Step 4: Where Do I Want to Go? Developing a Financial Plan
Welcome to Step 4: Where Do I Want to Go? Developing a Financial Plan. This is probably one of the most involved, as well as the most important, steps on the Path to FI. If you have not completed the first three steps, I would strongly recommend you finish them before moving on.
The goal of this blog post is not to give you a precise template, but rather to teach you the principles and framework to create your own customized financial plan that will allow you to achieve your personal financial goals. As such, I will not discuss in depth every financial goal you might have, each type of tax advantaged account you should be saving in, each investment you should consider, or what your asset allocation should be. It would require an entire book to review all of that information (which may or may not be in the works ;-)). Again, this is a bigger picture, high level view of creating your own personal financial plan.
There is no one way to create a financial plan. What I have written here are just some suggestions I have to help you develop your own. You can make it as formal or informal as you want, but I would be cautious about making it too grand or complicated, as you may never complete it if it is too overwhelming. The important thing is that you develop a plan, have some goals, and start taking action. I also think it is a good idea to get your spouse or significant other involved, since your financial destinies are intimately linked.
3 Key Principles
Although there isn’t one right way to do this, I do believe there are at least three key principles you need to adhere to in order to be successful:
It Must be Specific
- You need to be specific in this plan. You can’t just say things like “I want to be debt free” or ‘I want to be financially independent” and just leave it at that. Your financial plan is where the rubber meets the road. You need specifics that spell out exactly what you are going to do. Specific goals, specific accounts, specific dollar amounts, specific timelines. Here are some better examples of the aforementioned goals:
- I am going to be completely free of consumer debt and student loan debt by December 31, 2021 by paying off each of my three credit cards and my two student loans. I plan to do this by saving $___ per month. First, I plan to save $3,000 as an emergency fund to cover any unforeseen expenses (so I don’t have to go into any more debt), and then I will pay $___ every month toward my debts until I am debt free (which will be by the end of 2021).
- In order to be financially independent, my assets must generate enough income to cover my expenses. I estimate that my expenses are $60,000 per year (from tracking my expenses over time). By the 4% rule, I would need to save and invest $1,500,000 to cover these expenses. To achieve this, I am going to save 25% of my income and invest it in these tax advantaged accounts:_____. This savings rate will allow me to save $____ every year. Estimating a 7% annual rate of return, I will achieve financial independence by ____.
- Do you see the difference? Just saying you want to be debt free or achieve financial independence gets you nowhere. But analysis of your current financial behavior and the development of very specific goals and plans to meet those goals will give you a plan of action.
You Must Refer to it Often
- There is no point in making a financial plan if you aren’t going to use it. For this plan to guide your finances and more importantly, your behavior, you must review it on a regular basis. While I look at mine almost daily (sometimes multiple times a day), I understand I am a bit of a freak with this personal finance stuff, so I don’t expect everyone to do the same. But you need to keep it at the forefront of your mind.
- I think it is important to review it more frequently when you are just starting to take control of your finances. The more you develop good financial habits in line with your personal financial goals, the less you probably need to review your financial plan. Might I suggest you review your plan at least 1-3 times per week initially and then taper down over time. However, I would not recommend reviewing it any less than once per month (a lot can happen in a month).
- If you are going to be reviewing the plan regularly, it can’t be too long and complicated. Although it does need to be specific as emphasized above, if your plan takes an hour to review the likelihood of your reviewing it regularly is nil. So, don’t write a novel when creating your plan. Try to keep it to a few pages or less.
It Must be Fluid
- Your financial plan cannot be static. It MUST be fluid and change over time as circumstances change. Take the above example about reaching financial independence, a plan like that will likely take 10-20 years to achieve. How naive would it be to think that critical factors affecting that plan will not change over time? For example, your income could drastically change, which would affect your savings rate and thus the rate at which you could achieve FI. What if you decide to invest in real estate and add more passive income? This would change how much you need to save in the stock market by the 4% rule. As these circumstances change, your plan must adapt to reflect this, or it becomes useless.
- I look at my financial plan as a fluid plan of attack, rather than some static document that I am bound to. I am constantly tweaking and updating it to reflect changes in my financial life. If I learn a new investing principle, I try to incorporate it into my plan. If I develop a new income stream, I update my plan. Continual efforts to optimize your plan will pay huge dividends in the future.
Recording Your Plan
You will need to record your financial plan somewhere. This is something that will likely differ for everyone based on personal preference, technological savvy, and accessible tools. Some of you may be old school and just want to use a paper and pencil. That is great, many financial fortunes have been created over the years using the same. Some of you may love spreadsheets and their associated formulas such as the future value equation. If that floats your boat, by all means use a spreadsheet. For others a simple Word document might do the trick and can be updated easily.
Personally, I like the satisfaction of writing something by hand, but the convenience of having it available electronically in the cloud so I can access it from all my portable devices. So, I have come up with the following solution that works for me. For work I have an iPad and Apple Pencil. I use a program called PDF Expert where I can create PDF files. For my financial plan I created a pdf file that looks just like notebook paper, and I have written out my plan by hand on the iPad using the Apple pencil. Since it is electronic and stored in the cloud, I can access it for review anywhere. However, if I want to revise it (which I do regularly) I have to use the iPad.
Whatever you decide, just make sure it is something that you are comfortable with, can easily be reviewed, and can be easily changed and updated.
Tools You May Need
I’d like to suggest a couple of tools to have in your arsenal before moving forward. To develop specific plans with real numbers, you need to have access to at least two calculators: a mortgage/loan calculator and an investment/compound interest calculator. There are free versions available online or in both the Apple and Android app stores. I have free apps for both on my smartphone and use them regularly. Another option would be to use formulas within a spreadsheet if you understand how to do that.
The mortgage/loan calculator will help you develop specific goals for paying off debts, like a credit card, student loan, or mortgage. Variables you enter include the loan amount, interest rate, payment amount and frequency. The calculator will then tell you how long it will take to pay off the debt. You can play with the numbers and begin to understand how long it can actually take to pay off debt if you only make the minimum payments and, conversely, how much money you save by making larger regular payments.
The investment/compound interest calculator helps you estimate how your investments will grow with time. Variables you enter include principal investment, interest rate, time period in which the investment compounds (usually annually), duration of time of the investment, and any regular additions or deposits you contribute to the investment and at what frequency (annually, monthly, bi-weekly, etc.). Most calculators will then show you your ending balance and how much interest you earned. These calculators can really help you understand the power of compound interest and can be really fun to play with (well, they are for me). This will allow you to estimate how long you will need to reach your financial goals, including financial independence, based on how much you save and what interest rate it compounds at.
Beginning Your Plan
With this understanding, let’s begin.
After completing the first 3 steps on the Path to FI, you should now have 4 key pieces of information:
- Your why (what you value, your goals, your dreams)
- Your current net worth
- Your current income from all sources
- Your current expenses
With just this information you are able to calculate:
- Your FI number based on the 4% rule
- How long it will take for you to get there
First, estimate your annual expenses based on your current monthly expenses. For example, if you are currently averaging $5,000 per month in expenses, multiply by 12 for an estimate of your annual expenses, which would be $60,000. Remember, the reciprocal of the 4% rule tells you how much you need to save so you can safely withdraw 4% adjusted for inflation each year and not have your money run out. The reciprocal of the 4% rule is 25 times your annual expenses, which for this example would be $1,500,000. So, in this example 1.5 million dollars is your FI number, which is the amount you need to have saved and invested to pay for your current expenses.
Next, you need to determine how long it will take for you to get there. Let’s pretend you are like many Americans and have a combination of assets and liabilities, but may tilt a little heavier on the liabilities side. In your assets column you have $50,000 in your 401(k), $15,000 in a Roth IRA, $30,000 in home equity, and $5,000 in your savings account. Total assets equals $100,000. In your liabilities column you owe $150,000 on your mortgage, $10,000 in auto loans, $30,000 in student loans, and $10,000 in credit card debt. Total liabilities equals $200,000. Net worth is your assets minus your liabilities, which would be a net worth of -$100,000. To some with an already high net worth it may seem foreign to have a negative number, while others in serious debt may wish their net worth was this close to zero. The truth is many Americans are in this situation.
At this point we have an FI number of $1,500,000 to support annual expenses of $60,000 per year, and a net worth of negative $100,000. So, in this example we really need to pay off $100,000 in debt and save/invest $1,500,000 to reach FI. OK, now let’s look at income and savings rate. For this example let’s say your income from all sources is $125,000 per year and you end up paying approximately $25,000 per year in taxes, leaving you with $100,000 net income. If we subtract your annual expenses of $60,000, that leaves you with $40,000 to save and invest. I prefer to calculate savings rate based on net income, while some others prefer to do it based on gross income. Using net income would mean you have a 40% savings rate, which is REALLY good, because you are committed to getting out of debt and reaching FI.
Finally, let’s say you invest this $40,000 every year, adding to your principal of $55,000 in your 401(k) and Roth IRA combined. I typically would not recommend including your home equity here because that is an illiquid asset and difficult to draw any income from during retirement to meet your expenses. If you invest $40,000 per year and assume a 7% rate of return (which I think is a good combination of optimism and realism), using a compound interest calculator will show us that it takes just over 17 years to reach $1,500,000.
Thus, in this example you would need to pay off your $100,000 in debt which would take ~2.5 years at your current savings rate. Then, you would need to save and invest $40,000 per year and in 17 more years you could be financially independent. This equates to about a 20 year plan.
Just for fun, let’s look at the power of decreasing your expenses. If you were able to cut your annual expenses to $50,000 per year from $60,000 that does two amazing things. First, it increases your ability to save. You can now save an additional $10,000 per year increasing your savings rate to 50% at $50,000 per year. Second, if you can sustain a lifestyle of $50,000 in annual expenses, it changes your FI number from $1,500,000 to $1,250,000. Factoring in these two changes, saving and investing $50,000 per year at a interest rate of 7%, with a principal balance of $55,000, will get you to your new FI number of $1,250,000 in about 13 1/2 years. Just by decreasing your expenses $10,000 per year, you can achieve financial independence 4 years earlier. Increasing your sources of income over time will get you there even faster.
Are we done yet? Not even close. Using your personal data to calculate your own FI number and how long it will take for you to get there based on your income, expenses, and savings rate just gives you a basic framework to start working with. It gives you a starting point (your current net worth), and where you would ultimately like to end up (FI). We haven’t even touched on what goes in the middle yet.
Before moving on, it is imperative to remember that the 4% rule is really just a rule of thumb that gives us a ballpark estimate of how much money we will need to support our expenses. The 4% rule makes a number of assumptions including a certain stock/bond allocation, a fixed withdrawal rate, no other income producing assets outside the paper asset class, and the data only applies to a 30 year period, not forever. In reality, many people will have other sources of income (social security, pension, real estate, business income, etc.) and most people will adjust their withdrawal rates based on market performance, withdrawing less when the market is down. I guess my point here is that the 4% rule is a guide, not doctrine to be followed blindly.
What Goes in the Middle
With your current net worth and your FI number you have a relative beginning (your current net worth) and an endpoint (FI). Now you need to to determine what goes in the middle. This will consist of intermediate goals, such as paying off debt, saving up for a downpayment on a home, saving for you kid’s college education, paying off your home, etc. You can and should be working towards many of these goals simultaneously. Your goals should also include saving and planning for the unexpected: emergency fund, life insurance, disability insurance, etc. Many of these intermediate goals will be addressed in subsequent posts in this series of 12 steps on the path to FI. One important point to remember is that these intermediate financial goals will change the timeline for you to reach financial independence since a portion of your savings will be dedicated to achieving them.
As you begin to list these goals and make plans to achieve them, you will start to better understand the importance of maximizing your income, reducing your expenses, increasing your savings rate, and investing wisely (the core principles of FI). You may decide to create a budget for certain expenses. Tracking your expenses may have shown you areas you are wasting money and where you could completely cut out certain expenses. You may begin searching for ways to increase your income or develop passive streams of income. You will likely start researching investments, balancing your personal risk tolerance with the potential return on those investments.
As you start to save money for your goals, you will also need to decide which buckets or accounts to save in and in what order. Some questions will invariably come up. Which accounts take priority? My 401(k), my Roth IRA, a high interest savings account, or my taxable account? Should I pay off my home mortgage or invest the money? What should I invest in? What should my asset allocation be (what percentage of stocks and what percentage of bonds)?
As I mentioned in the beginning of this post, I can’t answer all of these questions here. Many of my past posts answer some of these questions, as will future posts. But for now, let me share with you how I personally do things and offer some basic suggestions about financial priorities. Hopefully this will give you enough of a springboard to start creating your own financial plan.
My Financial Plan
I made my personal financial plan by mapping things out year by year, or by blocks of years in which I am saving for the same financial goal (paying off student loans, paying off my house, reaching my FI number, etc.) After carefully tracking my income and expenses for a prolonged period of time, I have a firm understanding of how much money I make, how much I pay in taxes, how much I pay in tithes, how much my fixed expenses are, how much I spend on things I value, and what my savings rate is. I also have a plan of how I am going to invest my money, in what accounts and in what order I am going to invest in, and based on a conservative rate of return, how long it will take me to reach my goals.
As an example, here is how my plan works for 2019. I am a salaried physician, so I know what my income is for the year and how much I get paid in my bi-weekly paychecks. Based on the past, here is how I have things mapped out:
- 50% of everything I bring home goes to taxes and tithes to my church. This money essentially comes right off the top and I never really think twice about it. That leaves me with half of my money left.
- Next, I pay myself first before making any consumption purchases. I have elected to withhold enough from my paychecks to maximize my 403(b), getting the full employer match, as well as my 457(b) deferred compensation plan. I also have enough withheld from my paycheck to maximize our family’s Health Savings Account. Note that this is all pre-tax money I am saving for retirement, thereby reducing my taxable income.
- I intentionally overpay taxes so that I receive a sizable tax return every year (I have explained my rationale for this before). Using my tax return, I contribute to 529 plans up to the state income tax deduction for each of my four children for their college educations. I also contribute the maximum to my Roth IRA and a spousal Roth IRA via backdoor Roth IRA contributions.
- Every paycheck I also have an automatic transfer set up to my taxable brokerage account where I further save and invest for the future. At this point, while I still have a home mortgage and some student loans to pay off, it is not a large amount. But the important thing is I am establishing the habit now and will increase the amount in the future as I am able.
- Note that this is all part of paying myself first, as I described in my post 5 Unconventional Choices for an Unconventional Life. Only at this point do I start allocating money for other expenses. Here, I have a relatively fixed amount for all of my expenses including my mortgage, utilities, insurance, food, etc.
- I also save a small amount every paycheck for expenses that I know will come in the future. I save a small amount every paycheck for future travel since our family has made experiences and travel a priority. I also save a small amount every paycheck for a car purchase in the distant future (when one of our cars is ready to bite the dust) so I can pay cash for it when that day comes.
- Finally, with the amount that is left I work toward some of my intermediate financial goals. I no longer have any credit card debt or any auto loans, so for me my next goal is to finish paying off my student loans. With my current plan my student loans will be paid off by early 2020.
This is just a glimpse of my financial plan and how I have things mapped out. This is only for 2019. I have mapped out each year, or block of years, based on my financial goals and life plan for essentially the rest of my life. Of course, this changes all of the time as I described above. As you can see, I am working towards multiple financial goals simultaneously (paying off student loans, saving for my kids’ college education, and working towards FI) but always keeping the big picture in mind.
You may also ask what my asset allocation is and what I invest in. I try to keep things very simple. Currently my asset allocation is 80% stocks and 20% bonds. I’ll write about asset allocation in depth later, but an 80/20 mix was what I felt comfortable with. I primarily invest in low cost, broad based passive index funds using the Bogleheads’ Three Fund Portfolio model of 1) Total U.S. stock market index fund, 2) Total international stock market index fund, and 3) Total U.S. bond market index fund. In my taxable account I substitute the total bond market fund with a tax-exempt municipal bond index fund for better tax efficiency.
Let me be clear that what I have shared is NOT what I think everyone should do. Remember, personal finance is personal and you will need to find what is best for and works for you. I am only sharing this to help you get an understanding of how I prioritize my finances, break things down, and develop a plan.
Also remember that everyone is at a different stage in life and a different stage in their finances. I am at a stage where my income is higher and saving for retirement is one of the highest priorities. But I didn’t get there overnight. It took me 15 years to become a neurosurgeon and only now am I close to paying off my student loans, 20 years after I started my education. You may be at a stage where just coming up with a budget and keeping your expenses less than your income is all you can do, and that’s OK. I was there at one point as well. The key is to not compare yourself with others and just continually try to improve your own situation. If you do this consistently over time, one day you will wake up rich.
Priorities to Consider
As you start to develop specific financial goals and plans for yourself, I recommend you consider the following list of priorities:
- Establish an emergency fund that meets your specific needs.
- If you are the primary provider for your family, insure against catastrophe with term life insurance and disability insurance.
- Contribute to your 401(k) to at least get the full employer match.
- Develop a plan to pay off all consumer debt: credit car debt, student loan debt, auto loans, etc.
- After debts are paid off, begin working to maximize tax advantaged accounts to save for retirement/FI. This should include your employer sponsored plan like a 401(k) as well as an IRA (traditional or Roth based on your situation). If you are self employed consider a SEP IRA or Solo 401(k).
- Consider a Health Savings Account if you have access to one.
- If you are free from consumer debt and are contributing the maximum amount to all of your tax advantaged accounts, consider investing in a taxable brokerage account vs. paying off your home mortgage early, or do both simultaneously.
- Consider investing in alternative asset classes like real estate and small businesses.
- Develop an income strategy/plan for once you reach financial independence.
In future FI Step by Step posts I will go into much more detail about each of these things, but that doesn’t mean you can’t get started making goals and plans today. Remember, your financial plan is a fluid document which can and should be updated on a regular basis as you gain financial knowledge and skills.
Wrapping Things Up
I hope you now have enough information to get started today on your own personal financial plan. While this may seem overwhelming, you don’t need to do everything at once. Just start with a basic plan and some simple goals and then add to it over time. I promise that as you start working towards FI by achieving simple goals, you will gain momentum and begin building wealth.
So stop wasting time and start mapping your path to Freedom Through FI!
If you have any other ideas or suggestions that might help others, please leave them in the comments section below.
