The first step of the financial planning process is to develop a budget. A budget is a analysis of all your inflows [income] and outflows [expenses] in a year. Whatever your goals, short-term or long-term, achieving them starts with a detailed of how much income you have coming in a calendar year and how your are spending it.
- Its okay to start with a monthly analysis, but since some expenses are variable or periodic rather than monthly, it is better to end up with a calendar year budget.
I would suggest there are several steps in developing and analyzing a budget.
- Note: There are a variety of online sources for a budget worksheet.
Calculating Your Spendable Income
Your spendable income is your income after pretax deductions and income taxes.
- Determine your gross annual income which incudes gross earned income and passive income such as the net [after expenses] income from rental property. It also includes taxable interest, dividends and capital gains distributions from after-tax accounts.
- From this amount deduct pretax deductions from gross income which include:
- Retirement Plan salary deferral to a 401-k, 403(b) 457, SARSEP Plans. For self- employed it includes Traditional IRA, SEP, Keogh etc.
- Deduct other pre-tax contributions such as your share of health insurance costs and/or health savings account [HSA] contributions for example.
The remaining amount is your taxable income.
- From this amount deduct estimated income taxes [federal, state, social security and Medicare taxes.
After completing the above, you have calculated your spendable income which is the annual cash you have to live on, pay off debt and save and invest. I would suggest breaking this amount into thre sub-divisions.
- Contributions to after-tax savings and/or investment accounts including bank accounts and after-tax investment accounts.
- Fixed expenses such as mortgage/rent, installment loan payments, credit card payments, utilities including cable, insurance costs [property/casualty, life, basic food expenses, can credit card payments.
- If you pay real estates taxes separate from your mortgage, list separately as a fixed expense.
- Variable expenses which include non-basic food expenses, clothes, entertainment [includes eating out, streaming services, etc], athletic clubs, charitable contributions.
- Note: If you pay your bills with a credit card, many card companies will provide a detailed breakdown on your credit card expenses on their website.
After completing the above, you should have a good picture of where you money or spendable income is going.
Now it is a time to look for red flags. Red Flags [RF] are anywhere from caution, to warnings, to “oh oh, we have a serious problem.
- RF1. Does your fixed and living expenses exceed your spendable income. This means you are spending more than you are making and is huge RF. It also means you are either draining savings including retirement accounts and/or financing your lifestyle with debt, most likely credit cards.
- RF 2, do you have consumer debt? Consumer debt are living expenses, most often variable expenses which are financed with credit cards and at the end of the month you are unable to pay off your credit card debt and end up paying a high interest rate on the purchase until the card is paid off.
- For example, if you have a $100 balance on your credit card that you cannot pay off and because each month you add to the balance, after 12 months at 20% [current average credit card rate] this $100 actually has a cost to you or payoff of $122.
- RF 3, are you saving and investing for future goals, retirement for example? If so, how much and are on track to retire comfortably.
Consumer debt is like a rope pulling you back when you want to go forward. I would suggest your first priority is to pay off all your consumer debt as fast as possible. This starts with listing each debt, current principal, interest rate and monthly payment. With this information, you can calculate how long it will take to pay off each loan.
Once you have this information, I would suggest the following:
- As you pay off one loan, apply that payment to the remaining highest interest rate loan.
- If you have additional cash flow, apply it to the loan with the highest interest rate.
Going forward, if you cannot pay cash, you cannot afford it. Period!
Detailed Budget Analysis
If you have any or all of the above Red Flags, do a detailed budget analysis. [Its a good idea at all time, but especially if you have the RFs.]
- Note: You can find forms for preparing a detailed budget at various online websites.
The objective of the detailed budget analysis is to assess how you are spending your money. It will enable you to look at areas which you can spend less.
An easy example is if you are stopping by your favorite coffee shop daily and buy a $5 coffee. That’s fine if you have no RFs and are meeting your long-term savings objectives. However, if you have any of the RFs, then you need to rethink this expense.
Simply, if you have one or more RFs, I would suggest you need to look at every expense and determine if can be reduced or eliminated. This can be very hard as “wants” in our every day life are hard to give up even if we cannot afford them.
Two Options for Red Flags
If you have RFs, you essentially have two options.
- One, increase your income either by changing jobs or careers to obtain a better paying job or adding and additional job to your current job.
- Two, reduce your expenses.
If you have red flags, the only way to eliminate them is to do one or the other or both.
Developing a budget will not only help you track your income and expenses and address Red Flags if you have them, but perhaps more important, provide peace of mind because you have the basis of a financial plan.