Capital, Quicken and WealthTrace.
For professional help with financial planning, there are many choices. Fee-only financial planners, some of whom also may handle investments, work with individuals in a variety of ways. Some charge hourly rates, some charge flat fees to develop a plan and others offer subscriptions. Those who have successfully completed a rigorous course of study and follow a program of continuing education qualify for the certified financial planner (CFP) designation. You can search for a CFP using FPA PlannerSearch, an online tool of the Financial Planning Association, the organization of financial planners. Another resource is the XY Planning Network, a group of independent, fee-only financial planners who have a variety of specialties.
Financial planning is also offered as a service by brokerage and wealth management firms. Whether clients of those firms receive financial planning advice from an advisor of their choosing or from a representative or representatives assigned to them by the firm, the financial plan created probably will be generated by planning software specially designed for financial advisors. The cost of financial planning at brokerage and wealth management firms usually is incorporated in the overall fee charged by the firm, and creating a financial plan often is a first step taken before the advisor or firm begins an investment program.
Frequently asked questions (FAQs)
Financial planning is a process to help better manage the financial aspects of your life by identifying goals and wishes, minimizing risks and getting a handle on spending, saving and investing. The end product of the financial planning process is often a written financial plan that gets revised and updated over time.
First, make your financial goals specific. Instead of saying you want to get out of debt, for example, your goal might be to eliminate your $100,000 student loan. Next, make your goal measurable, like paying off the loan in 10 years, or $10,000 a year. Third, give yourself a deadline, like paying off $833 every month. Fourth, write down your goals and your progress. Finally, take pride in each step you are taking, which will propel further goal-setting.
Financial optimization is the process of allocating resources in the most efficient way possible. Tax planning can be useful in financial optimization because it takes into account the tax aspects of financial decisions — such as investing pre-tax dollars in a traditional IRA and making taxable withdrawals in retirement versus investing after-tax dollars in a Roth IRA and making tax-free withdrawals in retirement. Depending on one’s circ*mstances, different choices in investing and spending can have different tax consequences, which affect investment returns and net income.
Credit card balances constitute the highest-cost debt most people incur. Some banks charge more than 20% a year in interest on those balances. There are two popular strategies for paying off that debt. One involves paying off the card with the smallest balance first, regardless of its interest rate, so you get rid of it and can begin to make progress on other debts. Others recommend paying off the highest-cost debt first and then moving to the next expensive debt.
One of life’s most difficult financial transitions comes when you stop receiving a regular paycheck and start using accumulated savings and Social Security benefits for income. Many people are confused about the best ways to convert their nest egg into regular income. Financial planning in retirement can help with that process and also help determine when to start taking Social Security benefits, whether an annuity might be a useful choice, and how to withdraw money from retirement accounts in the most tax-efficient way.
