Financial Planning and You
Updated: Jun 8
Financial planning is all about building wealth and protecting wealth from your biggest expense. What is everyone's biggest expense? Is it a mortgage? utilities? college? In most cases the answer is no. Everyone's biggest expense is good ol' Uncle Sam. He is our partner in everything we do. Luckily there are some legal techniques available to minimize his role as a partner in our lives.
Building individual wealth all starts with a great financial plan. If someone wants to start a business they create a business plan. If someone wants to reach their goals in a certain field they are told to write them down. Well, in the world of personal finance it isn't any different. One must have a rock solid financial plan to maximize their opportunities to achieve the personal wealth they desire.
I like to think of financial planning like a football game. They both have two half's and just like a football game, if you fumble everything in the first half it is really difficult to recoup the losses in the second half.
FIRST HALF OF FINANCIAL PLANNING
Your financial plan in your first half of wealth building is your accumulation phase. This is when you are working and collecting your assets to provide for yourself in the future. Not to mention, if done well, the assets can provide for your family far after when you are gone.
First, please understand that there is a difference between people that are wealthy and people that appear rich. True wealth is someone that owns various assets that spins off cash to them. All cash is is a medium of exchange we use for commerce. There is nothing fancy about it. A wealthy person understands that owning assets such as stocks and real estate is true riches. Owning these assets is true stability. Just because two people spend the same amount of money each year does not mean they are in the same "class". The stability of the source of that re-occurring cash is the true difference between wealth and someone that is trying to feel rich. Continue reading and we might just change your family tree.
HOW DO WE BUILD THIS WEALTH? WE HAVE TO START WITH THE BASICS...
STEP 1: Save up an emergency fund! This is the most important to building long term wealth. It sounds boring and obvious- but this is critical! An appropriate emergency fund is between 3-6 months worth of cash. This cash isn't invested at all. This cash sits there as cash and acts as "investment protection".
This initial emergency fund step for some will be the most difficult. It will feel like you are wasting time or giving up stock market gains. When in fact you are building the foundation of your portfolio. It won't matter if you are the greatest investor in the world constantly beating the market if you are always pulling the gains out of the portfolio to pay for life's emergencies. This emergency fund acts as "insurance" for your portfolio. This sideline cash behaves as protection for your assets when life happens. So please understand you are not wasting this cash-- you are buying asset protection with the lost investment opportunity with this fund. Just like most things in life--there is a cost. The simple truth about an emergency fund is the cost is inflation and lost opportunity cost.
This emergency fund step is also a mindset changer. This dedication towards the discipline that it takes to build an emergency fund will ultimately be a mind shift for most investors. To build wealth an investor must be a quality saver. Having the ability to stare at $15,000 or $25,000 in the face without spending the money for some is nearly an impossible task. Building this emergency fund of 3-6 months of expenses and commit to delayed gratification with thousands of dollars serves as a financial boot camp for most people. The fact of the matter is, if you can commit to building an emergency fund, you can build long term wealth. Once this step is complete--you are ready to be the steward of tremendous wealth you are about to build.
STEP 2: TO ROTH OR NOT TO ROTH?
The emergency fund is all set. We are ready to invest. There will be two main options that most people need to choose from. The options are traditional retirement accounts or Roth accounts. Unequivocally the correct choice to choose is the Roth option for most people.
The differences are simple to understand...
ROTH: You contribute to this account with after tax income. For example, someone receives there paycheck after taxes taken out and then they make the contribution. This account then grows tax free and upon retirement you can make withdraws from this account tax free! Therefor if you have $2M in a Roth account the $2M is free and clear of Uncle Sam. This is the same whether the account is a Roth IRA or a Roth 401K. About 50% of employers today offer these Roth versions of a 401K.
TRADITIONAL RETIREMENT ACCOUNTS: These accounts are contributed with tax deferred money. What does this mean? You can contribute the amount you would like to your 401K or traditional IRA with it not being taxed first. For example, if someone makes $1,000 per week. They can contribute $200 to the retirement account and then only pay taxes on the remaining $800.
This account then grows tax free until retirement. However, when that happy retirement day arrives, the retiree has to pay regular income tax on all withdrawals made from their traditional 401k or IRA account. Not only is there tax paid on a traditional 401k or IRA but there will be required minimum distributions. These RMD's are a forced distribution placed on these accounts. It doesn't even matter if you don't want to withdraw the money-- You simply have to do it. These RMD's typically range from . The more substantial of a nest egg one has the larger the tax bill becomes.
The situation is simple. The lower income bracket that you are in today means the Roth option is an even better option for you. Chances are you may be in a higher tax bracket when retirement comes.
HOW IMPACTFUL ARE Required Minimum Distributions (RMD's)?
Its important to know that these RMD's increase as a retiree advances in age. Remember, your partner Uncle Sam let you grow all of this money tax free and now he wants his cut.
On $2M a 70 year old would be forced to withdraw approximately $74,000. That isn't too bad. However, a 90 year old will have to withdraw about $175,000! Of course this jump in income will raise the tax bracket of this retiree. None of these forced RMD's would be in place if the assets were held in the superior ROTH IRA.
CAN YOU HAVE BOTH OPTIONS: Certainly. In fact when contributions are made to a Roth 401K the company matches in their traditional 401k. In the end this company match is free money so who cares if its taxed in the end.
THE SECOND HALF OF WEALTH PLANNING...
STEP ONE: ANSWER THE QUESTION: DO I HAVE ENOUGH?
This is the most popular question everyone wants answered before retirement. To be honest most people on the verge of retirement are terrified. They have been in a routine for years and the thought of ditching that old paycheck is hard to ratify in their mind.
Well there is a simple formula to begin solving this equation: No pension means you can't have any debt and if you have a pension means you can have some debt. This is the jumping off point.
It's pretty simple really-- If you are at the mercy of the market you can't have debt. This includes mortgage debt. Stability is very important in retirement. A pension can provide a lot of stability for a portfolio. Therefor the debt can be serviced with less stress. If you don't have a pension the expenses need to be minimal to serve as the stability ingredient in one's finances.
What happens when the market takes a downturn? A retirees cash reserve is being depleted? And there is a mortgage to service? It is an easy situation to ponder when there is a bull market but sleeping at night becomes a nightmare when a 2008 occurs or a covid-19 pandemic shows up at the door.
Now do you have enough to retire? That depends. There are a lot of of experts out there that claim you need 80% of your original income to provide for retirement. This rough estimate is a cookie cutter answer and this isn't a cookie cutter game. The important thing to understand first is expenses, expenses, and more expenses. Calculate these and the changes that will occur in with these and an answer will stare at you in the face.
A SIMPLE QUALIFYING QUESTION TO ASK YOURSELF...
Can you live off of 4-7% of your portfolio each year? If the answer is yes this became a whole lot easier. Please know that there are two calculations that can be ran to estimate a retirement viability test.
LINEAR CALCULATION: This type of calculation is a simple one. One can say 7% return on X amount of dollars will net me X amount of dollars each year. A linear calculation is used to calculate how much money someone will have in the distant future when they are in the accumulation phase. This type of calculation isn't used once a retiree enters retirement. Although I have to suspect it was before the second calculation was created.
MONTE CARLO CALCULATION: Ever wondered if you would be successful if you lived 1000 lives? Well that is exactly what the Monte Carlo Calculation does. Upon the retirement phase of ones life this calculation MUST be ran. This is a calculation that uses historical data to run 1000 different scenarios of your retirement plan. This calculation analyzes a retirees plan from every which angle to provide the confidence one needs to finally pull the trigger.
But regardless of the calculation- 4-7% is a healthy withdrawal rate to navigate retirement with intelligent social security planning.
Please know this is a bird's eye view on retirement planning. The fact of the matter is: Control your taxes, limit your expenses, eliminate your debt, and understand your withdraw rate required to retire.
John Lawrence is a financial advisor and owner/founder of J.A. Lawrence Wealth Management.