Life may be full of twists and turns, but strong financial planning basics can help you stay on track toward reaching your goals. From paying off your student loans to growing your money in one of the best retirement plans or IRA accounts, a financial plan can get you where you want to go.
Whether you create your own or engage in financial planning with a professional, such as a Certified Financial Planner (CFP), comprehensive financial planning can help you manage your money better and achieve your financial goals.
Financial planning 101 walks you through the basics of how to start financial planning, the steps involved, and common pitfalls to avoid.
What is financial planning?
Financial success requires intentionality, not just a high income or inheritance. You can improve your relationship with your money with mindfulness.
That's where financial planning comes into play.
Definition of financial planning
What is meant by the term "financial planning"? Financial planning refers to the process of achieving financial security by considering one's entire financial picture and developing a realistic plan to reach one's short — and long-term goals.
But what does a comprehensive financial plan consist of? Consider the following:
- Cash flow
- Existing debt
- Savings and investments (including retirement planning)
- Taxes
- Education planning
- Legacy and estate planning
The financial planning process can be DIY for a quicker, less expensive option. Or, you can work with a professional for expert guidance. While DIY planning can be a good starting point, it may lack the in-depth analysis and security that a financial advisor can provide.
"Financial advisors can help you create a financial plan by understanding your goals, values, and risk tolerance, and then building a customized path that they can guide you along to enrich your life to its fullest potential," says Jordan Gilberti, CFP and founder of Sage Wealth Group.
Why financial planning matters
Financial planning identifies your goals and helps you create steps to reach them. No two financial situations are the same, so neither should your financial plan.
"The purpose of a financial plan is to help clients — whether it be an individual, family, or business — achieve their financial goals and objectives by creating a structured roadmap for managing their finances effectively," says Chloe Wohlforth, CFP, Partner at Angeles Wealth Management. "A well-crafted financial plan considers a person's current financial situation, future financial goals, and risk tolerance."
Without financial planning for individuals and couples, knowing if you're on the right track is hard.
Let's say you are retirement planning but haven't allocated a high enough percentage of your paycheck because you're trying to pay down debt. A custom financial plan would aim to lower your debt payments through debt consolidation, enabling you to invest more toward retirement each month.
Key components of financial planning
Everyone's financial plan looks different and some are more complex than others. For those just starting out, here are key components to consider:
Budgeting
Even if you have a high income, it's still helpful to budget.
Many people overspend without realizing it. Even if you have plenty of cushion, it's helpful to map out exactly how much you can afford to divert to savings, investing, and paying down debt.
Cash flow management
Cash flow management is similar to budgeting, but it involves managing the timing of when you receive money vs. when you spend money.
Unexpected medical bills, home repairs, and car expenses can derail your budget. However, good cash flow management includes extra savings buckets like an emergency fund, so unexpected costs don't affect your ordinary income.
"An emergency fund is typically a savings account that serves as a safety net from unforeseen financial difficulties that you may face throughout your life," Gilberti says. "Examples may include a job loss, disability, home appliance breaking, and more."
Debt management
One of the biggest obstacles that prevent people from reaching their financial goals is debt. Growing debt can impede your budget long after you incur the debt.
Not all debt should be treated the same. High-interest debt, like credit card debt, should be tackled as quickly as possible. Low-interest debt, like a mortgage, shouldn't necessarily be paid off any faster than the minimum monthly payments because you could earn more by investing.
Let's say you have a monthly mortgage payment of $2,500 on a 30-year fixed mortgage. You recently got a raise and realized you could pay off your mortgage faster by contributing more than the minimum payment. However, you haven't yet maxed out your 401(k). In that case, maxing out your 401(k) is the better choice as it lowers your taxable income, and your money will grow even more from compound interest.
Investment planning
Reaching long-term goals like buying a home or even putting money toward a big vacation helps to invest, not just save. Investing involves risks, but financial planning can help you account for those risks and find suitable investments based on your goals.
You can invest in a brokerage account with:
- Best online brokerage accounts
- Best investment apps for beginners
- Best stock trading apps
- Best robo-advisors
Let's say you're planning to buy a home next year. You might not want to invest your down payment funds in anything other than something very low-risk, like certificates of deposit (CDs). However, if you plan to buy a home in 10 years, perhaps investing in a mix of low-cost ETFs and bond funds helps you reach that goal faster than if you just put savings into a bank account.
Retirement planning
Similar to investing for the future, but often analyzed separately, is retirement planning. You want to consider:
- How much income you need to sustain your retirement lifestyle
- What age you want to retire, and how long your estimated life expectancy is
- Where you want to live and how much it costs
Once you know your retirement goals, you can start strategizing how to reach those goals. You can use online tools like an online retirement calculator if you're creating your own financial plan, or consult a financial advisor who can help guide you through this process.
Insurance and risk management
Insurance provides peace of mind, similar to having an emergency fund. It protects you financially if your belongings are stolen, damaged, or destroyed.
Common types of insurance policies to consider are:
- Homeowners Insurance
- Renters insurance
- Life insurance (whole or term)
- Health insurance
- Auto insurance
Education planning
College is expensive, and finding a way to afford it without taking on a substantial amount of student loan debt is no easy feat. If you plan on having kids, you can invest on their behalf through a 529 savings plan or custodial account.
This additional savings bucket allows you to designate funds for your kid(s) without detracting from your other financial goals. Custodial accounts and 529 plans come with their own tax advantages, investment opportunities, and rules.
For example, the money in a 529 plan can only be spent on qualifying educational expenses, like tuition, apprenticeships, and student loans. If you are not certain if your child will want to go to college, a different education savings vehicle may be preferred.
Estate planning
Wills and trusts aren't just for the wealthy but rather for anyone who wants to relieve their family of burdens, avoid unnecessary drama, and ensure their final wishes are respected. These documents are important for deciding who gets what, who takes care of your kids (or pets), and how you want your funeral and medical stuff handled.
Depending on the complexity of your financial situation, you may need to hire an attorney to create a personalized will or trust. If you can't afford to hire a lawyer, you can DIY estate planning with one of the best online willmakers. But ensure you follow all the steps required to make the document legally binding.
Steps to create a financial plan
Here are the steps involved in the financial planning process.
1. Set your financial goals
The first step in creating a strong financial plan is identifying your goals. You should know what you're aiming for, whether by yourself or with a partner.
"Set your goals and priorities by envisioning a future for yourself over the short, medium, and long term, and what you would like to achieve financially," says Gilberti. "Get yourself organized by gathering all relevant financial documents, including your investment accounts, insurance policies, debts, and other assets."
Ask yourself: What do you want to achieve in five years? How about in 10 or 20 years? Are you looking to buy a house? Have kids? Plan a huge trip?
Financial planning should feel intentional, and you can more easily draw motivation from clear, obtainable objectives. Consider at least three goals with the following information:
- How much will it cost? For example, if you're looking to save for a house or pay off student debt, you should have a number you're aiming for. For instance, how much will it cost to buy a house, and how much do you need to save to make it happen?
- What is my deadline? Once you know how much you need to save, you must set a realistic timeline. For example, how long will it take to save up for a down payment on a house?
- Where should I store the funds? While you can store all your funds in the same bank account, you may want to separate your funds into different savings accounts or brokerage accounts, such as if you want to invest some of those funds to reach your goals.
2. Track your spending
Next, track your spending and cash flow to see where your money goes. What are your highest spending categories? Are there expenses you can cut back on, or are you overspending in any specific categories?
Reducing and managing debt is often a crucial step in financial planning. High-interest debt will weigh you down even if you're storing a good chunk of cash in a savings or brokerage account. The longer your debt accumulates interest, the more money you'll lose in the long run.
Once you have a grasp on your spending habits, you can budget. A beginner-friendly method of budgeting is the 50/30/20 rule, which is often suitable for both consistent and irregular-income households. Basically, this plan is a rule of thumb that designates 50% of your income to necessary expenses, 30% to wants, and 20% to debt or savings.
But keep in mind that everyone's financial situation is unique and the 50/30/20 budget plan won't be suitable for everyone.
Using a budgeting app can also be very useful. It will break down your spending by category and keep track of how much you spend over time, allowing you to compare your finances from month to month.
3. Develop strategies for achieving goals
Once you know where you stand, you can develop saving strategies to reach your goals.
For example, assessing your debt can help you make decisions about how to pay off your credit card balances, student loans, and car payments.
Also, one of the best ways to save for future financial goals and build wealth is typically through investing. While investing involves risk, your financial planning process can involve strategies like designing a diverse portfolio of stocks, bonds, and real estate that can significantly lower the risk and ideally help you grow your money based on your goals.
4. Monitor and update your financial plan
Remember that financial plans aren't static. You'll need to consistently reevaluate them to ensure that they reflect your current situation and goals.
Life changes that prompt you to revisit your financial plan include:
- Job change: A new job, promotion, or job loss may constitute a change in salary or benefits. Reevaluate your budget and allocate how much you're putting toward each financial goal.
- Marriage or divorce: Getting married or divorced can significantly change your income. Plus, you will likely need to reevaluate your budget.
- Children: Kids are expensive, so updating your financial plan to include expenses and future savings buckets for your kids is crucial.
- Death of a loved one: A spouse or family member dying can significantly impact your financial situation. You may also have to consider insurance, inheritance, funeral costs, and estate plans.
- Moving: Moving to a new home (upgrade or downgrade), relocating to a new city, changing states, or moving out of the country requires significant changes in your budget, taxes, and cash flow.
Common financial planning mistakes to avoid
While financial planning can help you reach your financial goals, it's not as if the process always leads to success, especially if you skip some important steps. Some common mistakes to avoid include:
Not having a budget
Even if you think you are good with money, it is easy to lose track of your spending if you don't have a budget. Even if you already have a lot of savings and pay off your credit card automatically every month, you may end up spending more than you think.
Overspending could come back to bite you if you neglect to invest in other areas, such as retirement investing or an emergency fund.
"The best way to budget is to ask for help. Often, clients don't budget because they don't know where to begin, " says Wohlforth. "An advisor can help you think about your expenses in different categories."
Underestimating emergency savings
Part of establishing a realistic budget is setting aside cash in case of emergencies. Don't make the mistake of saving too little. Consider factors like how long you could go without an income and your insurance situation to see how much you should save.
Neglecting retirement savings
Retirement may seem far off, but generally, the sooner you start saving and investing for retirement, the easier it is to reach your retirement goals due to the power of compound returns over time.
Some of the best retirement plans are:
Benefits of working with a financial planner
DIY financial planning works for some, but a financial planner brings expert insight and guidance to the table. Financial planners can help you navigate tricky situations and create a custom plan based on your individual situation. Plus, you gain an accountability partner.
More specifically, working with a financial planner often provides benefits like:
- Tailored financial advice: Comes up with specific financial strategies like budgeting, managing debt, and choosing investments based on your situation.
- Objective insight: It's tempting to let emotions guide your financial situation, especially when the market dips. But a financial planner can offer a more objective perspective, reminding you that the market's ups and downs are normal and staying the course is often the best strategy.
- Ongoing monitoring and plan adjustments: A good financial planner can help you make adjustments along the way. For example, you might have semi-annual meetings with your financial planner to review your goals and see if any changes should be made to your strategy, such as due to life changes.
You can find a financial advisor through online reviews or by talking with friends and family.
Get started with a financial planner
FAQs
What are the main goals of financial planning?
The main goals of financial planning are tracking and monitoring your individual financial situation to help you reach your financial goals. Financial planning commonly involves budgets, cash flow management, debt consolidation, and retirement planning.
How often should I update my financial plan?
You should update your financial plan when you experience a life change like a new job, marriage, kids, or the death of a loved one.
Do I need a financial planner, or can I do it myself?
You can start financial planning on your own if you're comfortable setting financial goals and engaging in activities like budgeting and opening a retirement account. However, if you're unsure how to create a financial plan or simply want additional guidance, you can reach out to a professional such as a financial planner, financial advisor, or financial consultant for help.
What are the key steps to starting a financial plan?
The key steps to starting a financial plan often begin with setting short- and long-term goals, followed by assessing your current financial situation and then setting strategies to reach your goals, often by adjusting your current financial practices.
