How To Create an Effective Personal Financial Plan
Creating an effective personal financial plan involves steps you must follow. Define the kind of life you want to lead in the short, medium, long term, and retirement. It would help if you considered matters like career, family, financial and wealth, education, attitude, character, friendships, public service, enjoyment and relationship with God. It would be best to consider where and how you want to live in retirement. Once you have defined your vision, you assess your current financial status to see how to improve income and contain expenses, establish goals to attain, prepare a spending budget, select savings and investment options, prepare and follow a plan (roadmap), monitor and evaluate progress regularly and consult financial planning experts where you are unsure. Below is a rundown of the steps: Creating an effective personal financial plan involves steps you must follow. Define the kind of life you want to lead in the short, medium, long term, and retirement. It would help if you considered matters like career, family, financial and wealth, education, attitude, character, friendships, public service, enjoyment and relationship with God. It would be best to consider where and how you want to live in retirement. Once you have defined your vision, you assess your current financial status to see how to improve income and contain expenses, establish goals to attain, prepare a spending budget, select savings and investment options, prepare and follow a plan (roadmap), monitor and evaluate progress regularly and consult financial planning experts where you are unsure. Below is a rundown of the steps:
1. Defining Vision and Lifestyle
The starting step in personal planning is to define the kind of life (vision) you want to lead in the short, medium, long term, and retirement. Vision is an imagination of an attractive future status worth striving for. A vision in personal life is a vivid imagination of a beautiful future state that you would like to be in and is worth striving to attain. A dream reflects deep desires, visions, and hopes about life. It answers, "Where am I, where should I be going, and what should the end look like?" Vision is perceiving the end goal while still at the starting point. A vision is the ability to see something that is not visible yet. It is the end outcome once you have successfully implemented the goals. Defining the vision is about figuring out the type of life you want to lead and the amount of money, riches, and wealth to support the desired current and future lifestyle. When thinking of a vision, you want to consider areas of your life that could improve. You could focus on career, family, financial and wealth, children or self-education, attitude, character, friendships, public service, enjoyment and relationship with God. You must also have a vision of how you want to live in retirement. You may also want to plan to retire earlier than the average retirement age. You must set short, medium and long-term goals as you create your vision. Personal financial planning is a daunting task, and you should consider involving a professional financial advisor who can help you make an exhaustive financial plan.
2. Diagnose and Appreciate Your Current Financial Situation.
The vision you come up with requires time, money, and resources. So, you must consider the current state of your income, expenses, debt, savings and investments. This assessment gives you a good picture of where you stand financially and what you could improve to increase regular income and cut expenses to create room for savings and investments to generate more wealth and income for current living and retirement. You want to have sufficient regular income in retirement without having to work for the income.
Revenue is the incoming cash and includes salaries, wages, fees, rental income, investment dividends, business profits and any regular or foreseen income you earn. Expenditure is the outgoing cash for regular essential things like groceries, mortgage payments or house rent, utility bills and discretionary expenses such as travel, entertainment, shopping and hobbies. When planning for cash flow, you must consider all possible sources of income and how to enhance income to meet essential and discretionary expenditures, including money you need for saving and investing to increase wealth. It would help if you also considered all expenses, including retirement expenses, so you can plan how to prepare for retirement income.
You must manage your debts to prevent them from hindering your savings and investing plan. Debt management is the exercise of preparing to liquidate problem debts or all obligations. Paying off debts frees money for other priorities, such as saving and investing. As you make your financial plan, consider your debts and have a plan to liquidate them as soon as possible. Consider seeking professional advice on how to settle your debts.
As you diagnose your current financial position, consider the following activities because they impact your financial plans.
a) Saving and Investing
Saving and investing are the main blocks you use to execute a financial plan and attain goals. You use persistent and consistent saving and investing to create and multiply money to reach goals that require finances. Saving and investing, therefore, demands careful planning. The cash for saving and investing should be part of the monthly spending budget. Saving and investing are closely related as they go hand in hand, but they are independent and somewhat different. At the end of the month, when it is time to decide what to do with the money left over after paying off all the necessary monthly expenses, you typically have two options: save or invest it if it is substantial. Below are some explanations of the meaning of saving and investing.
Saving
Saving has two primary meanings. One meaning is to pay less for your purchases owing to a discount or shopping in a cheaper shop. The other meaning refers to regularly putting cash aside, little by little, in a safe or an interest-bearing instrument like a bank deposit account. Savings are usually short-term in nature with a few weeks or years horizon. One creates savings for several reasons: to meet emergencies, purchase a home, meet college fees, purchase a new vehicle, travel, or accumulate funds for more significant, longer-term and higher-yielding investments. Though saving is for short-term needs and a means of avoiding erosion of value by inflation, savings precede and form the foundation for investing in more significant portfolios that bring higher returns.
Investing
On the other hand, investing uses money or savings to buy an asset you think will be safe and generate an acceptable return over time, making you wealthier each year. Unless you own a substantial amount, saving is the primary way to accumulate money for investing. Under normal circumstances, investment starts only after savings. The term investment means an addition to the stock of physical capital. An investment can include putting money to earn interest, dividends or capital gains over time. The assets include small businesses, fine art, rare wines, gold coins, comic books, stocks, mutual funds, bonds, pension schemes, IRAs, real estate, and antiques. Sound investments are the best way to grow money, riches and wealth, but this can take years due to fluctuating economic conditions.
Saving and investing have several purposes, including creating an emergency fund and a down payment for a big-ticket item like a car or a house, protecting income from inflation, multiplying cash to generate more money and assets and creating income or passive income-generating assets to provide retirement income. The investment market has multiple investment opportunities that vary in safety and income generation. Some are safe but have low returns, while others have inherent high risks but provide higher returns. Still, some have low returns but faster appreciation rates, providing significant capital gains. It can be challenging to identify which assets are safe at the outset, provide reasonable returns, and always align with your goals- risk appetite, needs, budget, and age. Investments need time to achieve the desired income levels, so early starting is advisable. It would help to diversify investments to balance risks and cash flow. To choose wisely, you should enlist the help of a registered financial advisor.
b) Tax planning
Taxes are an obligatory expense that reduces your total income. You cannot avoid taxes but can minimize them with appropriate planning. Various income categories attract different forms of taxes, and the tax authorities change the taxes over time. Therefore, tax planning is critical. Tax planning aims to discover how to accomplish all the other elements of a personal financial plan in the most tax-efficient manner possible without falling foul of the tax law. Most incomes are taxable, but tax planning may uncover income and expenses not subject to tax or methods to avoid or minimize tax liabilities. Tax planning is essential to personal financial planning to utilize tax exemptions. Engaging in tax planning allows you to identify areas where certain income generated can avoid tax and expenses, and business losses can be applied to offset tax liabilities.
Furthermore, you can use tax harvesting to reduce your retirement income tax and avoid estate or inheritance tax, saving your estate inheritors a lot of money. Taxation laws are complex and vary from country to country and State to State in the USA. Therefore, seeking expert advice to make the most of tax planning is beneficial.
c) Risk management and Insurance Planning
Regular income or income-generating assets can encounter unforeseen risks that can wipe the income or the assets out, leaving you with zero income. Risks can also bring unexpected costs. Risk management is an activity that seeks to protect assets while at the same time multiplying income and involves various insurances. Insurance is an arrangement by which a company or government agency guarantees compensation for specified loss, damage, illness, or death in exchange for periodic premium payment. It is a form of risk management primarily used to hedge against a possible loss.
Insurance is a popular tool for wealth management. Insurance schemes have favourable tax treatments and are tax-effective for inheritance, estate succession planning, and asset management. Life insurance and assurance policies are investments because you pay small amounts over a period, and your family gets a higher sum upon death.
Insurance is essential for personal financial planning because of the risk of losing one's life, assets, legal claims, and illness that may derail one's economic plans. Therefore, taking insurance covers is part of good personal financial planning to guard against total loss of assets and income that can ruin financial planning. The first step in insurance matters is to determine insurance needs. Typical protection methods include:
- Property or damage insurance: This type includes automobile and property insurance. Automobile insurance covers third-party liability in case of a motor accident where you are at fault, and there are claims against you. Property insurance protects against property loss through fire or other damage. You may require separate insurance coverage for the personal household or any other items destroyed along with the property.
- Life assurance covers income loss due to the sudden death of a breadwinner. You can combine this with long-term disability insurance, which replaces lost earnings when someone cannot work due to an accident or illness.
- Health insurance: Health insurance covers various medical requirements that arise occasionally and require large sums.
d) Estate Planning
Estate planning defines how you want ownership, management and preservation of your assets and how you want them disbursed after your death. The plan also identifies the person who will look after your estate. It prepares you for managing your assets in your lifetime and after death. Assets include your car, home, other real estate property, bank account balances, investments, life assurance, pensions, furniture and personal belongings. If they exist, debts are all part of one's estate. Estate planning is for everybody, not just the wealthy or the old, for the time of departure from this earth does not follow age. Friends and relatives can spend a lifetime and savings battling over your assets if an appropriate estate plan is lacking.
It can be daunting to prepare an estate plan. Still, ensuring your assets end up where you want without interference from the tax and probate authorities or other third parties is necessary. Other estate planning tasks include creating a Will, a Corporation, a Limited Liability Company, a Limited Liability Partnership, limiting tax exposure by creating a Living Trust in the name of beneficiaries, and establishing a Guardian for minor living dependents. It also involves naming an estate executor to oversee the terms of the Will, creating and updating beneficiaries on plans such as Life assurance, setting up durable Power of Attorney to direct asset investments, and making funeral arrangements.
The main point is that estate planning is part of good personal financial planning. It avoids fights that can waste wealth and unnecessary taxes upon the demise of the owner of the wealth. Therefore, estate planning involves drawing a Will and avoiding the above wasteful events that can take a big chunk of a person's wealth upon his demise. To prevent mistakes, you should prepare the Will with the help of experts under no duress and with a sober mind. An estate plan needs regular reviewing and updating as the family and financial situations and laws change over the planner's lifetime.
e) Retirement Planning
Retirement is a crucial part of personal financial planning. Your age and health may prevent you from working to create income, yet you need money for food, medicine, and other daily needs. Additionally, old-age work opportunities are rare. Retirement planning helps you to create income-generating assets to finance your retirement needs and be self-sufficient.
Retirement planning includes choosing from several retirement income-building instruments or assets like the IRA, 401k, Health Savings Account (HSA), annuities, and pension plans. Building these assets takes time, and you must start saving and investing early to acquire them. When planning, you need to consider various factors such as returns, investment fees, and tax advantages of each instrument and how you manage and access the funds at the end. You must prepare a forecast retirement expenses budget to target acquiring assets that will generate the income needed for retirement. Retirement planning is a complex activity, and it is advisable to involve a financial advisor.
3. Setting Goals
Having defined your vision, you now want to set goals to achieve in the short, medium, and long run to realize it. Some goals may be attainable in months, and others in a few to many years. Some goals require money, and others require only time and Will. Before setting goals, you must consider your savings and investing purposes.
a) Purpose for Saving and Investing
A key component of goal setting is knowing your purposes for saving. We save and invest because we cannot predict the future, and it is necessary to put some money aside to have a safety net for needs in the present and the future. The other essential purpose for saving and investing is to create passive income for when one will no longer be able or want to work to earn a living income. This saving can provide financial independence, security, and peace of mind, knowing you have a realistic chance of dealing with the unknown during work and retirement. Passive income is earnings you get regularly but have no active role in its generation. Examples are rent, dividends, and pension. Saving money for retirement is a way of preparing to depend on yourself. If you have no cash in retirement, you will be a burden to people and may lead a stressful life. In summary, the main reasons for saving include multiplying and growing money, protecting money's value against inflation, creating multiple streams of income, having peace of mind, creating an emergency fund, buying an asset and household goods, creating an education fund, creating a fund for more significant investments, create retirement income and leaving an inheritance for children.
Saving requires willpower or discipline and a lot of careful planning. It requires sacrificing and forgoing consumption now, particularly the unnecessary luxury type, to save for comfortable consumption in the future. Impulsive spending and a laissez-faire life, usually the sturdier forces, will prevail if you have no purpose for saving. A saving and investment purpose will provide a power you can summon to stay on course when things get tough. Whatever the purpose of saving and investing, you need to define and have goals to motivate you to start this journey. Without these, there will be no compelling force to start and continue saving and investing.
b) Defining Goals
Having considered your savings goals, you can now turn to goal setting. It is necessary to have goals for each area you want to improve. The goals must be SMART (Specific, Measurable, Attainable, Relevant and Time-bound). A SMART goal might read, "I want to save US$100 monthly to buy a car worth US$4,000 in three years from now". You should have a goal to create an emergency fund in six months. For every goal, you should determine how much money is needed by when and how much you should put aside periodically to achieve the amount. You could have goals to attain concurrently or sequentially (one after the other).
4. Prepare a Spending Budget
Finding income is critical, but handling your expenditures is more crucial. You must ensure that your costs, including essential and discretionary expenses, and the amounts for saving and investing are equal to or less than your total income. You must balance the budget; if expenses are higher, you must determine how to increase revenue or cut costs. The budget must show weekly or monthly income and expenditures, including savings and investment amounts.
To achieve this control, you must prepare a budget to help you see and control your income and expenses. A budget is a template allocating income to sub-heads like groceries, mortgage payments or house rent, utility bills and discretionary expenses such as travel, entertainment, shopping and hobbies. You must include in the budget the amounts for saving and investing to achieve the goals of your vision and plan. The budget also includes amounts for sorting out chronic or all personal debts. You can prepare budgets once you identify the aims for saving and investing the amount required to achieve each expenditure category. You prepare a spending budget containing amounts necessary for meeting current needs and wants and quantities for saving and investing to attain goals.
If planning for retirement income, you must have a retirement budget. This budget must show the income you will need in retirement, the expenses you will incur regularly, and an estimate of the assets necessary to generate that income in retirement. The retirement budget contains types of assets and values that need to be acquired to create passive income for living in retirement. Such assets could include a pension, an annuity, company shares, long-term treasury bonds and rental property. The income they generate in the future should equal the retirement expenses budget. You build retirement assets slowly in your working life, which are part of the goals you set above. For example, you can plan to create an annuity or rental property over time (like 15 years) that will generate US$2,000 per month if this amount is your retirement expenses budget.
An essential principle in personal spending budgeting separates net income into five parts: spending, saving, investing, offerings and tithing. In his book "Five Wealth Secrets (2018), " Craig Hill recommends keeping your net income in five jars, each containing 80% net income for spending, 3% for saving, 4% for investing, 3% for offerings and 10% for tithing. Savings are for short-term purposes such as emergencies or buying necessary big-ticket household items. Investing is for medium and long-term goals, such as acquiring income-generating assets such as real estate or shares (stocks). Offerings or Alms money is used to support needy people or noble causes and to support the work of God, such as Sunday service offerings in the case of Christians. Tithe money is strictly for supporting the work of God, as explained in the Bible. All these five categories should have budget lines and amounts in the budget. Savings are usually for short-term purposes, while investing is typically for long-term goals.
5. Choose Investment Opportunities
Saving and investing happen in a portfolio context. To accumulate money for whatever purpose, you need to place it in an interest or profit-earning portfolio. So, you must consider investment vehicles like interest-bearing bank deposits, stocks for dividends or capital gains, mutual funds, Exchange-Traded Funds (ETFs), etc. There are plentiful investment portfolios available to savers and investors. You must choose options that align with your liquidity, time horizons, return (ROI) and risk tolerance goals. It all depends on how much money you have, how much is needed, and when. It would help if you chose the appropriate investment opportunity centred on reasons such as your goals, age, risk appetite and the amount available for investment. You should consult an expert if you are not confident about these matters.
6. Implement the Plan, Monitor and Evaluate
Implementation involves making a plan (roadmap) containing initiatives, actions, and steps you must execute daily, weekly, monthly, and yearly to attain the goals. You need a spending budget with monthly income and expenses, including amounts set aside for saving and investing, reflecting what you plan to do to achieve aims. You must look at the actual outturns monthly, compare them with corresponding budget actions and amounts, and take corrective actions on deviations from the plan. You can revise the goals and the budget as circumstances change. You need to look at the retirement budget to ascertain whether the acquisition of retirement assets is on course or if it requires adjustments.
7. Consult an Expert
Making an effective personal financial plan can be a daunting task. If you are uncertain at any stage of personal financial planning, you can enlist the services of a financial advisor. Advisors are certified experts who assist savers and investors in making the correct investment selections. They also help with other matters such as insurance, retirement planning, estate planning and taxation.
These are excerpts from the book entitled Personal Financial and Retirement Planning, available at Nuria Bookstore, Nairobi (Telephone 0729829697), Amazon - Print and eBook: https://www.amazon.com/stores/author/B0CQGHV8C8/allbooks