Setting up an Effective Financial Plan

Successful financial planning requires several deliberate steps.

A financial plan is a course of action for managing your money in a way that allows you to meet your financial obligations and wants.

Financial planning is important because it allows you to meet short- and long-term goals, stop making financial decisions based on fear, and help you prioritize major money moves at every stage of life.

A financial advisor can help you establish a customized financial plan for your needs, especially if you are investing for the first time.

But you can also establish a do-it-yourself financial plan that keeps you accountable for making good choices and sets you up to succeed financially, both now and in the future.

Create a Budget

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No matter how much money you make each month, you can always spend more than you earn. This is a habit that can derail your financial plan. In order to truly manage your money and improve your financial future, you need to evaluate your finances and set up a working budget for each month.

A budget is a spending plan that gives each dollar you earn a purpose. It allows you to determine whether you are meeting your financial goals and puts you in control of your money.

Although a budget may seem to require a lot of work when you're creating a long-term financial plan, a basic budget is surprisingly easy to create. List your monthly income and essential expenses, both fixed and variable. Then, subtract your expenses from your income to figure your discretionary spending amount, which can include "wants" like dining-out costs along with long-term savings and debt repayment.

Then, put together a budget for the month based on your financial priorities. For example, with the 50/30/20 budget, 50% of your take-home pay goes to needs, 30% goes to wants, and another 20% goes toward savings or debt repayment.

If you need help budgeting, consider using software or the envelope system, whereby you divvy up cash for different spending categories between different envelopes to help you control your spending. Establishing and following a budget is the key to financial planning because it instills the discipline needed to make the rest of your financial plan a success.

Eliminate Debt

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Getting out of debt is an important component of financial planning because the high interest you pay on certain debts can prevent you from saving money for the future or investing.

Establishing and implementing a debt repayment plan takes discipline, but it is possible. The right repayment plan for you depends on the amount and number of debts you owe.

If you have a lot of high-interest debt, for example, list all debts in order from highest to lowest interest rate. Pay any extra money you have toward the first debt. Once you have repaid it, move onto the next debt, repeating this process until you have repaid all your debts. If you have too many debts, consider paying off the one with the smallest balance first and then paying down those with larger balances.

You may need to drastically cut your spending and increase your earnings in order to pay the debt off more quickly. Once you are out of debt, reduce or even eliminate the use of credit cards to avoid going into debt again. When you do use your cards, pay the monthly statement balance in full within the grace period to avoid incurring interest.

Build an Emergency Fund

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Having a financial safety net is a key component of financial planning. This is why it's important to build an emergency fund of three to six months' worth of living expenses. This financial cushion will allow you to cover unplanned expenses and leave your long-term savings and investments alone, keeping your financial plan on track.

As the name suggests, an emergency fund should only be used for real emergencies, such as a job loss or sudden medical expense. Importantly, when you dip into your emergency fund, aim to bring it back up to the full amount as quickly as possible to ensure that the funds are there when you need them again.

You can incorporate an emergency fund into your financial plan by directing as little as 2% of your take-home pay into a separate savings account from where you do your everyday banking. After six months, consider increasing that contribution by 1% to 2% every six months to one year to build the financial cushion even faster.

If you earn $45,000 per year, a 2% savings rate will grow your emergency fund by $12 a week, or $624 per year, after taxes.

If you're creating your financial plan while you're still in debt, consider reducing payments on lower-interest debts (while still paying the minimums) and putting the extra money in your emergency fund. This strategy will help you pay down debt and build a financial safety net.

Invest for the Future

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You can't achieve major financial milestones like retirement or a fund for your child's higher education without careful financial planning. One of the best ways to grow your money to pay for these large expenses is to put it into mutual funds, stocks, and other investments in a retirement or other investment account during your prime earning years.

If you have high-interest debt, such as credit card debt, pay it down before investing. That's because your annual investment returns generally won't be sufficient to recoup the exorbitant interest costs you will pay on these debts. After you have done that, begin to build your retirement and investment savings.

A financial planner can help you determine the specific amount that you need to save each year to comfortably retire or meet your other long-term investment goal. Experts generally recommend that you put 15% of your gross income into retirement each year. That figure assumes that you will need between 55% and 80% of your pre-retirement income to live comfortably in retirement. If you have more ambitious retirement goals—for example, you want to retire early or with a larger-than-average nest egg—aim to increase the savings percentage.

You can save for retirement through an employer-sponsored 401(k) plan or a traditional or Roth Individual Retirement Arrangement (IRA).  For other goals, consider taxable brokerage accounts and other investment vehicles.

Unlike Roth IRA contributions or Roth deferrals to a 401(k), which are not tax-deductible, traditional IRA and 401(k) contributions are tax-deductible because they are made with pre-tax dollars.

As you draw closer to retirement, you might want to move more of your money into safer investments (cash and bonds, for example) that will not be as affected by market fluctuations. This way, you will still have the money you need if the economy crashes. When you're younger, you can keep more of your money in volatile but high-growth investments like stocks because there is still time for the market to recover. A financial advisor can help you identify which investments are right for you.

Diversify Your Portfolio

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If you are on track with your retirement and other investment goals, consider investing in other products like annuities or real estate. Investing in a variety of different asset classes helps minimize significant losses in any one asset class since the returns of different assets don't always move up or down in tandem.

During an economic downturn, for example, you might be able to draw a fixed monthly income from a rental property even as stock returns are diminishing. If you are consistent and careful with your investments, you might even reach a point when your investments generate more income than you do.

Set up a Sinking Fund

Even if your investments are liquid, or can readily be sold, you don't want to dip into them to pay for other expenses. This means that you'll need a sinking fund to meet other financial goals. Unlike an emergency fund, a sinking fund is one you rely on to pay for planned expenses, such as a down payment on a house or a vacation.

It's best to establish separate bank accounts for your sinking fund—either one account that you use for all your savings goals or separate accounts for each savings goal.

Socking away a small percentage of every paycheck into a sinking fund will help you grow it over time.

When you have met your goal amount, spend the money in the sinking fund; there's no need to replenish the money in the account as you would with an emergency fund.