Money Management for the Middle Class, part 1

I've been putting this series of posts I've had about managing personal finances on the backburner for at least six months now, in no small part related to my efforts to find a new place of employment instead.  Well, since I just got my latest rejection letter, I figured I would go ahead and get started on writing them down.  The first thing I discovered in writing this post is that putting down the minute details of building a financial plan would hands-down be the most boring thing I ever put in my journal.  So, after a major post overhaul, this is mostly just a few tidbits that are important to consider.

So, I'm guessing that most people think of preparing a budget when, or even if, they decide to go about managing their money.  Unfortunately, there's really so much more that should go into a financial plan than simply how much money you will spend in the next year.  Alas, I'm jumping about; I guess the first thing we should talk about is “Why make a financial plan?”  Well, there are many reasons, but the best one is that making a plan gives you the knowledge of where your money is now, where your money will be in the future, and along the way between now and death (or retirement) what income or expenses you will have that you need to account for.  At the end of the day, it is a useful tool for evaluating the financial decisions you are making today and how they will impact you over the course of your lifetime.

How to Create a Financial Plan
Well, the stupidly easy answer is that you don't do it yourself.  You can, and I am really going to stress the word can here, go to one of two types of financial consultants to get it.  The first type of consultant wants you to pay them a large sum of money now, perhaps a few thousand dollars, but will supposedly give you impartial advice on your finances.  The second type of consultant performs a financial plan for free, but will try to hook you into using them for any financial purchases you will need to make based on the outcome of your financial plan.  The argument typically made, and expect it if you use a "free service" is, "Well, you're going to have to get those services from someone, so why not the person that helped you?"

There should probably be tons of disclaimers about good and bad financial advisers and which of the above professional services is better.  If you want to create a financial plan on your own we need to assume a few things here: you are reasonably good at excel, you have the ability to pull together a year's worth of expenses, payroll stubs, and current balances for investments, life insurance, and other assets, and you have a general sense of accounting or know how to build a budget. 

Ultimately, the financial plan is going to be looking at the goal of getting to retirement in the black (cash positive) and then some, and predicting the amount of money you need to live off of for the period you think you will survive after retirement.  Grim but true, the accuracy of your plan is directly related to your accuracy in predicting the age of your death and the age at which you would like to stop working.  If you are unsure of your family's history or your career path, good places to start are Age 65 for retirement and Age 85 (90 if you are Female) for death.

Now you, or your financial advisor will layout a map of all your annual incomes and debts from your current age to that magic retirement age you determine. 

Things to Keep in Mind

- One of the major pitfalls you may run into, and financial advisers will likely overlook or gloss over is that most people find their wages are capped close to retirement.  Since a lot of the time retirement costs are based off the last few years of employment, escalating during this period can force you to think you need to save more than you actually need.  A conservative assumption would be to assume all salary gains after age 55 are capped.  A more general approach would be to assume it is capped at age 60.  Other professions also have wage caps – such as an hourly worker hitting their maximum hourly wage – so be sure these are accounted for in your timeline.

- You have to be careful that you also don’t over-escalate investment contributions from your 401k.  Currently, the contribution maximum is $15,500 per year for 2008 unless you are over fifty years old (in which case you may take an additional $5,000 catch-up).  The government has been steadily increasing this amount year to year, but it is entirely possible, and probable, that you will hit this investment cap for your tax-free savings in the tail end of your career.  Failure to observe the cap could give you a false sense of how much tax-free savings you can make near retirement.  I couch that by saying that hopefully during your last few years of working your savings will not hinge on tax-free 401k contributions.  There are similar investment limits for a Roth IRA; however, these are after-tax investments.

- Most other after-tax investments allow unlimited contributions.

- You also want to factor in inflation in your earnings and expenditures.  Inflation will increase your cost of living by somewhere between 3-5% each year.  If you are getting help from a planner and they are recommending a number outside this range or near the border, be advised that they are likely too risk-prone (<3%) or too risk-adverse (>5%).

- You may want to think about how you could change your spending to create annual surpluses.  It is very critical to financial planning (and really, your financial future) that you have an annual surplus from your current wages in and your current expenses.  If you are already overspending your budget on an annual basis, it is imperative that you get your finances under control.  This will lead you down a path where you cannot gain financial independence, and you will quickly lose the ability to retain your assets.

Your Financial Map

So now you have a financial map, which looks like maybe just a few dozen columns and rows of financial data.  What is it that you do with that?  I’ll start with Insurance Planning and how that affects your financial plan in Part 2.