‘How to’ series: How to Start a Financial Plan

Financial Planner Philadelphia

How to Series on Financial Planning

Good financial planning begins with getting the big picture “right” for you and your family. Only then does it make sense to focus on the details. To use a workout analogy, there is no point to setting the goal of running a marathon if you haven’t walked a mile in years.

Think of the financial planning steps listed below as your initial training miles in the financial planning marathon. Once you have addressed these steps (or stretched for those beginning walks), you are ready to begin training for the marathon.

Step 1 – Pay off your bad debt

Car loans, school loans, credit cards and personal loans. Anything that isn’t home mortgage debt can be grouped into bad debt. Focus on paying off all your bad debt before you do anything else.

How do you start paying down your bad debt? First, make sure you are paying at least the minimum amounts on all your debt. Second, direct 100% of any extra money to paying down the debt with the highest interest rate.

To make this work, you may need to stop buying certain things that you are accustomed to having. I understand it is difficult to give these things up, but if you think about it, these purchases most likely contributed to your debt in the first place. So use the funds you save to pay down your debt. You can restart your caffeine habit once you are out of debt.

Step 2 – Build an emergency fund

Emergency funds are essential. You should have three to six months of living expenses saved in an account that is safe, liquid and immediately available.

If you don’t have adequate cash in an emergency fund and an expense comes up (for example, the dreaded annual car inspection that turns into new tires, brake pads and rotors), how will you cover the costs? My guess is the double C word—credit card!

Before you know it, your credit card can have a larger balance than you anticipated, and you will be racking up that bad debt. An emergency fund allows you to pay cash for these large expenses, which means you won’t go into debt and find yourself back at step 1.

Step 3 – Max out your retirement

You have no bad debt and you’ve built an emergency fund. Now it’s time to start saving for retirement. The easiest place to start is often your employer-provided 401(k) plan.

A 401(k) plan has three features that make it an opportune place to start saving.

  1. Tax savings – Your wages are taxed as ordinary income. If you defer a portion of your wages into a 401(k), the federal government will not tax you on the amount contributed to the retirement plan, as the money is taxed when it is distributed from the account.1 Thanks to this federal government-offered feature, you pay less in current income tax.
  1. Free money – Yes… free money! Often your employer will match your contributions (up to a certain limit and subject to a vesting schedule). They want you to do the responsible thing by contributing to your retirement. Because they know it’s in your best interest, they encourage you to defer into your 401(k) by offering you a match on your contributions. The match is free money you receive simply by saving.  Say it with me…FREE MONEY! Where else are you going to get a 100% rate of return on something?
  1. It’s easy – Deferrals from your wages are directed into your 401(k) account from your paycheck. Because you never touch or see it, you never have the chance to not save it and you won’t get in your own way. This savings habit of “out of sight, out of mind” is a simple and extremely effective way to start saving.

The goal should be to put the maximum amount allowed into your 401(k). In 2015, the maximum amount you can defer into the plan is $18,000 (or $24,000 if you are 50 years of age or older).

Step 4 – Save for other needs

Do you want to buy a bigger home, a second home or a new car? Are you thinking of expanding your family? What about those future expenditures, such as schooling? You should start saving (or investing) for these other needs as soon as you can.

How much should you be saving? Easy, as much as possible!

Step 5 – Pay off other debt

With rates being so low, and the fact that many will receive a tax benefit from the interest deduction, it often makes sense to pay off your home as the last measure of financial planning.

With that said, I do see a lot of pre-retirees focus on paying down the mortgage prior to full retirement. If this is a goal, a plan should be developed to move this goal up the list.

So what now?

What I have here isn’t an exact science. It’s very intentionally an oversimplification of sound financial planning habits. It doesn’t account for personalization or maximum efficiency.

But I believe that if you take these steps you will find yourself in a significantly better place financially.

1A penalty tax may be imposed for early withdrawals.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.

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