Even in normal circumstances, the holidays can be stressful. With the concerns about travel and the impact on many people’s income from COVID-19, the 2020 holidays are likely to be even more challenging. In this post, I’ll provide ideas that might help alleviate some of …
“A Man is Not a Plan!” It sounds like a very dated statement, but a guide on a recent trip I took told me about a conversation he had with one of his nieces about her finances. They were talking about how she could improve her financial situation by building a sound financial plan. As they were talking, one of them came up with the slogan, “A Man is Not a Plan.” He suggested I use it as the title for one of my posts. So, here it is!
In this post, I will talk about the key components of a sound financial plan. A financial plan provides the structure to help you organize your financial information and decisions. I’ll provide brief explanations of the things to consider about each component, what you need to do and, for most of them, links to posts I’ve written that provide much more detail. I’ll also provide insights on how to know when you need help and who to contact.
Sound Financial Plan
A sound financial plan includes the following sections:
- A list of your financial goals – In this section, you’ll want to identify your three to five most important financial goals.
- A list of your current assets and liabilities (debts)
- Your budget
- Your savings and investment strategies to help you attain your goals, including
- Short-term savings
- Designated savings
- Retirement savings
- Desired use of debt, including re-payment of current debt
- Your giving goals
- Risk management strategy, i.e., types and amounts of insurance to buy
- Understanding of your income tax situation
- What you want to have happen to you and your assets when you become incapacitated or die and related documents
You will likely be most successful if you create a formal document with all of these components of a sound financial plan, such as by using Financial IQ by Susie Q’s Personal Financial Planner. You’ll want to review and update your financial plan at least every few years, but certainly any time you have a significant change in your finances (e.g., a significant change in wages) or are considering a significant financial decision (e.g., buying a house, getting married or having children). Of course, a less formal format is much better than no plan at all, so you should tailor your efforts to what will best help you attain your financial goals.
A budget itemizes all of your sources of income and all of your expenses, including money you set aside for different types of savings. It provides the framework for all of your financial decisions. Do you need to change the balance between income and expenses to meet your goals? Can you make a big expenditure? How and what types of insurance can you afford? How much debt can you afford to re-pay?
I think that a budget is the most important component of a sound financial plan and should be the first step you take. Everyone should have a good understanding of the amounts of their income and expenses to inform the rest of their financial decisions. While some people will benefit from going through the full process of creating a budget and monitoring it, others can be a bit less detailed.
In the text section of your financial plan, you’ll want to include a list of your financial goals as they relate to your budget and how you plan to implement them. You can include your actual budget in your financial plan itself or as a separate attachment.
I generally think of savings in three categories (four if you include setting aside money for your kids): emergency savings, designated savings and retirement savings. You will want to address each of these types of savings in your financial plan. The information you’ll want to include for each type of savings is:
- How much you currently have saved.
- The target amounts you’d like to have saved.
- Your plan for meeting your targets.
- For what you’ll use it.
- How fast you’ll replenish it if you use it.
- How much you need to include in your budget to meet your targets.
- Your investing strategy.
- A list of all financial accounts with location of securely stored access information.
Emergency savings is money you set aside for unexpected events. These events can include increased expenses such as the need to travel to visit an ailing relative or attend a funeral or a major repair to your residence. They also include unexpected decreases in income, such as the reduced hours, leaves of absence or lay-offs related to the coronavirus.
The general rule of thumb is that a target amount for emergency savings is three to six months of expenses. I suggest keeping one month of expenses readily available in a checking or savings account that you can access immediately and the rest is an account you can access in a day or two, such as a money market account.
Designated savings is money you set aside for planned large expenses or bills you don’t pay every month. Examples might include your car insurance if you pay it annually or semi-annually or money you save for a replacement for your car you are going to buy in a few years.
To estimate how much you need to set aside for your designated savings each month, you’ll want to look at all costs that you don’t pay every month and figure out how often you pay them. You’ll want to set aside enough money each month to cover those bills when they come due. For example, if your car insurance bill is $1,200 every six months, you’ll want to put $200 in your designated savings in each month in which your insurance bill isn’t paid. You’ll then take $1,000 our of your designated savings and add $200 in each month it is due to pay the bill.
Saving for retirement is one of the largest expenses you’ll have during your working lifetime. There are many aspects of saving for retirement:
- Understanding how much you will receive in retirement from government programs, such as Social Security in the US or the Canadian Pension Plan in Canada.
- Setting your retirement savings goal.
- Estimating how much you need to save each year to meet your retirement savings goal.
- Deciding what are the best types of accounts in which to put your retirement savings – taxable, Roth (TFSA in Canada) or Traditional (RRSP in Canada).
- Determining in what assets (bonds, stocks, mutual funds or ETFs, for example) to invest your retirement savings in light of your risk tolerance and diversification needs and how those choices affect your investment returns.
Debt can be used for any number of purchases, ranging from smaller items bought on credit cards to large items purchased with a loan, such as a home. Whether you have debt outstanding today, use credit cards regularly and/or are thinking of making a large purchase using debt, you’ll want to define your goals with respect to the use of debt.
For example, do you want to never have any debt outstanding (i.e., never buy anything for which you can’t pay cash and pay your credit card bills in full every month)? Are you willing to take out a mortgage as long as you understand the terms and can afford the payments? Do you have a combination of a high enough income and small enough savings that you are willing to use debt to make large purchases other than your home? Do you have debts you want to pay off in a certain period of time?
As you think about these questions, you’ll want to consider what debt is good for you and what debt might be problematic. A sound financial plan includes a list of your debts, how much you owe for each one, your target for repaying them, and your strategy for using debt in the future.
Credit cards are the most common form of debt. Your financial plan might include the number of credit cards you want to have and your goals for paying your credit card bills. As part of these goals, you might need to add a goal about spending, such as not buying anything you can’t afford to pay off in a certain period of time.
Many people have student loans with outstanding balances. In your financial plan, you’ll want to include your goal for paying off any student loans you have. Do you want to pay them off according to the original schedule? Are you behind on payments and have a goal for getting caught up? Do you want to pay off your student loans early?
In a perfect world, your car would last long enough that you could buy its replacement out of your designated savings. However, the world isn’t perfect and you may need to consider whether to take out a loan or lease a car. Your financial plan will include your strategy for ensuring that you always have a vehicle to drive. How often do you want to replace your car? What is your goal with respect to saving for the car, loans or leases? How much will it cost to maintain and repair your car? Your budget will include the amounts needed to cover the up-front portion of the cost of a replacement car, any loan or lease payments and amounts to put in designated savings for maintenance and repairs.
Most homeowners borrow money to help pay for it As part of creating your financial plan, you might include your goal for home ownership. Are you happy as a renter for the foreseeable future or would you like to buy a house?
If you want to buy a house either for the first time or a replacement for one you own, you then need to figure out how to pay for the house. How much can you save for a down payment? Can you set aside enough in designated savings each month to reach that goal? What is the price of a house that you can afford, after considering property taxes, insurance, repairs and maintenance?
Once you have a mortgage, you’ll want to select a goal for paying it off. When a mortgage has a low enough interest rate, you might make the payments according to the loan agreement and no more. If it has a higher interest rate or you foresee that your ability to make mortgage payments might change before it is fully re-paid, you might want to make extra payments if you have money in your budget.
Paying Off Debt
If you have debt, you’ll want to include your goals and your strategy for paying it off in your financial plan. You’ll first want to figure out how much you can afford each month to use for paying off your debts. You can then compare that amount with the amount needed to meet your goals. If the former is less than the latter, you’ll need to either generate more income, reduce other expenses, put less money in savings or be willing to live with less aggressive goals. These decisions are challenging ones and are a combination of cost/benefit analyses and personal preference.
Many people want to give to their community either by volunteering their time or donating money. If you plan to give money or assets, you’ll first want to make sure that you can afford the donations by checking your budget and other financial goals. It is also important to make sure that your donations are getting used in the way you intended, as not all charities are the same. A Dime Saved provides many more insights about giving in her Guide to Giving to Charity.
Protecting your assets through insurance is an important part of a sound financial plan. The most common types of insurance for individuals cover your vehicles, residence, personal liability, health and life. There are other types of insurance, such as disability, dental, vision, and accidental death & dismemberment, that are most often purchased through your employer but can also be purchased individually.
As I told my kids, my recommendation is that you buy the highest limits on your insurance that you can afford and don’t buy insurance for things you can afford to lose. For example, if you can afford to pay up to $5,000 every time your home is damaged, you might select a $5,000 deductible on your homeowners policy. Alternately, if you can afford to replace your car if it is destroyed in an accident, you might not buy collision coverage at all. Otherwise, you might set lower deductibles as your goal.
For each asset in your financial plan, including your life and health which can be considered future sources of income or services, you’ll want to select a strategy for managing the risks of damage to those assets or of liability as a result of having those assets.
A financial plan includes a list of the types of policies you purchase, the specifics of the coverage provided and insurer, changes you’d like to make to your coverage and your strategy for insurance in the future. You’ll also want to attach copies of either just the declaration pages or your entire policies to your financial plan.
Car insurance can provide coverage for damage to your car, to other vehicles involved in an accident you cause and injuries to anyone involved in an accident. The types of coverages available depend on the jurisdiction in which you live, as some jurisdictions rely on no-fault for determining who has to pay while others rely solely on tort liability.
Homeowners insurance (including renters or condo-owners insurance) provides coverage for damage to your residence (if you own it), damage to your belongings and many injuries to people visiting your residence.
One way to increase the limits of liability on your car and homeowners insurance is an umbrella insurance policy. An umbrella also provides protection against several other sources of personal liability. If you have money in your budget for additional insurance, you might consider purchasing an umbrella policy.
Health insurance is likely to be one of your most expensive purchases, unless your employer pays a significant portion of the cost. Whether you are buying in the open market or through your employer, you are likely to have choices of health insurance plan. Selecting the health insurance plan that best meets your budget and goals can be challenging.
There are many types of life insurance, including term and whole life. Some variations of whole life insurance provide you with options for investing in addition to the death benefit. Once you have compiled the other components of your financial plan, you’ll be better able to assess your need for life insurance. If you have no dependents and no debt, you might not need any. At the other extreme, if you have a lot of debt and one or more dependents, you might want to buy as much coverage as you can afford to ease their financial burden if you die. To learn more specifics about buying life insurance, you might review this post.
An annuity is a contract under which you pay a fixed amount (either as a lump sum or in installments) in exchange for a future stream of payments. Some annuities provide income from the designated start date until you die. These annuities protect against longevity risk, i.e., the risk that you will outlive your savings. This post contains more information about annuities.
Some of your financial decisions will depend on your income tax situation.
- Do you want your investments to produce a lot of cash income which can increase your current income taxes or focus on appreciation which will usually defer your taxes until a later date?
- Is a Roth (TFSA) or Traditional (RRSP) plan a better choice for your retirement savings?
- Are you having too little or too much income taxes withheld from your paycheck?
- Do you need to pay estimated income taxes?
- How will buying a house, getting married or having children affect your income taxes?
- Will moving to another state increase or reduce your income taxes?
As you consider these and other questions, you’ll want to outline at least a basic understanding of how Federal and local income taxes impact your different sources of income as part of creating a sound financial plan.
Although it is hard to imagine when you are young, at some point in your life you may become incapacitated and will eventually die. There are a number of documents that you can use to ensure that your medical care and assets are managed according to your wishes. You can either include these documents as part of your financial plan or create a list of the documents, the date of the most recent version of each one and where they are located.
Powers of Attorney
There are two important types of powers of attorney – medical and financial.
A medical power of attorney appoints someone to be responsible for making your medical decisions if you are physically or mentally incapable of doing so. You can supplement a medical power of attorney with a medical directive that is presented to medical personnel before major surgery or by the person appointed to make medical decisions that dictates specifically what is to happen in certain situations.A financial power of attorney appoints someone to be responsible for your finances if you are physically or mentally incapacitated. The financial power of attorney can allow that person to do only a limited number of things, such as pay your bills, or can allow that person to do anything related to your finances.
There are several forms of trusts that can be used to hold some or all of your assets to make the transition to your beneficiaries easier when you die. Trusts can also be used to hold money for your children either before or after you die. While I am familiar with some types of trusts, I don’t know enough to provide any guidance about them. If you are interested in them, I suggest you research them on line and/or contact a lawyer with expertise in trusts.
If you die without a will, your state or provincial government will decide how your assets will be divided. In many jurisdictions, your spouse, if you have one, will get some or all of your assets. Your children or parents may also get some of your assets. Most people want more control over the disposition of their assets than is provided by the government.
A will is the legal document that allows you to make those specifications. Your will can also identify who will become legally responsible for your minor children or any adult children who are unable to take care of themselves. That responsibility can be split between responsibility for raising your children and responsibility for overseeing any money you leave either to their guardian(s) or for them.
How to Know When You Need Help
As you can see, there are a lot of components to a sound financial plan and many of them are interrelated. There are many resources available to help you develop and refine your plan. Many of those resources are free, such as the links to the articles I’ve published on relevant topics. There are also many other sources of information, including personal stories, on line.
You can also get more personalized assistance. There are many types of financial advisors, a topic I’ll cover in a post soon. Many financial advisors provide a broad array of services, while others specialize in one or two aspects of your financial plan.
Sources of Advice for a Sound Financial Plan
The table below lists the types of obstacles you might be facing and the types of advisors that might be able to help you create a sound financial plan.
|I can’t figure out how to make a budget or how to set aside money for emergency or designated savings.||Bookkeeper, accountant, financial planner|
|I can’t make my budget balance.||Bookkeeper, accountant, financial planner|
|I have more debt that I can re-pay.||Financial planner, debt counselor, debt consolidator|
|I don’t know what insurance I should buy.||Financial planner, insurance agent or, for employer-sponsored health insurance, your employer’s human resource department|
|I’m not sure I’m saving enough for retirement.||Financial planner|
|I have questions about how to invest my savings, including whether I am diversified or need to re-balance my portfolio.||Financial planner or stock broker|
|I don’t understand how income taxes work.||Accountant|
|I need help with a Trust, Power of Attorney or Will.||Wills & estates lawyer|
Clearly, a financial planner can help with many of these questions, but sometimes you’ll need an advisor with more in depth expertise on one aspect of your financial plan.
Ever wonder how you’d handle a complete reversal of your finances? I have a friend who had a lifestyle most people would envy and lost everything, including her marriage. I didn’t meet her until after her recovery from her financial disaster. She is one of …
Retiring is one of the riskiest financial decisions you will make. On the day you retire, you can calculate your net worth. You won’t know, however, how much retirement savings you need because you don’t know:
- how much you will actually spend on day-to-day expenses
- how much those expenses will be impacted by inflation
- whether you’ll have significant medical or other expenses
- how long you will live or
- what returns you will earn on your investments.
I retired a little over a year ago and realized that, even though I have a lot of money saved, it wasn’t enough to give me confidence we wouldn’t run out. I took on a large consulting project to help cover our expenses for the next year or two. Researching this post, though, added even more confidence as we have more than enough to meet some of the simple rules of thumb. We will see what happens.
In this post, I’ll provide some insights about how to think about a target you might want to set for your retirement savings. As a follow up, I talk about how much you need to save to meet your retirement savings goal in this post.
4% Rule and Multiply by 25 Rule
As I checked to see what others were saying on this topic, I found a very common theme for determining how much you need to save for retirement. In some places, it was called the 4% Rule and, in others, the Multiply by 25 Rule. Being the math geek that I am, my first thought was that 4% = 1/25 so they are the same thing! It turns out that, in the nitty gritty details, the Multiply by 25 Rule is intended to tell you how much you need to have available on the day you retire while the 4% Rule guides you in how much you can spend in your first year of retirement. Nonetheless, as explained below, they both result in the same amount needed in savings on your retirement date.
4% Rule for Retirement Spending
The 4% rule is intended to tell you how much you can spend from your retirement savings each year. Let’s say you have $1,000,000 in invested assets when you retire. It says you can spend 4% of that amount or $40,000 (including all of your expenses and taxes) in your first year of retirement. In each subsequent year of your retirement, you can spend $40,000 increased for the cumulative impact of inflation since you retired. The 4% Rule assumes that you are invested 50% in stocks and 50% in bonds.
4% Rule Illustration
The graph below shows the amount you can spend each year (blue bars which use the left axis scale) and the amount you’ll have remaining at each age (red line which uses the right axis scale) if you retire at 65, inflation is 3% per year, bonds earn 2.5% and stocks earn 7% annually. These assumptions are similar to long-term average assumptions that are common these days.
As you can see, in this scenario, the amount you can spend increases from $40,000 when you are 65 to almost $100,000 a year when you are 95 solely due to inflation. In the first few years, your spending is less than your investment returns, so your savings increases. After you turn 72, your savings exceeds your investment returns so your savings starts to decrease.
4% Rule Background
The 4% rule was developed by William Bengen and is presented in detail in a 1994 study published in the Journal of Financial Planning. (If you like numbers and graphs, check out this paper. It is a surprisingly easy read.)
Using historical data from 1926 to 1991, Bengen found that there were no 50-year periods in which a retiree would run out of money if his or her initial withdrawal rate was 3.5% or lower. With a 4% initial withdrawal rate, the shortest time period in which the savings ran out was 33 years. In only 10% of the scenarios did the money last for less than 40 years.
If you turn this rule around and know how much you want to spend in your first year of retirement, say $60,000, you can calculate the amount you need to have saved by dividing that amount by 4% (=0.04). In this example, you need $1,500,000 (=$60,000/0.04) in savings on the day you retire using this rule.
Multiply by 25 Rule for Retirement Savings
The Multiply by 25 Rule says that the amount you need in retirement savings is 25 times the amount you want to spend in the first year of retirement. Using the example above in which you want to spend $60,000 in your first year of retirement, you would calculate that you need $1,500,000 (=25 x $60,000) in savings. As I said, the math is the same for determining how much you need to save because multiplying by 25 is the same as dividing by 0.04. It is just that the rules are stated from different perspectives (how much you can spend given the amount saved as opposed to how much you need to save giving how much you want to spend).
When do you need more or less?
As indicated, those rules make assumptions that might not be right for you. There are a number of personal factors that impact how much you need in retirement savings.
Your Risk Tolerance
The 4% Rule assumes that you invest half in bonds and half in stocks. Some people are willing to take more risk by investing more heavily in stocks. Other people can’t tolerate the ups and downs of the stock market, so invest more heavily in bonds. As shown in this chart below, taken from my post on diversification and investing, the higher percentage of stocks in your portfolio, the higher your average return (the blue lines) but the more likely you are to lose some of your principal (the portion of the whiskers that fall below 0).
If you plan to put more than 50% of your retirement assets in stocks, you can withdraw a bit more than 4% each year. Turning that around, it means you need a bit less than 25 times your estimated expenses in your first year of retirement. The table below was copied with permission from a March 19, 2019 article from Schwab found at this link. It shows how your time horizon (see below) and investment risk impact the 4% Rule.
Life Expectancy and Retirement Age
The analysis underlying the 4% Rule focuses on a retirement period of 30 years. If you retire in your mid-60s, it would imply that you would most likely have enough money to last through your mid-90s. If you are in poor health or have a family history of dying early, you could consider spending a bit more than 4% (that is, multiply by less than 25 to determine how much you need to save).
On the other hand, if you plan to retire at 45 and want to have enough money to last until you are 95, you’ll need to save more. The Schwab table above shows planning horizons up to 30 years. Based on the numbers in the table, it looks like you could subtract about 0.1 percentage points from the numbers in the 30-year row for each year your planning horizon extends beyond 30 years to estimate how much you need to save.
For example, if you want to be highly confident (90% sure in this case) you will have enough money to last for 50 years, you would be looking at 20 years beyond the 30-year horizon. Multiplying 20 years by 0.1 percentage point is 2.0%. According to the table, you can spend 4.2% of your savings in the first year with a Moderately Conservative portfolio and 90% (highly) confident that you won’t run out of money in 30 years. My approximation would subtract 2.0% from 4.2% to estimate that you could spend about 2.2% of your savings in the first year if you wanted to be 90% confident you won’t run out of money in 50 years. You could then divide your estimated first year expenses by 2.2% or multiply by 45 to estimate how much you need to save.
Other Sources of Income
Some people’s employers provide defined benefit retirement plans. These plans generally pay a flat amount every month starting at normal retirement age (as defined by the employer) until death. In the US, people who have worked or whose spouses have worked are eligible for Social Security benefits, as discussed in this post. Similarly, Canadians are eligible for Canadian Pension Plan benefits. Many other countries have similar programs.
When you are estimating how much you need to save for retirement, you can consider these sources of income. If all of your other sources of income increase with inflation, it is a fairly straightforward adjustment. You just need to subtract the income from these other sources from your first-year-of-retirement expenses before applying the 4% Rule (as adjusted for other considerations).
For example, if you plan to spend $100,000 a year in retirement and have $40,000 of Social Security and defined benefit plan benefits, you would subtract $40,000 from $100,000 to get $60,000. Using the Multiply by 25 Rule, you would multiply $60,000 by 25 to get $$1.5 million instead of multiplying the full $100,000 by 25 which would indicate you need $2.5 million in savings. In this example, you need $1 million less in savings because you have other sources of income.
Unfortunately, most defined benefit plan benefits do not increase with inflation. The math for adjusting the Multiply by 25 Rule is fairly complicated. I’ve developed a simple approximation that you can use that will get you close to the correct percentage. To approximate the adjustment to the amount you Multiply by 25, divide your defined benefit plan income by 2 before subtracting it from your first-year expenses.
You Want to Leave Your Assets to your Beneficiaries
I remember being a teenager and having my father explain to me how much I needed to save for retirement. The approach he proposed was that you could spend 2% of your assets which is equivalent to a Multiply by 50 Rule. (No wonder I was nervous about my finances when I retired!) His logic was as follows:
- Invest in the stock market and get a 10% return. (He did this analysis a long time ago, when stock market average returns, inflation and taxes were all considered to be a bit higher than they are today, but not by so much as to make the logic faulty.)
- You will pay taxes of 40% of your returns, which makes your after-tax return 6%.
- Inflation will be 4% per year. Because he wanted his investment income in every year to cover his expenses without dipping into the principal, he had to re-invest 4 percentage points of his investment return so he would have 4% more investment income in each subsequent year.
- Subtracting the 4% reinvestment from the 6% after-tax return leaves an amount equal to 2% of his investments that he could spend each year (excluding taxes because he separately considered them).
So, if you are like my father, you will want to save closer to 50 times your first-year retirement expenses, rather than 25 times. It is important to remember that my father’s Multiply by 50 rule applies to your expenses excluding income taxes and the Multiply by 25 Rule applies to your expenses including income taxes, so they aren’t quite directly comparable.
Liquidity of your Assets
As indicated above, the 4% Rule assumes your assets are invested 50% in stocks and 50% in bonds. You may have other assets that contribute to your net worth, such as equity in your home, your personal property, a family farm and rental property, among others. These other assets are all consider illiquid – that is, you can’t convert them to cash easily. Further, some of them are assets that you never want to have to convert to cash to cover expenses, such as your home and personal property.
As you project how much you will have in retirement savings, you’ll want to exclude any equity in your house as it isn’t available to invest. A portion of it may be available at some point if you plan to downsize, but you’ll want to be cautious about including it in your savings plan. Other of these assets, such as rental property, could be liquidated to cover retirement expenses. In your planning, though, you’ll need to make sure you consider the selling costs (e.g., real estate agent’s commission) and taxes you need to pay on capital gains and that they may not generate a return as high as underlies the 4% Rule.
Irregular Large Expenses
The analysis that supports the 4% Rule assumes that you have the same expenses every year and that they change due only to inflation. That’s not how life works! You may want to be like me and want to take an expensive vacation every three or four years in retirement, you’ll likely have to replace your car at least once in retirement or you could have major home repairs if you own your home. In addition, end-of-life medical bills can be very expensive.
As you are determining your first-year retirement expenses, you’ll want to include amounts for any such expenses in your budget at their average annual cost. For example, let’s say I want to take a vacation (in addition to my already budgeted travel expenses) every five years that has a total cost of $10,000. I need to add $2,000 (= $10,000 per vacation divided by one vacation every 5 years) to my regular annual expenses for these big vacations. Similarly, if I plan to buy a $25,000 car every 15 years, I need to add $1,667 (= $25,000/15) to my annual expenses. In both cases, you would add these amounts to your budgeted expenses before you divided by 4%.
How to Set Your Personal Target
So, what can you do to estimate your personal retirement savings target? Follow the following steps.
Make a Budget for Today if You Don’t Already Have One
It is hard to estimate your expenses in retirement, but it is very helpful to understand what you are spending today. If you don’t have a budget or haven’t tracked your expenses to see where your money is going, I suggest starting there. Here is a link to a post I wrote with a spreadsheet to help you monitor your expenses.
Estimate Your Expenses in Your First Year of Retirement
Next, look at your current budget and/or spending and estimate how it would change if you were retired today. On what types of things might you want to spend money in the future that you don’t spend now? Might you want to buy special gifts for your grandchildren that are more extravagant than what you spend for your children’s gifts now? Also think about expenses you have now that you won’t have in the future, such as commute expenses and possibly a separate wardrobe for work.
Be sure to think about Social Security (or equivalent) and income taxes. In addition to Federal income taxes, you may pay state or provincial and possibly local income taxes. If you plan to live somewhere else in retirement, it might have a higher or lower tax rate. In the US, Social Security taxes are 6.2% (12.4% I you are self-employed) of your wages up to the limit ($128,400 in 2019). As you adjust your budget, you can eliminate Social Security taxes and will want to think about whether your state or provincial and local tax rate will be substantially different from their current rates.
Some people say that your expenses will decrease by 20% when you retire. In my very short retirement, I find I’m spending more than I expected as I have more time to do things and many of them cost money. This post from Financial Samurai provide some insights as to how retirement might impact your expenses.
Increase Your Retirement Expenses for Special Purchases
Do you want to travel? How often do you think you’ll need to buy replacement cars and how much do you think you’d spend if you bought one today? What other expenses might you have that aren’t in your budget? For each of these expenses, divide the amount by the time between them to estimate an average annual cost, as I illustrated earlier in this post.
Adjust Your Budget for Inflation
All of the amounts you’ve estimated so far are in today’s dollars. That is, they reflect the current prices of every item. You’ll want to increase these amounts for inflation between now and the time you retire. Over long periods of time, annual inflation has averaged 3% to 3.5% though it has been a bit lower recently. To adjust your budget for inflation, you’ll want to multiply it by 1.03n, where n is the number of years until you retire. Don’t like exponents? The table below provides approximate multipliers by number of years until you plan to retire.
Subtract Other Sources of Income
If you think you’ll have a defined pension plan benefit or will receive social insurance (Social Security) benefit, you can subtract those amounts from your inflation-adjusted budget. My post on Social Security provides insights on how to estimate your benefits for my US readers.
Figure Out your Risk Tolerance and Length of Retirement
If you want to be almost 100% confident you will have enough money to last for your full retirement, regardless of how long it is, and leave most or all of your principal to your heirs, multiply the difference between your inflated budget (excluding income taxes) and other sources of income by 50 to derive your retirement savings target.
If you plan to be retired for only 10 years, you can multiply by a number as low as 10, according to the chart from Schwab. Where between those two numbers you choose is up to you. The longer you expect to be retired, the more conservative your investments and the more confident you want to be that you won’t run out of money, the higher your multiplier.
The best way to pay off your short-term and revolving debt depends on your priorities and what motivates you. Two of the common approaches for determining the order in which to re-pay your loans discussed in financial literacy circles are the Debt Snowball and Debt …
From Susie Q: I’m not as familiar with student debt as I am with the other topics on which I write, so was pleased to accept this guest post from Kate Underwood. With Kate’s permission and approval, I’ve interspersed some comments and numerical examples in …
You may have thought you were done when you created and balanced your budget. However, there is one very important step left in the budgeting process – making sure you are living within the guidelines set by your budget, i.e., monitoring your budget. That is, are you earning as much income as you planned? Are you limiting your expenses to the amounts in your budget? Did you put aside the savings you included in your budget, whether for expenses you pay infrequently, for retirement or something in between?
In this post, I’ll tell you how to use a new, budget-monitoring worksheet to compare your budget with your actual income and expenses.
Entering Your Budget
Since the purpose of the spreadsheet is to compare your actual expenses with your budget, the first thing to do is to enter your budget. Most people find it easiest to monitor their budget on a monthly basis, even if they created an annual budget. If you created an annual budget, you’ll want to divide all of the values in your budget by 12.
Once you have your monthly budget, you’ll enter it on the Budget Monitoring tab of the budget-monitoring spreadsheet at the link below. Note that this spreadsheet is different from the one you used to track your expenses and create your budget, though many aspects of it will work the same as the budget creation spreadsheet (named Budget Template).
Enter Your Category Names
To enter your budget, enter the names of the categories from your budget in Column A starting in Row 8. Here are three different ways you can input your category names:
- Type the names directly into Column A.
- Use Excel’s copy and paste features to copy them from your Budget Template spreadsheet.
a. On the Budget tab in your Budget Template spreadsheet, highlight all of your category names by putting your cursor on cell A11, holding down the shift key and moving the down arrow until all of them are highlighted. Let go of the shift key.
b. Hold down the Ctrl key while you hit C or hit the copy button if you have one.
c. Go to the Budget Comparison tab of the monitoring spreadsheet.
d. Put your cursor in A8.
e. Hold down the Alt key while you hit E, S and V or hit the paste-values button if you have one. If you just use a regular paste button, you will get errors because the cells from which you are copying have formulas in them.
3. Link your monitoring spreadsheet to your Budget Template spreadsheet.
a. Put your cursor in A8 of the Budget Comparison tab of your Budget Monitoring spreadsheet.
b. Hit the equal sign on your keyboard.
c. Go to the Budget Template spreadsheet.
d. Go to the Budget tab.
e. Put your cursor in A11.
f. Hit Enter.
g. Excel should return you to cell A8 of your Budget Monitoring spreadsheet.
h. Hit the F2 (edit) key.
i. Hit the F4 key 3 times. Hit Enter. There should now be no $ in the cell reference.
j. Copy the formula in A8 and paste it in as many cells in Column A as needed until all of your category names appear.
When you enter the category names, make sure that the row with the total amount of income is called “Total Income,” the row with the expense total is called “Total Expenses,” and the difference between those two values is called “Grand Total.”
Enter Your Budget Amounts
Next, enter the monthly budget amounts in Column B next to each of the category names in Column A. You can use any of the three approaches described above for the category names. If you have an annual budget, you’ll need to divided the values by 12 before copying them if you use the second approach or add “/12” (without the quotes) in step (i) before you hit enter if you use the third approach.
Entering Your Actual Income and Expenses
You can enter your actual income and expenses using the same instructions as were used for entering them in the Budget Template spreadsheet. See my posts on tracking expenses and paychecks and income for more details or review the instructions at the top of each tab. Be sure to use the same category names as you used in your budget so all of your income and expenses will be included in the Actual column on the Budget Comparison tab.
For monitoring your actual income and expenses, you don’t need to enter the number of times per year you receive each type of income or pay each bill since your goal is compare what you actually received and paid with your budget.
Options for Expenses You Don’t Pay Monthly
Here are three different ways to monitor expenses that you don’t pay monthly:
- Enter them in the Monitoring Spreadsheet as you pay them and keep them in mind as known variances from your budget each month. This approach is the easiest to implement but also the least helpful for comparing your actual expenses to your budget.
- Adjust the budget amounts to reflect the amount of those expenses you expect to pay in each month. For example, if you pay your car insurance bill four times a year in March, June, September and December, you would
- take your budget amount
- adjust it to a full year if you budgeted on a monthly basis by multiplying by 12
- divide the annual amount by 4
- include the result in your budget for March, June, September and December
- put 0 in your budget column in all other months
This approach is a little more complicated to implement, but will make comparing actual expenses with your budget much easier.
- Add an expense transaction every month equal to 1/12thof your annual expense on the Bank Transactions, Cash Transactions or Credit Card Transactions tab. In the months in which you actually make the payment, you’ll enter 1/12th of your actual annual expense. If the total of the amounts you set aside in previous months differs from the amount you actually pay, you’ll need to include this difference in the actual payment amount in the month you make the payment. This approach is equivalent to moving money from your checking account to your savings account in every month you don’t have this expense and moving it back to your checking account in the month in which you pay the expense.
You can also use any one of the above approaches for income you don’t receive monthly. If you use the third approach, you’ll put 1/12th of your actual annual income on the Income tab.
Monitoring Your Budget – What Happens When Your Actual Isn’t as Good as Your Budget
There are many reasons why your actual income and expenses might look worse than your budget. You may have been planning to work overtime or get a second job to increase your income. Those lifestyle changes can be challenging, so you might not have done them.
More likely, you spent more than you budgeted, either due to an emergency, an impulse purchase or difficulty in breaking long-standing habits. Emergencies happen to everyone. If possible, you’ll want to include building or re-building your emergency savings (see this post for more on that topic) in your budget. While overspending your budget can be problematic, especially if you do it continuously, don’t be too hard on yourself. Changing your spending habits is really hard.
A Few More Words about Budget
Congratulations! You made it through the entire budgeting process. As I said in my first post on budgeting, staying on a budget is like being on a diet. Just as every calorie counts, so does every dollar spent. Sticking to your budget will increase the likelihood you will meet your financial goals, so do your best!