The 4 Steps of Building a Solid Financial Foundation

If you’ve ever wondered how to create a financial plan for the future, you’re in the right place. While financial planning can feel overwhelming and sometimes even confusing, making a plan can help you reach your financial goals and improve your quality of life.

Keep reading to learn about the steps you can take to build a solid financial foundation.

The 4 Financial Planning Steps

When you create a financial plan, there are four main steps you’ll need to take. Read about these below!

Step 1: Understand your Income and Cash Flow

The first step you’ll take when developing your financial plan is to get an accurate snapshot of where you currently are. After all, you don’t know how far you need to go if you don’t know where you’re at right now.

Start by getting an idea of what’s coming in – in other words, your income. Add up what you typically earn in a month, whether from your day job, business, side hustles, or investments. When you add up each stream of income on a monthly basis, you’ll get an idea of how much you are bringing in each month.

Then, you’ll want to take it a step further to determine how much is going out each month – also known as your expenses. Expenses will likely fall into three categories:

Fixed expenses: These are the expenses that usually stay the same each month, since these are bills that you need to survive, like rent, food, utilities, child care, and transportation.
Goal contributions: In this bucket, you contribute money to future goals, like retirement, an emergency fund, or buying a house. You should aim to contribute to future goals in some capacity every month.
Discretionary expenses: These are the most fun things to spend money on, like going out to eat, traveling, clothes, subscriptions, and technology. When you want to start trimming down your budget, these are the easiest things to cut back on.

Make a spreadsheet to track your fixed expenses, discretionary expenses, and goal contributions. Once you know how much money you are spending, and how much you earn each month, you can prioritize where you want to spend more, make more, or save more.

So, how much should you aim to spend in each category? Experts recommend allocating 60% toward fixed expenses, 20% on discretionary expenses, and 20% on goal contributions. For example, if you take home $5,000 per month, you should aim to spend $3,000 on fixed expenses, $1,000 toward discretionary costs, and $1,000 toward goal contributions.

If you realize that you are spending way too much on discretionary expenses, look for ways to cut back, whether it’s eating out less or canceling old subscriptions.

You should also identify the areas that are most important to you within these buckets. For example, maybe you like spending more on rent because that’s something you value. Or, maybe traveling brings you a lot of joy, so you are unwilling to cut back on your vacation expenses.

When you identify areas you aren’t willing to compromise on and areas where you are willing to spend less, you can create a budget that works for you and your needs, wants, and situation, providing more clarity on your values and priorities.

Step 2: Set Goals and Determine the Steps to Reach Them

The next step is to set financial goals – both in the short and long term. What age do you want to retire? Do you want to pay for your child’s college education? Vacation in Hawaii next year? Build up your emergency fund?

Whatever your goals, there’s likely a way to reach them if you plan in advance. If you need help determining your goals and how to start saving for them, contacting a financial advisor might be a good idea!

Chances are, your goals will require consistent saving and investing. For example, if you have a goal to build your emergency fund to $20,000 or save to buy a house, you’ll be prioritizing certain savings strategies. Here are a few tools that could come in handy as you start your savings journey:

Savings account: A savings account is where you keep your cash reserves that you need to access quickly. Standard savings accounts often accrue a small amount of interest each year. This is typically where people start growing an emergency fund or keeping money for vacations and big upcoming purchases.
High-yield savings account: This account is exactly like a regular savings account, but the money will accrue more interest than usual, helping you earn more on it in the long term. Many banks that offer high-yield savings are online-only, so the only disadvantage is that they may not have a physical location that you can get to immediately.
Money market bank account: This is like a checking account, but it often pays a small amount of interest, making it great for everyday expenses and growing your savings.
Certificate of deposit: A credit union or bank is often willing to pay a predetermined amount of interest over a specific time period, like 6 months or a year. However, there is usually a penalty for early withdrawals. This is a good place to keep money you won’t need right away, earning you more interest.

For some people, investing might be a higher priority than saving, especially if you are approaching retirement or want to retire early. Here are some of the most common investment terms you need to know:

Stocks: This is a partial ownership or stake in a company. When you own a stock, you’ll get a portion of the company’s profits, which may go up and down in value over time.
Bonds: This is a loan you make to the government or a company. In exchange, you get interest payments for a set period of time. While this doesn’t grow as much as stocks, it’s a more conservative investment.
Mutual funds: When you contribute to a mutual fund, your money is allocated to a basket of different investments, helping you diversify your investments all at once.

In addition to the savings tools above, a financial advisor may recommend these tools as you begin investing:

401(k)

A 401(k) is a tax-advantaged retirement account offered through your employer. You can use this account to invest in products like stocks, bonds, or mutual funds. The money goes in tax-free, but you’ll owe taxes on it once you withdraw it during retirement. A 403(b) or 457 also functions with the same concept. Remember that if you take money out of these accounts before age 59.5, you’ll owe an additional penalty in addition to the taxes.

Roth 401(k)

A Roth 401(k) is just like a typical 401(k), making it an excellent option for retirement savings, but the tax situation is a little different. When you put the funds into this account, they will be taxed, but when you withdraw, it is tax-free.

Individual Retirement Account (IRA)

An IRA is like a 401(k) – contributions are tax-deductible and grow tax-free, but you’ll owe when you withdraw during retirement. Anyone can open an IRA; it isn’t dependent on your employer. If you withdraw before age 59.5, you may need to pay penalties.

Roth IRA

This account is just like an IRA, but the money you put in is taxed, while the money you take out is usually tax-free. You can access contributions before age 59.5, but you’ll owe taxes and a penalty if you withdraw earnings.

529 Plan

Helping your kids save for college? A 529 plan is a tax-advantaged way to save for higher education expenses. You could get a tax break when you contribute to this account, and if you withdraw for education expenses, it won’t get taxed.

Step 3: Safeguard Today and Tomorrow

Life is unpredictable – that’s why the next step is to make sure you’re covered in case of an emergency. It’s not uncommon for families to think they’ve covered all their financial bases, only for an emergency situation to eliminate their income streams or deplete their retirement savings.

This is why life insurance and disability insurance are the two coverages you should strongly consider at this point.

Disability insurance will give you peace of mind if an illness or injury prevents you from working for a long time. This coverage pays a benefit so that if you are sick or injured, you’ll receive a portion of your lost income, helping you keep up with your daily expenses and medical bills.

While many employers offer disability insurance as a benefit, look at your policy carefully – it may not be enough to ensure your family’s long-term income needs. You can purchase an additional policy if you need more coverage!

Life insurance is also important, especially if your spouse or dependants live off your income. This will protect your family in the unlikely event of an early death so they can cover their expenses when they no longer have your income to rely on.

You can choose between a term life policy and a permanent policy. Term life is the cheapest option and will help you maximize your coverage within a certain period. A permanent policy may be more expensive, but you’ll be covered for life, often with additional benefits.

Step 4: Take Care of Your Debt

There are many kinds of debt – some good and some bad. Either way, debt significantly impacts your financial situation, which is why you need to take steps to manage it.

The first step is to list your current debts and put them into different categories, including credit card, student loans, car loans, mortgages, personal debt, or business loans. It’s essential to understand which of your debt is good or bad.

Good debt will help your financial situation over time, including mortgages, student loans, or business loans. You’re essentially investing in your future self with this type of good debt because it will eventually help you grow your net worth or income in the future. Bad debt includes high-interest loans like credit cards or personal debt – this balance isn’t really helping you in the long run, and it’s getting more significant over time.

The next step is to ask for lower interest rates on both good and bad debt. You can consolidate high-interest debt into a single loan with a lower rate. You can even call your lender and ask for a lower interest rate.

Then, you’ll want to cultivate a plan to pay off your bad debt as quickly as possible. Determine how much you can contribute to it each month, then contribute the most money to the loan with the highest interest rate. Once you’ve paid it off, increase your payments on the next-highest interest rate, and so on. Other people take the smallest debt and get rid of it first so it feels like they are making progress. Whatever your strategy is, prioritize getting rid of bad debt!

For example, Dan and Sara have three bad debts: a credit card with an interest rate of 30%, another with a 20% interest rate, and a car loan with a rate of 8%. They decide to take out a personal loan with a 12% interest rate to pay off their high-interest credit card debt, essentially lowering the amount they will pay in total since they are reducing the interest on it. While they keep paying down the minimums on their car loan, they contribute more to their loan each month since it is still at a higher interest rate than their car.

With this strategy, they have reduced their interest rates and will actually pay less toward their debt over time since they are prioritizing higher interest rates first.

Conclusion

With some planning, consistency, and strategic thinking, you’ll be on your way to a solid financial foundation in no time.

If you need help weighing your financial options, securing your future with insurance coverage, or just general financial advice, contact Think Life today – we’re here to serve you and your family!