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On the Road from $0 to a Million, This Simple Pyramid is Your Map; What Level Are You On?

Are you too focused on singular financial problems like paying off debt or picking stocks? The most successful people take a big-picture approach to their money. Here’s how you can, too, using the Financial Planning Pyramid.

The Financial Planning Pyramid can help define where to focus next as you work on your personal finances.Proper financial planning takes into account the whole picture and not just a piece. Saving for retirement might be your current goal, but if you don’t have a plan for emergencies, that goal can get derailed in a second and and kill any dreams of sipping margaritas on the beach. Enter the Financial Planning Pyramid.

As you work on your finances, think of building your wealth as a pyramid. A good financial plan builds upon a solid foundation and enables you to reach your goals even in the face of life’s uncertainties.

Here, we’ll take a look at the five levels of the Financial Planning Pyramid, starting at the bottom.

1. Cash flow

In order to develop a comprehensive financial plan, you need to start with the most basic of needs – cash flow. If your income doesn’t exceed your expenses, it’s impossible to save for the future. It seems like a no-brainer, but this can be the most difficult part of the planning process. Even millionaires need to reassess cash flow from time to time.

Ensuring positive cash flow means working with a budget, trimming expenses and perhaps increasing your income. It’s hard work, but it’s so critical, it forms the base of the Financial Planning Pyramid upon which all else is built.

An honest assessment of what you spend each month is a vital part of a quarterly financial check up (you do this, right?) in order to get an accurate picture of how much you can invest. Even something as simple as $50 a month can amount to a significant sum. 

Once you’re settled into a good balance of paying bills and investing, you’ll want to protect what you’ve built. The first defense you’ll want to set in place is an emergency savings account. This should be a savings account apart from your regular bank to which you transfer a few dollars every week or month — for years, Capital One 360 has been a favorite of Money Under 30 readers.

How much is enough? Financial advisors suggest saving between three and six months’ worth of expenses, but you can use your own judgment. If you’re self-employed or have a variable income, you may want to consider saving more than six months.

2. Risk management

The other part of the protection piece is managing risk. Insurance is hardly the most exciting part of planning, but it’s essential that you have the proper safety net in place to catch you in the event of an unforeseen catastrophe. So important, in fact, it’s the second level of the Financial Planning Pyramid. Health insurance, auto insurance and homeowner’s insurance all serve to protect you from facing catastrophic out-of-pocket expenses in the event of a loss.

Life insurance should be set up to replace income for enough time that a surviving spouse can make arrangements so he or she isn’t forced to sell your house or claim bankruptcy. Another consideration to keep in mind is the fact that more people end up disabled than dead; it may be worth your while to check into long-term disability policies.

3. Investing

We should all save for retirement, but if you’re savvy, you’ll also invest money for other goals, too: buying  car, a home, or funding your kids’ college expenses. You’ll want to keep these savings goals independent from your retirement goals.

An online mutual fund or brokerage account is the perfect way to begin setting aside money for these life goals.

Paying off debt is essentially an investment, too. Rather than accumulating interest-bearing assets you’re eliminating interest-charging liabilities. Prioritizing debt repayment and investing for other goals is one of the most nuanced (and personal) financial decision you’ll have to make. That said, the important thing to remember is that any investment or debt payment increases your net worth, so doing something is better than doing nothing!

Retirement planning is usually the sole focus for most of you, but you can already see how it’s just one part of a bigger puzzle. Investing for retirement should take into account your 401(k) or 403(b), IRA, and any other retirement package you may have available. You can consult online calculators like this one to help you determine what you need to put into a retirement account in order to reach a specific goal.

A good rule of thumb is that you need to save 25 times your desired retirement income. This assumes a 4 percent annual withdrawal rate. So for example, if you hope to withdraw $50,000 a year in retirement, you’ll need to save $1.25 million. Keep in mind, also, that inflation means $50,000 will not go nearly as far in 30 years as it does today. So the more you can save, the better.

4. Tax planning

Tax planning goes hand-in-hand with retirement saving as well considering the tax advantages of 401(k)s and IRAs, but depending on your income level, you may want to make a plan for other investments as well. Some types of investments like municipal bonds allow you to avoid paying taxes on your gains. Once you accumulate a five-figure portfolio in retirement investments, consulting a tax advisor is a good idea.

5. Estate planning

On top of the pyramid is estate planning. Although it’s not something most people need to worry about until you get closer to retirement, you should at least familiarize yourself with how it works. This stage involves how you want your assets passed on to heirs or given to charity. Trusts can be used to carry out your plans much more efficiently than probate, your state’s legal process for executing your estate in the absence of an estate plan.

At a minimum, everyone’s estate plan should include a will that spells out basic wishes and bequests. Should you also own your own business, a proper plan for succession should also be set in place, just in case.

How are you doing? What level of the Financial Planning Pyramid are you on?

About Daniel Cross

Daniel Cross has been in the industry as an investment writer and financial advisor since 2005. He holds the Chartered Financial Consultant designation (ChFC) as well as Series 7 and Series 66 licenses, and has embarked on the arduous journey of obtaining the coveted CFA designation. Daniel lives in Florida with his wife, daughter, and pet Tortoise ironically named Turbo.

Comments

  1. I really believe being able to have multiple sources of income and investing can get you a million dollars someday. Of course, you’ve got to make the right decisions and be a risk taker to increase your chances of achieving it, right?

  2. Could you please elaborate on the point about Tax Planning? What value does a tax advisor add?

    • Daniel Cross says:

      Tax planning in an investment portfolio is a separate animal altogether thanks to our unnecessarily complicated tax structure. Not only will you need to account for the obvious (income taxes, capital gains taxes, etc.) but different investment vehicles come with various tax structures. Retirement planning concepts like Roth IRA’s and Traditional IRA’s are chosen with both current tax levels and future tax levels in mind while other investments like MLP’s and municipal bonds have unique tax implications when you receive dividends, interest, or capital gains.

    • Tax planning is about a lot more than just investments. There are a number of financial decisions that affect your taxes and just paying attention to how those decisions are made can have a major impact on your finances. For example, choosing an HSA-compatible health insurance plan allows a person or family to save using tax-deductible dollars and then withdraw the money tax-free (when spent on eligible medical expenses). To get this benefit, the taxpayer just has to keep track of the medical expenses paid for out of the HSA and keep those records for 3 years after the return is filed. It isn’t difficult, it is just tweaking the structure of how a person does things they probably would have done anyway to get the best tax consequences available.

  3. I wonder about buying life insurance (or most insurances, for that matter). The risk of healthy 20-30 year olds dying is pretty low. If you have dependents and die, they would get social security death benefits, right? I assume this isn’t as much as a life insurance policy, but is death likely enough that you need to be spending extra money on a life insurance policy? Guess it’s probably up to your own risk tolerance.

    • Daniel Cross says:

      The basic idea is to have enough insurance to take care of whoever is left behind until they can survive on their own. What happens if you have a mortgage that your spouse can’t afford on their own? What if you and your significant other have an accident? Who will take care of the children? How will college be paid for? If you have a significant amount of money saved up (think hundreds of thousands) you might not really need a life insurance policy. It’s there to protect your loved ones if something unfortunate should happen.

      • I understand the function of life insurance. But doesn’t social security provide the same? I know of people whose spouse has died and their kids then get survivor benefits from social security. Do spouses get that as well? Why have life insurance in addition? I’ve tried to find the answer to this and imagine it is similar to retirement benefits. Yes, you get SS once you retire but it’s not much so you should save for retirement. However with death being a somewhat remote possibility what makes buying life insurance worth the cost?

  4. Thank you for taking the time to mention a blip about LT personally owned disability policies… A subject many ppl overlook when in fact it should be dealt with before health or life insurance.

    I’m still amazed when a married couple without children thinks there is no need for life insurance, and how early people think they will become “self insured.”

  5. Uh, in what world do “more people end up disabled than dead”?
    EVERYONE ends up dead. Eventually.
    Not everyone ends up disabled, it’s more like 1 in 4 in their lifetime.
    Thus, more people end up dead than disabled.