Financial Literacy: The Four Basic Steps of a Bullet Proof Plan

Written by Dr. Lucas Dyer, Financial Advisor, Northwestern Mutual

Planning with money is both emotional and logical. Before having my own financial planner, which I have had since 2012, many decisions were made based on emotions. Paying my house off fast. Taking a loan out for the longest time possible to get a cheaper monthly payment. Purchasing something now and saying I will pay this off later is all emotional. The logic would tell me that the math does not add up and, in most cases, does not make sense. However, many people try to make emotional decisions with logic and logical decisions with emotion. It just doesn’t work! Financial Advisors help people separate the two. This article will outline four steps to help you organize your thoughts, allowing you to separate the emotional decisions from the logical choices.

Understanding Your Cash Flow

The logical aspect of understanding cash flow is knowing your burn rate. How much does each month cost you to live your life? All expenses are tossed in, and from there, how much is left over each month from your monthly pay after taxes (net pay)? The second is knowing your net worth (assets minus liabilities). The numbers are what the numbers are. From a logical standpoint, this is simple math.

Risk Management (income protection)

Mitigating risk is pure emotion and is overlooked in many financial plans. It is not fun, nor does it yield any instant gratification. But it is the only area that will protect your income should you become sick or injured. For most employers, generally, this is 60% of your base pay (before taxes), excluding any bonuses, and is provided for a short time, usually less than a year. This 60% is taxed at your ordinary income rate by the IRS and ends up being closer to 42% to 50% of your actual pay after taxes. If you were hurt and could not work or perform your duties, could you live off half your pay? Adding additional income protection is a sure way to maintain your ability to earn income and ensure you have a foundation to continue to build. Logic says no money in equals no money out. Emotionally, many say, “I will be ok as I won’t become injured,” or “I won’t get sick.” These are simply not true.

Risk Management (life insurance)

Many of my clients tell me they wish they could have a lot more life insurance. They wish they would have bought it sooner and kept it longer. Many wait until a life-changing event to purchase coverage; that’s an emotional decision. They just got married. Just had a child. Just bought a house, etc. Very few think about this with logic. Life insurance is based on two factors impacting price: age and health. The younger and healthier you are, the more affordable it is. There are two types of insurance: term and permanent life insurance (PLI). The term insurance is just that, kept for a period, a term, typically 10 to 30 years or until age 80, then goes away. You can outlive this, which is scary for many entering their later years. PLI is permanent, stays with you your entire life, and provides several tax benefits and cash accumulation. You cannot outlive this, which offers peace of mind until the day you pass.

Investments and Retirement

Investing is logical in that money is put away into various accounts. It is based on math and percentages, which provide a rate of return (ROI) progressing toward growth and accumulation. All of these accounts are subject to tax laws and stock market volatility. The accounts are usually divided into five distribution buckets, but these three are the most common:

Non-Qualified: This is not recognized by the IRS and is not tax deductible. Non-qualified is usually an investment account or individual stocks. This account can be accessed (liquid), but taxes will be paid on any gains, called capital gains tax, or taxed as ordinary income.

Qualified: 401k, 403b, and IRA are the most common. All are taxed at the end. No taxes are paid to go in, but they are taxed when you pull money out as ordinary income. These accounts cannot be accessed without penalty until age 59.5 and, in some cases, will require required minimum distributions (RMDs) at age 73. Meaning the IRS will make you take money out and pay taxes on that money. In most cases, yearly contributions are capped but will reduce taxable income for that filing year.

Roth: All are taxed at the beginning, contributions are generally not tax-deductible, and you can’t report contributions to the IRS. The money is taxed going in but not during growth or upon distributions. Money can, in some cases, be taken out prior to 59.5, but in general, 59.5 is the magic number.

Speaking with a professional about taxes and financial planning is always best. The information provided will help you better understand the emotional and logical aspects and organize your thoughts as you start planning today to live a better tomorrow.

For a deeper level of understanding or to see what my team and I can do for you, please reach out and let’s connect, or follow me on LinkedIn.

By Paolo Cantos
Paolo Cantos