You’ve set your goals, made your budget, and started a strategy. Now it’s time to formalize your financial plan. Each goal may require a different financial vehicle to help you to achieve it. The vehicles may vary greatly depending upon whether the goal is long or short term. Money for short term needs should be kept in low risk, highly liquid accounts. To help understand the basics of various investments, these are some of the concepts with which you should become familiar:
1. The Time Value of Money
2. Rule of 72
3. Controlling Risk
4. Tax Considerations
5. Putting It All Together
The Time Value of Money
That is one way of looking at the Rule of 72 and understanding the power of compounding and the importance of following a regular plan of saving and investing. Here is another example with the effects of different rates of return on a fixed sum of money.
CONTROLLING RISK
The key is always DIVERSIFICATION
A balanced financial plan always includes many facets. Building your financial home is no different than building a regular house. Start with the foundation. Ensure you have adequate emergency funds (enough to cover at least three months of bill payments & it can be a line of credit ). Have a strong debt reduction plan in place and ensure you have ample protection for your family and your assets (life, home, auto, & health insurance). Pay yourself first, if possible through a payroll deduction or allotment program. Your savings/ investments can take many forms. The basics normally include some type of fixed interest rate program and investment in equities through a good mutual fund. A mutual fund offers the advantages of diversification, professional management, liquidity, and choice of objectives and some can be started for as little as $25/ month. The biggest killer of financial futures is PROCRASTINATION. Don’t put off activating your financial plan. Once you start it, BE PERSISTENT. A wonderful example of the advantages persistency is Dollar Cost Averaging.
TAX PLANNING
A Balanced Program
You’ve learned about safety, liquidity, and growth, but the wild card that can drastically effect your financial future is TAXES. You must understand the fact that there are three ways that most retirement accounts will be treated for tax purposes: TAX-DEDUCTIBLE, TAX-DEFERRED, or TAX-FREE. If an account is tax-deductible, it will normally be tax-deferred, but it will NEVER be tax-free. On the other hand, an account may be tax-free and tax-deferred, but will NEVER be tax-deductible. You can’t ever receive all three in the same program. Understand the rules and build your plan accordingly to give you the maximum benefit. Know the difference between structures such as traditional & Roth IRA’s. Take advantage of 401k plans with matching funds. Understand annuities, variable programs, and the difference between tax deductions & tax credits.
As always DIVERSIFICATION is the key, however, in this case we refer to TAX DIVERSIFICATION. Your emergency funds will always be in a taxable liquid account. Your retirement funds should not only be diversified between fixed income and equities, but also between qualified accounts (tax deductible and tax deferred, but fully taxable when withdrawn) and accounts which offer tax-free withdrawal at retirememt
Plans offering tax-free access are TFSA, and some forms of life insurance.
A Balanced Financial Plan
Don't ignore any of the classic financial planning steps:
STEP 1 - PERSONAL PLANNING
STEP 2 - TAX PLANNING
STEP 3 - RISK MANAGEMENT
STEP 4 - INVESTMENT PLANNING
STEP 5 - RETIREMENT PLANNING
STEP 6 - ESTATE PLANNING
Take advantage of 401k plans with matching funds.programs. Ensure you have an up to date will and as your situation warrants investigate the use of revocable and irrevocable trusts. In summary, here are the key areas of any good financial plan:
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