Investing is an
important part of the financial planning process. Yet, information overload and
busy lives make managing finances successfully a challenge for almost everyone
at some point. This unit is designed to help you understand the basic building
blocks of sound financial management–the steps you need to complete, or at
least consider, before you begin an investment program.
Visualizing the financial management building blocks in a pyramid (Fig. 1), the
wealth protection blocks on the bottom of the pyramid form a strong, secure
foundation and provide crucial stability for the wealth accumulation and
distribution blocks on top.
Each building block relies upon the strength and stability of the personal finance strategies used in the blocks below it. Decisions for one building block may have a definite impact on options available in adjacent blocks. For example, if you overuse credit, you may not qualify for a mortgage on a home. As you move up the pyramid, your financial life becomes more complex. This complexity, along with changes in your life, may require that you re-evaluate and change earlier strategies. Working from the bottom to the top of the pyramid, we will discuss the 11 key components of a successful financial plan that make up the blocks of the pyramid. We will discuss in turn the components of wealth protection, accumulation, and distribution.
Note: You can click on each building block in Figure 1 to jump ahead to the topic to which it refers.
Figure 1
Cash management strategies include budgeting, keeping financial records, maximizing the interest earned on checking and savings accounts, and regularly preparing financial statements, such as net worth and cash flow. One of the soundest pieces of financial advice is to spend less than you earn. It sounds simple, but if you are not fully aware of how you spend money, you may be spending more than you realize. After you track your income and expenses, following a budget that is adjusted to your individual situation and goals is an excellent strategy to plan your spending.
To estimate the value of your assets and chart your financial progress, each year you should add together everything you own (assets), then subtract everything you owe (debts), including your mortgage and credit card debt. This summary of assets and debts is called a net worth statement or balance sheet. It will help you analyze the way you currently manage your finances and make decisions to improve your financial situation.
You want your net worth to increase each year. During the early stages of your life, when you’re establishing yourself at work and accumulating the necessities of life, your net worth may rise slowly. It will probably grow the most right before retirement when you are at the peak of your career and accumulating assets to ensure a secure retirement. Plan to review and update your net worth annually. The actual date of your review is not important. It might be your birthday, New Year’s, right after you do your taxes, or some other important date. It is more important that you remember the date and complete your annual checkup. It also is important to regularly reconcile bank and other financial statements with your own records.
A vital aspect of the cash management building block is financial record-keeping. An effective record-keeping system should be convenient and not too complicated to maintain. A number of systems are available commercially, or you can design your own (e.g., with file folders). It is important that the system makes sense to you and that you use it consistently.
Setting aside money to meet unexpected expenses provides a financial safety net and allows you to take advantage of financial opportunities as they arise. Most experts recommend an emergency fund equal to 3 to 6 months living expenses; however, you do not need to set aside this total amount in a low-yielding passbook, certificate of deposit, or money market account. The amount of your emergency fund depends upon your age, health, job outlook, and personal financial situation (e.g., amount and kind of insurance coverage). An emergency fund might be adequate with enough to cover 3 to 6 months of expenses using a combination of cash and credit if you have a source of low-cost borrowing (e.g., home equity credit-line loan, cash-value life insurance, or retirement plan). If your household has multiple sources of income or dual earners, you can count on those other sources of income in an emergency.
You might want a larger emergency fund if you are in business for yourself, your work is seasonal, your job is uncertain, or you rely heavily on commissions. If your health is questionable (e.g., you foresee long-term disability or extensive medical expenses), you anticipate a large expenditure for the care of a relative in the near future, or your child is about to enter college, you may also need a larger cash reserve.
Your emergency cash reserve can be subdivided to minimize penalties for early withdrawal of large amounts of funds at one time and to maximize interest earned on accounts should an emergency occur. Money that would be needed within 3 months of a financial emergency is best placed in an interest-bearing checking account, passbook savings, money-market deposit account, or money market mutual fund. Funds needed 4 to 6 months after an emergency could be placed in short-term certificates of deposit (CDs) as well as 3- and 6-month Treasury bills. Money that would not be needed for 7 months to 2 years could be placed in a money market mutual fund and longer term CDs (12-, 18-, and 24-month). Money you can avoid withdrawing for 2 to 5 years during a financial emergency could be placed in Treasury notes, short-term bond funds, or 3- to 5-year CDs.
Every day we are exposed to many risks which can cause a financial loss. Accidents, property damage, illness, and death are risks we often consider. However, other risks, such as the possibility of being sued or becoming disabled and unable to work, are also important. We each have to decide how we will protect ourselves should a risk become a reality. If you do not have a plan, you might have to go into debt or use funds set aside for other financial goals in the event of financial disaster.
Appropriate risk management strategies protect against catastrophic financial losses, regardless of the cause. Good comprehensive insurance coverage against severe setbacks is essential. Areas for coverage include life, health, homeowner’s or renter’s, auto, disability, and liability. Smart consumers can obtain this coverage at a cost that allows them to move up the pyramid to accomplish other goals without being insurance poor. Note that this type of risk management should not be confused with investment risk, which is a different financial concept.
To determine when you need to purchase insurance, consider the best way to handle each of your risks. Because your risks change over a lifetime, evaluate your situation every few years and make appropriate changes. Can your savings cover a financial loss so that you don’t need to buy insurance? Increasing the deductibles (the portion of a loss that you pay) on your policy usually saves you money as well. However, when self-insuring or carrying high deductibles on policies, you must set aside the necessary funds in your emergency cash reserve to pay for those expenses in case of a loss.
Risk management strategies can be combined with savings and investments to achieve financial goals (e.g., buying cash value life insurance). However, be careful to ensure that your strategies provide the best return on the money involved. Determine if insurance protection can be purchased less expensively so that you can invest the savings for a greater overall return.
The goal for taxpayers is to pay no more than the least possible tax owed. Avoiding taxes through legal tax strategies is not to be confused with illegal tax evasion. Legally avoiding taxes means using effective financial record-keeping, decision making, and planning strategies to reduce your total income tax . One example of good tax management is adjusting the amount of federal income tax withheld from your paycheck. If you receive a big income tax refund (over $500) each year, you are giving the federal government an interest-free loan. Evaluate the amount you have withheld and determine if you could use this money more effectively throughout the year to manage cash flow or invest for financial goals.
Tax laws continue to dictate how we structure our financial plans. As laws favor or disallow certain strategies, we need to make adjustments. Two examples of this phenomenon are Individual Retirement Accounts (IRAs) and home equity credit-line loans. When everyone was allowed a tax deduction for a Traditional IRA, this strategy was widely encouraged and used. Since tax laws restricted IRA deductions, many people automatically either turn to Roth IRAs or eliminate IRAs completely as a viable alternative. Now that tax deductions for non-mortgage consumer interest are not allowed, many people have turned to home equity credit-line loans to finance large purchases and deduct the resulting interest.
As tax laws change, adjust your financial plans to use strategies which are most favorable to your situation. Most of us are aware of the tax advantages of tax-deferred savings. The idea, of course, is to put off paying income taxes on money until you withdraw it in retirement when, possibly, your tax bracket may be lower. However, you have no guarantee that this will happen, especially if you are very successful at saving for retirement and accumulating assets. In addition, the tax laws are constantly changing. You should seek the advice of a Certified Public Accountant (CPA), Certified Financial Planner® (CFP), or tax professional to gain insight into how tax laws will affect you.
For example, under a tax law effective in 1997, up to $250,000 of profit from the sale of a primary residence is tax-free if you file an individual tax return; up to $500,000 if you and your spouse file jointly. To qualify for this tax-free benefit, you must own and live in your home for 2 of the 5 years prior to the sale. Only one spouse is required to own the home, but both need to have lived there to qualify for the larger $500,000 capital-gain tax exclusion. Further, you can use this new exclusion even if you have previously claimed the old $125,000 exclusion. How often you use this new exclusion is unlimited, but generally you can qualify only once in any 2-year period. If you must sell a home because of ill health, a job-related move, or unforeseen circumstances prior to meeting the 2-year test, you can claim a prorated exclusion [See Internal Revenue Service <www.irs.gov>.
To get where you want to go in life, it is important to decide in advance how you will get there. Goals are signposts on the highway to the future. They serve as your guide to personal, career, and financial success. By keeping specific goals in view, you can direct your energies toward achieving your goals.
Financial goals are important because they help us to organize and direct our financial lives, providing a framework for decision-making. They can help us cope, provide some control in an environment where many things seem out of control, and help us visualize our financial future.
How can you establish financial goals and utilize the building blocks you need to achieve your dreams? First, you can learn how to create $MART goals. $MART financial goals have several important criteria:
$ |
Must be $PECIFIC with dollar amounts, dates, and resources to be used in accomplishing the goals. |
M |
Must be MEASURABLE; determine regular amounts weekly, bimonthly, or monthly to set aside to accomplish goals. Another good "M" word to consider is MUTUAL. Goals that are mutual or shared with other family members will be easier to achieve. It also is important to think about how you will keep yourself and other family members MOTIVATED to achieve goals, especially long-term goals. |
A |
Your goals need to be ATTAINABLE given your financial situation. |
R |
It is important that your goals are RELEVANT and REALISTIC. What RESOURCES are available for you to use in achieving your goals? It is also important that you REVIEW and REVISE your goals periodically as necessary. |
T |
You need a specific TIME-LINE for accomplishing your goals. To achieve those goals, you must also be willing to make TRADE-OFFS in your financial life. Know the difference between needs and wants. Because there is never enough money to fund all of your financial goals at one time, you need to prioritize your goals. |
Take the time to put your goals in writing. Putting them on paper will reinforce their significance. Use the worksheet "$MART Financial Goal-Setting" to help you list short- and long-term financial goals. Then, to stay motivated, visualize how you will feel when you accomplish your goals. Lastly, it is very important that you periodically set aside a pre-determined sum of money for each specific financial goal.
When is the best time to stop a growing debt burden? Before it gets out of hand, of course. You can spot a debt problem early by looking at indicators, such as the number of bills coming in each month. Is the number increasing steadily? This could signal an increasing reliance on the use of credit. Cut back on credit buying now; you will be ahead of the game. Are you consistently paying only the minimum each month on your credit cards or other debts? This habit can be a critical "red flag." If you can pay only the minimum now, do not increase your debt load. Also, keep in mind that, when you pay only the minimum amount each month, you are paying high finance charges on the unpaid balance. This costs money and delays the achievement of financial goals.
Periodically, get a copy of your credit report and check it for accuracy and completeness. This is especially important before making large purchases where you plan to use credit, such as for a car loan or a mortgage. In many cases credit reports have minor inaccuracies that need to be corrected. Sometimes there are errors that might result in your being turned down for a loan (to correct an incorrect credit report, use the form provided by the credit reporting agency). Contact the "Big Three" agencies Equifax(1-800-685-1111,<www.equifax.com>), Experian(1-888-397-3742, <www.experian.com>), or Trans Union (1-800-916-8800, <www.tuc.com>) for details. If you have recently been denied credit, employment, insurance, or rental housing based on information contained in your credit report, you are entitled to a copy free of charge from the company that issued the report on which the credit denial was based. You can also check your credit score online at <www.myfico.com>, <www.equifax.com> and <www.eloan.com>.
| Credit management strategies can be used to: | ||||||||
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If you have large credit card balances, it is a good idea to repay them before starting an investment plan. Repaying your debts can often provide a greater return on monies than many investment strategies. Repaying high interest rate loans can also provide money that can be used for future investments.
Home ownership is a financial goal for many people. A home is often the largest investment, and sometimes the only investment, that many people make. Given the low appreciation rate of real estate in some areas, it is probably better to think of purchasing a home as buying shelter, not as an investment that you expect to rapidly appreciate (increase in value). Home equity, the dollar value of a home in excess of the mortgage owed on it, is considered an asset against which you can borrow. This strategy must be used with extreme caution, however; you could lose your home if you do not repay the amount borrowed.
You don’t have to be a big-time, high-income investor to have an investment plan. Even if you have only a small savings account, investments can become part of a long-term strategy to achieve specific goals.
A diversified investment portfolio can be developed after building the blocks of a firm financial foundation. Until adequate cash management, an emergency fund, insurance plans, tax management, and credit usage are under control and functioning effectively, it is probably unwise to begin an aggressive investment program.
A diversified investment plan begins with a well-defined philosophy and encompasses strategies designed to specifically accomplish financial goals (e.g., children’s education and funding retirement) without having to sacrifice one goal for the other.
Are you planning to provide your child or children with a college education? If so, do you know how much it will cost? Do you know how you will finance this goal?
Meeting the financial costs of educating children is a financial goal for many people. The strategies to help you meet this goal may differ from other saving and investment strategies, however. Always investigate the tax and financial aid implications of your college-saving strategies.
The earlier you start planning for a college education for your child, the more time you will have to accumulate funds. Consider and plan for the cost of the entire college education. However, because saving ahead for the total cost may be unrealistic for parents, other possibilities need to be explored, including scholarships, grants, loans, and work-study programs. Learn the details about each one.
To determine what you need to invest for college, complete the worksheet found on the Calculating What You Need to Invest page.
Planning for retirement is a challenge for everyone. Again, the earlier you begin, the longer you will have to accumulate funds and capitalize on compound interest. A plan designed to meet specific retirement goals may be separate from or part of the investment building block.
Some people have given a great deal of thought to retirement, but others have not. Less than half (42%) of working Americans have made a retirement savings calculation, according to the 2006 Retirement Confidence Survey, and 70% have begun to save for retirement. Unfortunately, this means that 30% of workers have not yet begun saving. Most experts believe that regular, systematic savings is a habit that is best established early and maintained, not only throughout the working years, but into the early stages of retirement since people are living much longer. Today, many people spend as many years in retirement as they spent in the workforce.
Financial experts have long described sources of retirement income as the three-legged stool: Social Security, company pension, and personal savings. Now with the growing concern over the future of Social Security, the reduction in benefits offered by employers, and the low personal savings rate, many see the three legs of the retirement income stool becoming shaky. Many say that the stool may need a fourth leg—paid work after retirement.
Now that the Social Security Administration has phased in automatic mailing of Personal Earnings and Benefit Estimate Statements to all wage earners, check yours for accuracy. It contains information that provides an excellent basis for retirement planning. Contact the Social Security Administration (1-800-772-1213) (See the Social Security Online Web site <www.socialsecurity.gov>) to obtain a benefit request form.
Another source of retirement information is your employer’s personnel department which may have general tips on retirement as well as specific information about investments available in your pension plan. Many online sites provide information about retirement planning (See American Savings Education Council <www.asec.org>).
If you successfully implement the strategies outlined in the financial management pyramid, you are much more likely to have assets left over at the end of your lifetime and will need a plan for how your accumulated wealth is to be distributed. A will is a necessity if you want to direct the distribution of possessions after death. Yet, almost 70% of the adults in the United States do not have wills. Many people think they do not need to prepare a will because they have so little, or it costs too much, or they will do it later when they have more time or get older. Dying without a will is called dying "intestate" and means that state regulations will determine the distribution of assets. By having a carefully written legal will, you can provide for your family and others in a manner consistent with your desires.
In addition, a variety of other important legal documents can make provisions for crises other than your death including the following: General Durable Power of Attorney, Health Care Power of Attorney, and a Living Will. These documents are best completed before a crisis occurs and can ease a difficult period for your family. These components of an estate plan are not directly linked to the financial management pyramid, but can protect assets and insure that your financial strategies and health care decisions are respected.
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All the building blocks of successful financial management, including investing, are interrelated. Strategies used in one part of the pyramid can directly impact others. If one building block, such as credit use, becomes too large, the entire pyramid can topple. This pyramid aids effective decision making and the successful achievement of financial goals because all aspects of your financial situation are considered simultaneously.
To get where you want to go in life, it is important to decide in advance how you will get there. Goals are signposts on the highway to the future. They serve as your road map to personal, career, and financial success. By keeping specific goals in view, you can direct your energies toward achieving your goals.
$mart goals need to be written down on paper to reinforce their importance. Use this table to set some short- and long-term financial goals that follow the $mart goal format.
Remember Your $mart Goals |
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| $ | $pecific |
| M | Measurable, Mutual, Motivated |
| A | Attainable |
| R | Relevant, Realistic, Resources, Review, Revise |
| T | Time-line, Trade-offs |
Action Steps - Check off the steps after you have completed them
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Develop financial management knowledge and skills, i.e., record-keeping, budgeting, tax, risk, and credit management. |
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Reduce expenditures to free up money to help achieve financial goals. |
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Compare financial account statements provided by institutions with personal records. |
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Complete an annual financial checkup, including net worth and cash flow statements. |
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Build a team of financial advisors to guide and direct financial decision making. |
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Review financial management strategies periodically and revise when necessary. |
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Determine/establish adequate amount of emergency fund for your individual situation. |
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Deposit funds in easily available accounts where they can be accessed with minimal financial penalties. |
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Locate your insurance policies such as life, health, property, casualty, automobile, and disability. |
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Evaluate current policies and shop around for additional or replacement coverage if indicated. |
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Learn about tax laws and use related strategies to reduce total taxes owed. |
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Check your income tax withholding level and adjust, if indicated. |
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Explore the advantages of different tax strategies. |
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Utilize tax-advantaged and tax-deferred options when appropriate, i.e. IRAs, 401(k), 403(b). |
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Maximize tax deductions (e.g., using home equity credit-line loans versus non-deductible consumer interest. |
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Write out short-, medium- and long-term financial goals following the $MART goal format. |
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Keep credit use at a safe, manageable level. |
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Obtain a copy of your credit report to see if it is accurate and complete. |
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Determine which of these categories contain areas you wish to include in your financial goals. |
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Write down specific financial goals for those categories following the $MART goal format. |
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Establish and periodically evaluate wills and estate plans. |
Financial Literacy Center. (1997, January/February). Emergency fund pyramid. Loose Change Newsletter, 4.
Porter, N.M., & Christenbury, J.H. (1997, January). Money 2000 program notebook (Clemson University Cooperative Extension Service). Clemson, SC: Family and Youth Development Department.
Quinn, J.B. (1998, July 26). Calculating a target for retirement savings. The Washington Post, H2.
The 2006 Retirement Confidence Survey Summary of Findings. (2006). Washington, DC: Employee Benefit Research Institute. Available online at <www.ebri.org>.
Tritch, T. (1997, May). You're never too young to get your estate in shape. Money, 91-95.
Nancy M. Porter, Ph.D., is a Professor and Family Resource Management Specialist with the Clemson University Cooperative Extension Service http://www.clemson.edu/fyd/porter.htm. Her primary areas of expertise are family financial management and consumer education. Prior to joining the faculty at Clemson, Dr. Porter taught at Delta State University in Mississippi and in the Towanda Area Public Schools in Pennsylvania. Dr. Porter completed her B.S. and M.S. in Home Economics Education at Mansfield University in Pennsylvania. Her Ph.D. in Family Resource Management was earned at Virginia Tech.
Last updated: March 12, 2007 , webmaster@rce.rutgers.edu
