Personal finance 101: What is a financial plan?
A personal financial plan is a written examination of your finances, including your income, an asset evaluation, your liabilities, and your investments to determine both your current financial state and your future financial state. Financial plans are crucial for you to help assess whether you will be able to reach your financial goals and to decide the steps that you should implement in furtherance of them.
Despite the importance of personal financial plans, many people fail to engage in financial planning for their futures or to even understand what actual financial planning is. One survey that was reported in Fortune revealed that nearly two-thirds of Americans are not able to pass a fundamental test of financial literacy.
Financial planning should start early. When you begin saving while you are young, your money will have more time to grow. The purpose of a financial plan is to help you determine the feasibility of your goals and to understand the steps that you will need to take to reach them. Gaining a good understanding of what financial planning is can help you get started on a more successful financial future.
Knowing how to write a financial plan can help make the difference in your financial success. If you complete a plan, you will be less likely to make poor financial decisions. Financial planning can also help you enter a higher income bracket and improve your quality of life.
So what is in a financial plan? A financial plan should be comprehensive and include a number of elements like:
- Financial goals
- Statement of your net worth
- Analysis of your cash flow
- Strategy for retirement
- Risk management plan
- Tax planning
- Investment plan
- Estate plan
Creating a financial plan will take a bit of work, but the end results can be life-changing. Doing your own plan can put you on the path to greater financial health and a better future. It is important for you to understand that your personal financial plan and its components should not be static. After you have learned the purpose of financial plans and have completed your income, liabilities, and asset evaluation, you should review the document regularly to check your progress towards reaching your goals.
Financial plans necessitate regular reviews and modifications throughout your life. You should modify your plan when you experience major life changes that could affect your goals such as the following:
- Birth of a new baby
- Getting married
- Getting divorced
- Death in the family
- Second or subsequent marriages
- New blended family
- A new job
Personal finance 101: Why do a financial plan?
Once you have a general idea of what the plan is, you will need to see how to set up a financial plan. You will have to keep track of your assets, your income, how you spend your money, the debts that you have, and your taxes. The first step is to track where you are spending your money in order to have a clear idea of your current finances.
Track where you are spending your money
You should begin by tracking all of your expenditures for 1-2 months. Categorize your spending according to the purchase type or the store so that you can understand areas in which you might be able to cut back.
There are several methods to track your spending, including the following:
- Track your purchases by the store
- Use an app to track spending while you are on the go
- Track as you go with an expense spreadsheet
- Use separate accounts for spending and bills
- Download your transactions from your bank and credit cards into a spreadsheet
Tracking your spending for a month or two can help you to understand the picture of your personal finances to set your financial goals.
Organize your financial records
The next step is to organize your financial records. You should gather all of your documents into one place and organize them. Some of the documents that you should gather include the following:
- Bank statements
- Pay stubs
- Credit cards
- Retirement account statements
- Auto records
- Mortgage statements
- Tax returns
- Insurance records
- Medical bills
After you have gathered the documents, create a filing system and make certain that they are filed in the correct folders.
Complete an evaluation of your assets to determine your net worth
The next step involved with making a financial plan is to complete an asset evaluation and to determine your net worth. To do this, you will need to determine the market value of each of your assets. This is the price you’d be able to sell the asset for if you found a willing buyer.
Begin by taking an inventory of all of your assets and write them down. You can then look up the fair market value of all of your fixed assets. Determining the value of your intangible assets may require some more work. After you have valued all of your assets, you will then need to take an inventory of all of your income sources and your liabilities.
Write down all of the sources of income that you have so that you can see a monthly total. If your monthly amounts vary, use an average value of your earnings for the last six months. Finally, list all of your debts and total them. You can then determine your net worth by subtracting your liabilities from the value of your assets. There are some net worth calculators that are available online that can help you with this process.
Set your financial goals for the future
Setting your financial goals is the next step in writing a financial plan. Decide how much you want to have available for your retirement. Think about other goals such as your children’s college savings, purchasing a home, retiring early, and other things that you would like to accomplish. Decide how much money that it will require to meet each of these goals.
A financial plan example of possible goals might include the following:
- Pay off your credit card debts
- Create a budget that you can live with
- Save an emergency fund of three to six months’ worth of your income
- Spend less than you earn
- Save for your retirement
- Save a down payment
- Save for college
- Pay off your student loans
- Increase your income
Once you have an idea of your goals and how much money you will need to set aside to accomplish them, your next step of financial planning will be to identify the steps that you will need to meet each goal and to write your financial plan.
Create your plan in order to meet your goals
When you create a financial plan, you will need to write separate plans that will be included in the comprehensive financial plan. A good financial plan should address your savings, investments, tax strategies, risk strategies, and how your assets will be handled if you become incapacitated or pass away. Here is a review of each of these components in a financial plan example to give you a better idea of how they should work.
1. Savings plan
All good financial plans should include a savings plan. This is a plan for how much you need to set aside from your income each paycheck or each month to reach your goals. If you are young, you will have a longer time to save. However, setting aside more money while your expenses are fairly low is a smart choice.
As a general rule, it is a good idea to try to save at least 20 percent of your income each month. If you have a 401(k) with matching at your job, try to save at a minimum the percentage that your employer will match. You should try to save three to six months of your income in an emergency fund so that you will be prepared for the unexpected. If you are older, you will want to figure out how much money that you will need to set aside so that you can retire, including catch-up contributions.
2. Investment plan
A financial plan example should also include an investment plan. You will need to determine your investment strategy. If you have a long time to save, you might choose to be more aggressive with your choice of investments. For short-term financial goals, it might make more sense to be conservative in your choices as you build a portfolio.
After you have decided the strategy that you will take, write a personal investment policy statement that can help guide you when you choose your investments. After you have done this, you can then pick your investments while making certain to diversify as you build a portfolio.
3. Income tax plan
Creating an income tax plan is important for your overall financial plan. Your tax plan should be reviewed each year since tax laws and regulations change every year. Sit down with a tax professional to figure out the deductions that you may be eligible to take.
Your financial plan should be written in a way to maximize your tax savings. By taking steps throughout the year, you may be able to minimize the amount that you have to pay to the IRS. For example, your tax planning might include making maximum annual contributions to an IRA instead of paying more money to Uncle Sam.
4. Insurance plan
Another important component of a personal financial plan is an insurance plan. You should determine your risks and how much insurance you need to offset each of them. The insurance planning portion of your financial plan should include plans for your auto insurance, health insurance, homeowner’s insurance, and life insurance at a minimum.
The insurance needs of each person will vary. You need to figure out your areas of risk and decide how much insurance you need to help you to recover if disaster strikes. Your insurance needs might be affected by the following factors:
- Economic status
- Family status
5. Estate plan
Estate planning is something that many people put off because they either do not want to think about death or because they think that they have plenty of time to do it later. It is important to understand that the unexpected can happen at any time. Estate planning is vital for everyone over 18.
If you do not have a plan in place and are incapacitated, your loved ones may have trouble accessing your accounts to pay your bills for you or finding out important health care information. Regardless of your age, you should at least have durable financial and health care powers of attorney in place. Comprehensive estate planning may include a number of different documents, including the following:
- Durable powers of attorney
- Advance directives
- Living wills
Estate planning should include plans for how your assets will be distributed after your death along with plans for who will have the authority to make important financial and medical decisions for you, if you are unable to make them for yourself due to incapacity.
Implement your plan and review and revise it in response to changes
Your personal financial plan should not be treated as a static document. Instead, your financial plan is a living, breathing record that you should review and revise in response to changes in your life. Financial planning is an ongoing process that should continue throughout your life.
As a rule of thumb, you should review your plan annually and make changes where they are needed. For example, the tax laws change frequently, making it important for you to update your tax planning strategies in your plan in response to changes.
You should also review your financial plan after any major change in your life such as getting married, getting divorced, having a new baby, experiencing a death in the family, and other changes. Each of these situations could mean adjusting your plans, changing your designated beneficiaries, and making other modifications so that your plan continues to work for you.
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