You can create your own financial plan for free. You should take advantage of that if you want to retire now or sometime in the future or even if you haven’t given retirement a second thought.
There are thousands of free calculators available on the web that could be very useful to you. (Probably more useful than the $3,000 plan many financial advisers try to foist on clients.)
But before you get started with fancy calculators, you need some data:
1. Spending/Earnings/Savings. What does it cost you to live, on average, every month? How much do you earn? How much do you save? How will that change over time? If you aren’t already doing so, make sure you track your spending every month.
2. Inflation. Prices have risen, on average, a little over 3% each year over the last 20 years. What inflation figure do you want to use?
3. Assets and Liabilities. Before running a financial plan, you must have a balance sheet that lists all your assets and all your liabilities.
4. Estimated Rate of Return. Depending on the asset allocation you use, you need to make some assumptions about the returns you’re going to enjoy. The only way to estimate returns is to do so over a long period of time. Nobody knows what the stock market is going to do this year or next. But you can make some assumptions about the returns over the next 20 years. (Of course, even that is tricky. While the long-term returns of the market are about 9% per year, the last 10 years didn’t come close to that.)
5. Tax bracket. What bracket are you in now? What tax rate will you be paying in the future?
As you can see, creating a financial plan requires lots of assumptions. You make the most reasonable assumptions possible, of course, but they can be wildly off-base. That is the reason I really dislike very expensive financial plans some firms try to sell. They aren’t any good at helping you make decisions now. What is far better is to run simple plans and update them each year as the facts on the ground change.
Let’s take a very simple example. Martha earns $4,000 a month (before taxes) and saves $500 ($6,000 a year), which goes into her 401k. She is in the 35% marginal tax bracket, she assumes a 3% inflation rate and she wants to retire in 20 years. For this example, assume Martha has $100,000 already saved in her retirement accounts. She wants to have the same before-tax income (inflation adjusted) when she retires as she does now. She wants to know if she will reach her goal. Let’s create Martha’s plan by assuming she can earn 6% on her investments, on average, over the next 20 years.
The first step is to calculate how much money Martha is going to accumulate.
She’ll have $100,000 that will grow at 6% for 20 years. Here’s what it will be worth in 20 years:
Now, let’s consider how much income that $554,669 will generate after inflation 20 years from now. Let’s assume she will withdraw 4% of the value of the account each year. Remember, she spends $3,500 before taxes now. She’ll need $3,500 plus inflation 20 years from now. Right?
As you can see, if Martha wants to spend the same inflation-adjusted income in 20 years, she’ll have to generate $6,321 a month. Based on her current savings, she’s about $4,500 short. That’s quite a bit.
Martha has a few choices:
a. She can save more and spend less.
b. She can work longer.
c. She can get a part-time job once she retires.
d. She can invest more aggressively.
I don’t advocate option D. She should probably work towards a combination of all three (a, b and c).
From this example you can see that creating your own financial plan isn’t all that difficult. Once you have a clear picture of what questions to ask yourself, the rest is straightforward. Go through the exercise and find the calculators on the net. Make your own rough projections and update them yearly.
Have you created your own financial plan? What changes did you make as a result?
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{ 5 comments… read them below or add one }
Creating a financial plan is a really good idea. You can plan years in advance and make adjustments as different things change. I’ll make my 2011 plan based on where I see myself (or want to see myself) in 5 years.
I have created my own set of financial stuff within Excel, but then even the other financial software out there all seem to have come short in one area or another for what I cover in my financial files. The one main file though is the one I have various things in it.
Item 1: Spending/Earning/Savings
As for earnings, I put this into 2 basic categories. Gross Earned Income (The income as a result of working for it) and Residual Income (Income created by money put to work for that income). Why do I distinguish between the 2?
Earned Income is money that is mostly used for current expenses, but also have to be used for countable savings which I set 25% of actual gross earned income must go to such countable savings.
Residual Income is either in retirement funds (That is specifically to help with that purpose, but must have contributions to help that residual income so as to be able to retire relatively comfortable) or in the Emergency Fund (Note, the EF is not in just some 0.10% APY savings account. It is actually an overall investment of the money that’s available here and now). Yeah, yeah, I know Dave Ramsey would be saying I’m playing with death with this, but there’s some very important things about this fund that has to take into account of other things such as reparation/replacement of long-term assets over a longer time period when *REAL* inflation and taxation will eat up the power of that money otherwise.
As such, it stands to reason, residual income CAN NOT count as part of “Countable Savings”, but if such money is taken out of such investment, that money taken out is then counted *AGAINST* “Countable Savings”, which is in the opposite direction of the goal.
Item 2: Inflation
When I think of inflation, I not only think about the increased costs on the same goods (many people in society want you to only think about this aspect of inflation, but also the aspect of increased demands placed onto households by both the society itself and the government. Two such areas are safety (How much did people have to pay for various safety stuff say 30 years ago as compared to now day? Very little as far as I’m concerned), and technology gadgets (eventually after a while, how much of the technology gadget does society tend to require us to have available to us such as for communication purposes)?
I also don’t buy into such argument that such things truly save us money over the long run. If we are in the business and we find ways to save time, which then ultimately saves the business money (Even if it ends up costing the business more money up front), that’s one thing, but to require households to pay for those same items for the same costs, even though it doesn’t do much for households in regards to saving money, no good argument. The only item I have found to where this argument may actually apply, but even then, only from an indirect stand point of view, not directly, the computer with a spreadsheet program. Why do I say that? True, it’s not those 2 items themselves that have saved us money as those 2 items cost us money. On the other hand, with the help of the spreadsheet, I created my own financial files with the various things in it. By having the system do the work much more accurately and much more faster than what I could humanly do while also tracking our stuff, it has more or less served as my financial adviser. Not only has it served as my financial adviser, it has saved me in so many cases of not using the money else where. The worksheet that saved me of this very thing is the “Cash Flow Management” worksheet. That worksheet is by far the worksheet I use the most and it has had the greatest benefit.
As for any other added expense on the home front is concerned, there is no such argument for a such expense. That’s why I not only add in the inflation of goods/services, but also add to it the increased costs to the increased standards of living put onto households by it’s society and government.
Item 3: Assets and Liabilities
This was one of the very first things I did within the spreadsheet program after me putting together the cash flow management worksheet (The cash flow management worksheet was the very first worksheet I did). As for me, this is what’s known as the balance sheet, which I would not only say Assets and Liabilities, but also Owner’s Equity. Even when I had first put it in, my OE was very much so in the negative territory. Now it’s 5 digits in the positive side after taking taxes into account.
Item 4: With the help of tracking within my own spreadsheet program, I have determined rate of return can vary greatly depending on what set of assets and with whom you have it if it’s not self done. Example: The retirement account with the employer returns about 2% below benchmarks even though stated expenses are only suppose to be between 0.50% and 0.75% according to prospectus, but the remaining 1.25% to 1.50% is assumed to be taken out via the 12b loophole (so called operational) fees, so that’s why I put employer’s retirement account at 2% below market benchmarks. My other investments outside of account has been trending about 1% above market benchmarks, though 2010 year was way above, but that’s more of an exception than the norm.
Item 5: Tax Brackets, I do highly suspect we will end up in the federal 35% and state 8.1% tax brackets (thus where I get my 43.1% from as this not only take into account of federal, but also of state income tax) come retirement years. However, if I move to some place like TN, I will instantly cut out that 8.1% income tax. The only thing I would end up taking up would be the consumption tax rate but even that would only go up by about 3.5%, which that’s still a net of 4.6% savings.
Our current monthly spending is about $3,100 (A portion of this does cut down on the principle of the debt, so that part of it does go to countable savings), but then that’s also for a family of 7 and having to service some debt (student loans and a mortgage). As for retirement, we can knock out roughly $1,000 for debt service and another $1,000 attributed to the kids. As such, that leaves $1,100 left initially. However, we would need to add to that $1,100 by so much as well for things like travel. Even with employment expenses not being there, travel will be there. As such, it can be more like about $2,500 just for us 2 per month. That would then mean a minimal of $30,000 per year, which at 2% withdrawal rate, that would mean a net after tax base effect of $1,500,000.00. Of course, I already did our estimates to reach a point of 3,500,000.00 net of taxes come retirement years for total investable assets in today’s money power. We still have a long ways to reach that point, but after our initial 10 years of effort, we can finally say we are starting to see the snowball effect, though still on the weak side.
The hard part of the equation is figuring out what may happen over thirty years of retirement. The unknown expenses that can catch you off guard. I think I have enough, but I really don’t know.
Tasha, Sounds like you are a focused hardworking young woman. I am very excited to hear about your continued success.