LIZ MANNING (Adapted from Investopedia)
Updated February 15, 2023
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What Is a Financial Plan?
A financial plan is a document that details a person’s current financial circumstances and their short- and long-term monetary goals. It includes strategies to achieve those goals.
A financial plan can help you to establish and plan for fundamental needs, such as managing life's risks (e.g., those involving health or disability), income and spending, and debt reduction.
It can provide financial guidance so that you're prepared to meet your obligations and objectives. It can also help you track your progress throughout the years toward financial well-being.
Financial planning involves a thorough evaluation of one’s money situation (income, spending, debt, and saving) and expectations for the future. It can be created independently or with the help of a certified financial planner.
- A financial plan documents an individual’s short- and long-term financial goals and includes a strategy to achieve them.
- The plan should be comprehensive and highly customized.
- It should reflect an individual’s personal and family financial needs, investment risk tolerance, and plan for saving and investing.
- Planning in finance starts with a calculation of one’s current net worth and cash flow.
- A solid financial plan provides guidance over time and serves as a way to track progress toward your goals.
The Fundamentals of Financial Plans
Understanding a Financial Plan
Whether you’re going it alone or with a financial planner, the first step in creating a financial plan is to understand how important it can be to your financial future. It can provide the guidance that assures your financial success.
Start your planning effort by gathering information from your various financial accounts into a document or spreadsheet.
Then make some basic calculations that establish where you stand financially.
You may complete the following steps as an individual or a couple:
Calculate Net Worth
To calculate your current net worth, subtract the total for your liabilities from the total for your assets. Begin by listing and adding up all of the following:
- Your assets: An asset is property of value that you own. Assets may include a home, a car, cash in the bank, money invested in a 401(k) plan, and other investments accounts.
- Your liabilities: A liability is something you owe. Liabilities may include outstanding bills, credit card debt, student debt, a mortgage, and a car loan.
Determine Cash Flow
Cash flow is the money you take in measured against the money you spend. To create a financial plan, you must know your income as well as how and when your money is spent.
Documenting your personal cash flow will help you determine how much you need every month for necessities, how much is available for saving and investing, and where you can cut back on spending.
One way to get this done is to review your checking account and credit card statements. Collectively, they should provide a fairly complete history of your income and spending in a wide range of spending categories.
For example, document how much you’ve paid during the year for housing expenses like rent or mortgage payments, utilities, and credit card interest.
Other categories include food, household (including clothing), transportation, medical insurance, and non-covered medical expenses. Still others can include your spending on miscellaneous entertainment, dining out, and vacation travel.
Once you add up all these numbers for a year and divide by 12, you’ll know what your monthly cash flow has been (and where you can improve it).
When establishing your cash flow history, don’t overlook cash withdrawals that may have been used on sundries, from take-out, to shampoo, to sodas. ATM withdrawals can also highlight where you might cut unnecessary spending.
Establish Your Goals
A major part of a financial plan is a person’s clearly defined goals. These may include funding a college education for the children, buying a larger home, starting a business, retiring on time, or leaving a legacy.
No one can tell you how to prioritize these goals. However, a professional financial planner should be able to help finalize a detailed savings plan and specific investing that can help you reach them off, one by one.
The main elements of a financial plan include a retirement strategy, a risk management plan, a long-term investment plan, a tax reduction strategy, and an estate plan.
Benefits of a Financial Plan
- A financial plan involves a thorough examination of your income and spending.
- It can improve your understanding of your financial circumstances at all times.
- It establishes important short- and long-term financial goals.
- It clarifies the actions required of you to achieve your various financial goals.
- A financial plan can focus your attention on important immediate steps, such as reducing debt and building your savings for emergencies.
- It enhances the probability that you'll achieve financial milestones and overall financial success (however you define it).
- It can guide your efforts over time and provide a means to monitor your progress.
- It can keep you out of financial trouble and reduce the stress and worry you may have experienced in the past.
Reasons for a Financial Plan
Financial planning is a smart way to keep your financial house in order. It's a money tool for everyone, regardless of age, earnings, net worth, or financial dreams. It offers individuals a way to document their personal goals and corresponding financial goals. It can keep people on track to meet ongoing financial needs and major financial goals.
When to Create a Financial Plan
A financial plan is always an advantage for those who want to make sure that they manage their finances in ways that are best-suited for them. You can create one at any time, whether you've just joined the workforce or have been working for years.
Beyond that, here are some particular instances that call for the creation and use of a financial plan. They can also serve as signals to adjust existing plans.
- A new job that results in added income, new expenses, or new opportunities
- An income change that can affect your ability to pay expenses, pay off debt, or save
- Major life events such as marriage, children, or divorce that can change financial objectives and spending needs
- Health adversities that result in re-directing income and spending away from existing goals
- An income windfall, such as an inheritance or insurance payment, that can affect efforts to reach your financial goals (such as providing more money for investing and debt reduction)
How to Create a Financial Plan
Certain steps are needed to create a financial plan. In addition to calculating your net worth, determining your cash flow, and establishing financial goals, as outlined above, here are additional plan elements/steps to include.
Do It Yourself or Get Professional Help
Decide whether you'll create your financial plan on your own or with the help of a licensed financial planner. While you can certainly build a financial plan, a financial pro can help ensure that your plan covers all the essentials.
Build an Emergency Cash Fund
Based on what your cash flow allows, start setting aside enough money in a liquid account to cover all your expenses for at least 6 months (preferably, for twelve) if you find yourself without income due to unexpected events.
Plan to Reduce Debt and Manage Expenses
If you have debt, the faster and more effectively that you can eliminate it, the better for the growth of your savings, your standard of living, and the achievement of specific financial objectives.
Make it a habit to cut expenses whenever possible so that you can add to your savings. In addition, stay on top of expenses that you know you'll have, such as taxes, so you always meet those obligations on time.
Manage Potential Risks
Your financial well-being can be affected when accidents, health problems, or the death of loved ones strike. Plan to put into place the appropriate insurance coverage that will protect your financial security at such times. This coverage can include home, property, health, auto, disability, personal liability, and life insurance.
Plan to Invest
Take part in a retirement plan at work that automatically deducts contributions from your paycheck. And plan to maximize your tax-advantaged investing with a personal IRA if and when your income allows.
Also, consider how you might allocate any other available income to a taxable investment account that can add to your net worth over time. Your plan for investing should take into account your investment risk tolerance and future income needs.
Include a Tax Strategy
Address the goal of reducing your income taxes with tax deductions, tax credits, tax loss harvesting, and any other opportunities that are legally available to taxpayers.
Consider an Estate Plan
It's important to make arrangements for the benefit and protection of your heirs with an estate plan. The details will depend on your stage in life and whether you're married, have children, or have other legacy goals.
Monitor and Adjust Your Financial Plan
Revisit your plan at least yearly (on your own or with a financial professional) and more often if a change in circumstances affects your financial situation. Keep it working efficiently and effectively by adjusting it as needed.
What Is the Purpose of a Financial Plan?
A financial plan should help you make the best use of your money and achieve long-term financial goals, such as sending your children to college, buying a bigger home, leaving a legacy, or enjoying a comfortable retirement.
How Do I Write a Financial Plan?
You can write a financial plan yourself or enlist the help of a professional financial planner. The first step is to calculate your net worth and identify your spending habits. Once this has been documented, you need to consider longer-term objectives and decide on the ways to achieve them.
What Are the Key Components of a Financial Plan?
Financial plans aren't one-size-fits-all, although the good ones tend to focus on the same things. After calculating your net worth and spending habits, you’ll explore your financial goals and ways to achieve them. Usually, this involves some form of budgeting, saving, and investing each month. To ensure that you live comfortably and financially stress-free for the rest of your life, the areas to focus on include an emergency savings plan, a retirement plan, risk management, a long-term investment strategy, and a tax minimization plan.
The Bottom Line
A financial plan is an essential planning tool for your financial well-being, now and into the future. It involves setting down the current state of your finances, your various financial goals, and methods that can help you achieve them.
It's never too early or late to create a financial plan. And no matter the amount of money that you have, a financial plan can help you to determine the best way to put it to work so that you can meet your financial needs through all of your life stages.