Category Archives: Financial Planning

Analyzing Personal Finances with Ratios

Financial ratios are a common tool to measure the financial health of a company.  The price-to-earnings (P/E ratio) is a ratio that is commonly referenced by the financial media.  The P/E ratio is a quick measurement for valuing a company that measures the current share price to its per-share earnings.  A company that has a high P/E ratio is normally linked to a stock that investors have high expectations for growth.  The average P/E ratio of the market is in the 25 times earnings range. A value stock will have a low P/E ratio.  Ford (F) comes to mind because it has a P/E ratio of 5.

Another common ratio is EBITDA ratio.  This is giving me a flashback to Accounting 101.  The EBITDA ratio measures revenue with earnings.  EBITDA stands for earnings before interest, taxes, depreciation, and amortization.  It is believed by many financial managers that EBITDA determines the true financial health of a business.

For a business to be successful, its management needs to take stock of its financial health.  For an individual or household to be financially successful, they too should take a deep dive and look at their metrics.  Are there financial ratios that are relevant to personal finance?

There are many different aspects to being successful in personal finance.  There are, however, far fewer variables when it comes to personal finance than the financial management of a corporation.  With that, there are far fewer ratios to measure.

What should an individual investor measure to determine if their personal finances are healthy?  For a business to be successful, it needs revenue.  On the personal finance side, income is needed.  Too much debt is negative for both businesses as well as for an individual.  One sign of a healthy company is that it has many assets on its balance sheet.  That is also true for individuals and the foundation of acquiring many assets starts with having a high savings rate.

Income

Income is what drives your personal finances.  Income is a key factor for those who are working to earn a paycheck.  It is equally important for retirees who require income-producing investments to sustain their standard of living.

To save money, income is needed.  How much should people be saving?  In the 1980’s, Americans were saving 10% on average.  That percentage has decreased over the decades.  American’s are, however, trying to get their savings back on track.  They are currently saving more than 5% on average.

While saving 10% is better than the current rate, it is not as high as it should be.  In the Richest Man in Babylon, a savings rate of 10% was suggested.  I do not know the average lifespan from 5,000 years ago, but I know that it was not as long as people are living today.

To find out if you are saving enough, the saving-to-income ratio is a helpful tool.  To determine the saving-to-income ratio, divide household savings by the average household income.  Savings include everything that is in a 401K, IRA, brokerage account, savings account, and checking.  Real estate holdings such as your house should not be used.  Income includes all earnings from a job, business, and side-gigs.

For example, Sarah is a 25-year-old math teacher.  She has $20,000 in savings.  Her salary as a school teacher is $40,000 per year.  Sarah would have a saving-to-income ratio of 0.62.  Sarah would have a high savings-to-income ratio for age.

A good savings-to-income ratio for a 30-year-old person would be 0.1.  The saving-to-income should increase with age.  At mid-career, a person should have a 1.7% savings-to-income ratio by age 40.  At age 50, with retirement in sight, the savings-to-income ratio should be at 4.5%.  If a person is still employed at age 60, the savings-to-income rate should be in the 8.8% range.

Debt

The second factor consider is to measure debt.  As a member of the financial independence community, I view all debt as bad.  For a more mainstream approach to measuring debt, the debt-to-income ratio is a good measure.

Start with total debt.  Include both good and bad debts.  Calculate the totals for the monthly student loan, credit card payments, mortgage payments, and any other outstanding debt that you might pay every month.  Next, calculate the total monthly income.  To determine debt-to-income ratio: total monthly debt/income.

For example, Jim has $2,000 in monthly debt payments.  His household income is $10,000.  That would equal a Debt/Income Ratio of 0.2%.  That would be considered a reasonable amount of debt.

A household should never exceed a Debt/Income Ratio of 0.36%.  Anything above 0.37% is considered the danger zone.  It is considered the danger zone because of that ratio measures if there is enough household income to cover monthly debts and other obligations.  When the ratio of 0.36% is exceeded, there is less money to cover other expenses as well as for savings.

Savings

The last ratio is an important ratio for retirement planning.  Every personal finance blog, forum, and publication states that people need to be saving more for retirement.  How much exactly should people be saving?

The Saving Rate-to-Income Ratio is a helpful tool to determine how much a person should save for retirement.  An employer match on a 401K plan should be counted.  If an employee contributes 8% of their salary to their 401K and the employer provides a 4% match, the Savings Rate-to-income would equal 12%.

A good starting rate for a young employee who wants to retire early (younger than age 65) would want to start at 12% and try to increase their Savings Rate-to-Income Ratio by 1% per year.  If an employee is satisfied with a more traditional age of 65, the 12% rate should be adequate if it is followed for 40 or more years of employment.

That 12% does not include interest, dividends, or capital gains.  It does not include Social Security withholdings.  The 12% Savings Rate-to-Income also does not include any contributions that an employee makes to a defined benefit plan.

Conclusion

Financial ratios are a useful tool to measure and track how healthy a household’s personal finances are.    With financial ratios, they do not tell the whole story.  They should be used as a helpful tool.  They are useful to gain a snapshot to determine if income is sufficient, debt is at a manageable level, and if savings are high enough to cover future living expenses.

When you calculate the income, debt, and savings ratios, the results might be eye-opening.  If these ratios reflect that your personal finances are not as healthy as you thought, the good news is that they can be improved.  As you work to earn more, pay down debt, or save more, your efforts will be reflected in the ratios.  A 45-year-old should have better ratios than a new college graduate.

Calculate these ratios every six months.  A good time to run them is when you review your asset allocation.  These ratios are for tracking the progress you are making.  As you work to make improvements, your efforts will be reflected in these metrics.

This post might contain affiliate links.

Please be sure to read the Disclaimer page.

Plan for a Better Retirement

I love the entire weekend, but my favorite day of the week is Saturday.  It always has been that way for me.  Sunday is ok, but Sunday is not as good as Saturday.  What makes Saturday exciting for me is that I am off from work, but I am also off the following day.  Monday is still two days away.  That will change after I reach retirement.

When I think about retirement, I see it as a never-ending Saturday.  Retirement is the stage of life when you finally get to live life on your own terms.  There is no longer a boss who you must satisfy.  There are no more clients who you need to please.  You are probably thinking “sign me up”.

I see retirement as a white-board.  Before you reach retirement, it is a good idea to have some plans written down as to how you are planning on spending your time after you no longer have to head off to work to earn a living.  The nice thing about retirement being a white-board is that the markers that you use to write your plan can easily be erased and the plans can be changed.

Retirement is not a short-term endeavor.  If a person retires at the traditional age of 65, it can easily last 25 years or more.  For early-retirees, it can be more than 40 years.  In both cases, there are many factors to consider.

Spending

Spending will be different in retirement.  Some financial writers say that retirement spending is much less than when a person is working.  Sure, there is no longer the expenses for the daily commute, buying and maintaining work clothes, and eating lunch out every day.  Your spending will now be more on hobbies, interests, and travel if you chose to do so.  Just as you monitor your spending when you were working, you still need to have a budget in retirement.  Personal Capital is a great free tool to track spending while working and when retired.

Income     

Income fuels spending.  You need to have a solid grasp of where your income is coming from when the paychecks from work end.  How much are you planning on withdrawing from your portfolio every year?  When will you collect Social Security?  Do you have a pension?  Are you planning on working part-time?  Have a solid understanding of how much income is coming in.  It is still a best practice to spend less than you earn.

Time Management

When you are working, you have to develop time management skills.  Daily tasks need to be finished.  Are you always being pulled away for meetings about special projects?

Time management is also important for managing all your responsibilities at home.  The kids need to be taken to practice.  The house needs to be maintained.  The list can go on and on.

In retirement, time management is still important.  You are retired, and your life is yours to live as you see fit.  Don’t waste your time sitting home and watching tv.  Plan for daily exercise, thought-stimulating activities,  and finding ways to stay fulfilled.

When you are working, you might feel overwhelmed because there is not enough time.  Retirement is the opposite, but it can be equally overwhelming.  You don’t want to find yourself overwhelmed out of boredom.

You have worked your whole life to reach retirement.  Don’t waste it.  Plan on getting out and start living.  Retirement is the time to do what you always wanted to do but did not have the time in the past because work and family obligations were in the way.

People

Be social.  Unless you worked remotely, you probably had coworkers.  Being around other people is healthy and prevents loneliness.

If you have friends, retirement is the time when you get to spend more time with them and to further develop the relationship.  Pick up your phone and call or text them.  Take ownership of the relationship if you value it.  Don’t become a stranger.

The same is true for family.  Retirement is the time to grow closer to your spouse or partner.  You worked hard to have all this time together.  Embrace it.  Focus on making the relationship better every day.  Now that you have the time, put more effort into what you can bring to the relationship.

There is no excuse for loneliness.  There are many not-for-profit organizations that need volunteers.  The options to meet people and to make friends is endless.

Since you are reading this blog, you are most likely interested in personal finance.  Join the Financial Independence community.  There is Rockstar finance, the Bogleheads, ChooseFI, and many more.  These people chat on online forums and social media.  They also have meet-ups in almost every city.  I have made many friends online as well as at various meet-ups.

Conclusion

You have worked long and hard to reach retirement.  This chapter of your life is about how you are going to take advantage of the rest of your life.  Time is a precious gift.  It is up to you to make the most of it.

Retirement is different.  Retirement is a unique dimension of living.  This is the time in life when most people truly first experience freedom.  There are no more deadlines or commitments.

For some people retirement is scary.  They are no longer gilded slaves.  It is their first experience with truly overseeing their life and time.  There is nothing to be afraid of if you do your due diligence.  By putting it down on paper, the fear is reduced.  After you write it down, you have a set of directions to follow and amend as you see fit.

This post might contain affiliate links.

Please be sure to read the Disclaimer page.

Writing an Investment Statement Policy (ISP)

If you are familiar with this blog, you know that I like to have written plans.  The purpose of a plan is to have a guide.  I am not into hardcore manifestos that are rigid and do not allow room to make changes.  I like to have plans that are written in pencil and can be amended when opportunities present themselves.  An Investment Statment Policy is a good example of one such plan.

I believe in being intentional in life.  Before I act, I need to know what my intentions are.  In most situations, the outcomes are out of our hands, but the reasoning behind our actions are not.

By having a written financial plan, it is a map for our financial life.  A financial plan allows us to know where we currently are on the journey to financial independence.  It is also a guide to where we are going and what we should do when we reach different destinations on our financial journey.

As part of every financial plan, there should be an investment statement policy (ISP).  Nobody knows for sure where the economy is heading in the short term.  That is why it is considered wise to have an investment statement policy (ISP) to guide us along the way.

What type of an investor are you

Having an investment statement policy enables you to define who you are as an investor.  Are you a value investor who looks to buy low-priced stocks?  Do you follow a three-fund approach and like to own all the stocks in a market capitalization-weighted portfolio?  Are you comfortable with average market returns or do you try to beat the market by investing in actively managed mutual funds?  Do you invest in hot-trends like Bitcoin or alternative investments like crowdfunding?

By knowing the type of investor that you are will give direction to your decisions.  It will prevent you from chasing the hot investing tips that your coworkers are talking about at the water cooler.  Before you buy or sell an investment, you will look at your investment statement policy and ask yourself if it follows what you have established in your plan.

Know what you own

Without looking, could you list all your investments?  Could you explain why you own them?  What was your reasoning for adding a given ETF or individual security to your portfolio?

If you cannot list all your investments in less than a few minutes, you might have too many different investments.  If you cannot explain why you own an investment, you probably should not own that investment.  The same is true if you cannot give a sound reason as to why you bought an investment in the first place.

An investment statement policy can remove all those ambiguities that are tied to your investment decisions.  By having an ISP, you will know the why behind every investment in your portfolio.  Your investments will have a specific purpose in your portfolio.

Risk and return

Different asset classes come with different levels of risk and expected returns.  Conservative investments like FDIC insured savings accounts normally have low returns because the returns are guaranteed by the government.  Small-cap value stocks or emerging markets have higher than average returns because an investor is taking on more risk when they invest in these asset classes.

Do you know how much risk you are comfortable with?  Would you be able to keep buying more shares of an investment if it lost (30%) of its value in one year?  Do you think that you could hold onto an investment if it produced negative returns for a few years in a row?

By having an investment statement policy, these decisions will be made in advance.  If you have established that you see market volatility as a time to buy low, you will have established bands that will trigger when it is time to buy.  If you are not comfortable with short-term volatility, your investment statement policy will have already established a more conservative asset allocation that has less volatility.

Time Horizon

When will you be spending the money that you have invested?  Are you planning on retiring in 5 years, 15 years, or longer?  Knowing the answer to that question will help to establish how much of your money should be in equities and how much should be in fixed assets.

If you will not be retiring for ten or more years, holding a higher asset allocation of equities might be suitable for your situation.  If you are recently retired and are following the 4% rule, an asset allocation of 100% in stocks would be too aggressive due to market volatility.  When you are young you have time to recover from market corrections, but after you retire a (50%) market decline or prolonged recession could easily force a retiree back to work.

By having an investment statement policy, an investor can review their timeline annually.  An investment statement policy can help an investor with monitoring their path to retirement.  On that journey, the investment statement policy can guide them as to when it might be time to reduce some portfolio risk as retirement nears.

Monitoring Performance

Do you know what the expected return of your asset allocation is?  How is your portfolio performing this year?  Do you know how much your portfolio is up or down over the past 12-months?  Do you know what your average return was for the past 5 or 10 years?

Monitoring the daily performance of your investments is not helpful.  Listening to the daily market reports is an emotional roller coaster. In can do more harm than good and cause you to panic when there is short-term volatility.

By having an investment statement policy, you get to establish when you monitor your investment returns.  You can monitor your investments quarterly, twice per year, or annually.  If you are a passive investor, it could even be every other year.  It is your plan and up to you to establish how it will be monitored.  Personal Capital is a useful tool for monitoring the performance of your investments and it is free.

Skill Level

Are you a personal finance nerd?  Do you read investing forums, listen to podcasts, or attend local chapter meet-ups?  Do you write your own blog or are active in the financial independence community?  As a member of the financial independence community, you are most likely comfortable writing and updating your investment statement policy.

If you are not comfortable managing your own portfolio, there are many good financial advisors out there.  Even if you hire a professional to manage your money, work with them to help you to establish your investment statement policy.  You want to be sure that their decisions align with your needs and long-term goals.

Conclusion

Be intentional about your investment decisions and know the why behind every move.  Having an investment statement policy will help you to stay true to your long-term goals.  It is an invaluable part of a written financial plan.  An investment statement policy is useful to keep you focused on long-term goals when internal or external forces might be tempting you to stray.

After you write your investment statement policy, review it at least once per year.  Update it when needed.  Our financial situations are not static.  The investment statement policy will be different for everyone.  Your ISP will also change with time.  It is recommended to make amendments when a change is needed.  Just be sure that you can explain and make a sober justification for the change.

This post might contain affiliate links.

Please be sure to read the Disclaimer page.

Financial Planning for New College Graduates

You did it.  You earned your college degree.  Congratulations on this major life accomplishment. Now it is time to learn about financial planning for new college graduates.

Hopefully, you have a job lined-up in your field of study.  If not, don’t get overwhelmed.  Start applying and interviewing.   Before you know it, you will be working, growing your career, and earning a paycheck.

The good times are not over, but it is time to enter the real world.  By starting this next chapter of your life on the right track, you will be able to better ensure a sound financial future.  Right now, time is on your side.

As a new college graduate, I am sure the last thing on your mind is retirement.  Retirement might be many decades away, but the actions you take in the coming years will shape your financial future.  Below are the key steps that will help you to establish a plan that will guild you on your journey toward financial independence.

Step 1 – Save 15% of your salary.  Start this process of saving with your first paycheck.  It might sound like a high percentage, but this is just the first step.

Step 2 – Sign up for your employer’s retirement savings plan.  If you work in the for-profit universe, it is called know as a 401K.  At a not-for-profit organization, it is called a 403B.  If you work for the Federal Government, it is a Thrift Savings Plan (TSP).  On your first day of work, go to the Human Resources office and sign up to contribute 15% of your salary to their retirement savings plan.  Increase the amount that you contribute to your retirement plan by 1% every year.

Step 3 – If possible, only Invest using low-cost mutual funds and index funds.  Avoid trying to pick individual stocks or trying to time the market.  Identify an asset allocation that best matches your age and risk tolerance.  Historically stocks have produced higher returns than bonds. Stocks, however, are more volatile.  On the other hand, bonds are less volatile but do not keep up well with inflation.  Establish a plan that uses both stocks for growing your wealth and bonds to retain your wealth during bad economic times.

Step 4 – Establish a plan to pay off your student loan debt.  Don’t fall victim to the mindset of the masses when it comes to student loans.  You attended college and earned a degree.  Hopefully, you paid attention in class and are ready to put your degree to work for you as an employee.  You attended class, possibly lived in a dorm, and most likely ate your meals in the cafeteria.  It is time to pay back what you owe.  Avoid self-pity and feelings of entitlement.  Those ill feelings will just hold you back on many levels.

Step 5 – Get a part-time job.  For those who have the entrepreneurial spirit, start a side business.  You are young and full of energy.  Now is the time for you to be working and building a solid financial foundation.  Getting a part-time job will allow you to earn extra money.  Working a couple of evenings during the week and picking up some hours on the weekend will greatly help to increase your earnings. That extra money can be used to pay off your student loans, establish an emergency fund, or open a Roth IRA.

Step 6 – Put off attending graduate school.  Unless you work in an industry that requires a graduate degree to obtain entry-level employment, put off attending for a couple of years.  Find an employer who offers tuition assistance as part of their compensation package.  That will allow you to work in the day and take graduate classes in the evening or on the weekend.

Step 7 – Write a financial plan.  A financial plan is a map.  It allows you to identify where you are at from a financial standpoint.  A financial plan is also a map that can be used as a guide to where you want to be in the future.  It helps to have a guide than to go it alone.  Financial planning is too important of a topic to not have a plan and just fly by the seat of your pants.  A financial plan is a living document that needs to be reviewed annually.  The great feature of a financial plan is that it can be amended as your plans and goals change.

Step 8 – Establish a budget.  Calculate how much you will earn every month from your job.  Write out your budget based on percentages.  Know how much of your salary will go towards housing, food, entertainment, and every other expense.  Be sure to write a budget that is practical in terms of expenses and prudent in terms of savings. In other words, always try to reduce expenses and to increase savings.

Step 9 – Keep your transportation costs low.  Transportation costs are simply an expense in your budget.  Use your budget as a guide to determine how much you can afford to spend on a car.  Keep your transportation costs at 11% of your budget.  Your budget will determine if you can afford a fancy new car or a used economy model.  Try to keep in mind that a car does not determine your identity.  It is just what enables you to travel from Point A to Point B in a timely manner.

Step 10 – Keep your housing costs as low as possible.  If you are renting, try to find a roommate or two.  Having a few roommates greatly reduces the amount you will have to pay for rent every month.  As you advance in your career and if you have a family, you might consider buying a house.  Use your budget as a guide to determine how much house you can afford.

Step 11 – Be sure that you are properly insured.  If you are under the age of 26, you should be able to remain on your parent’s health insurance.  If not, ask your employer about when you are eligible for coverage under their plan.  You are young and most likely healthy, but one trip to the emergency room could ruin you financially if you do not have proper health insurance.  Also, be sure that you have the proper amount of insurance for your car, home or apartment, and life insurance if you have a spouse or children.

Step 12 – Avoid Debt. Keep your debt to a minimum.  Avoid payday loans and credit card debt at all costs.  Having a high credit score is important because it will allow you to get the most favorable interest rates if you do have to borrow money.  To ensure you do not take on too much debt, monitor your debt with the Debt-To-Income Ratio.  Always try to keep your DTI under 16% and never exceed 36%.  In life, sometimes debt is unavoidable.  Most people will have to take out a mortgage to purchase a house.  Some people will have to take out a car loan in order to have a means of transportation.  When doing so, use both your budget and DTI to determine how much you can safely afford.

Conclusion

There you have it.  You are finished with college and ready to take on the world.  Don’t put off applying these steps.  You can start implementing some of these steps on your first day of employment.  If you start out with a well-established plan, you will be well ahead of your peers.  Use these steps as a guide and you will surely become a financial success story.

Do you agree with these suggestions?  Do you think that anything is missing from this plan?  What would you add or do differently?

This post might contain affiliate links.

Please be sure to read the Disclaimer page.

 

 

The Roth IRA is 20 Years Old

The Roth IRA is 20 years old.  Where does the time go?  Time sure does seem to fly when you are having fun.  It seems to go faster when you are dollar-cost-averaging and building wealth.

That is exactly what the Roth IRA has done over the past 20 years.  It has been a great wealth building tool for many individual investors.  Since it was created, I have been depositing money into my Roth IRA in the form of dollar-cost-averaging with almost every paycheck for the past 20 years.

The Roth IRA has come a long way in 20 years.  The Roth IRA is named after William Roth a Senator from the state of Delaware and was part of the Taxpayer Relief Act of 1997.  What makes the Roth IRA different from a Traditional IRA is that unlike the Traditional IRA, there are not any immediate tax deductions.  The Roth IRA is funded with after-tax earnings and when the money is withdrawn at retirement, it is tax-free.

When I first started investing, the Roth IRA was not available.  It did not become available until I was investing for about 1-year.  As soon as I learned about the Roth IRA, it sounded like a great wealth building tool.

When the Roth IRA was first introduced, the annual contribution limits were only $2,000 per year for an individual who qualified. From 1998 until 2001, the contribution limits were $2,000. The contributions limits have slowly been increasing over the past 20 years.  In 2002, people over 50 have been allowed to contribute more in the form of a catch-up contribution as they got closer to retirement age.  In 2018, individual under the age of 50 can contribute $5,500 per year and people who are over age 50 can contribute $6,500 per year.

There are income limits on who can take advantage of the Roth IRA.  Single filers who earn less than $120,000 qualify for a full contribution.  Single filers who earn between $120,000 and $135,000 are eligible for a partial contribution.  Joint filers who earn up to $189,000 can take advantage of the full contribution.  Joint filers who earn between $189,000 and $199,000 are eligible for a partial contribution.

Since my wife and I earn less than $189,000 we are able to better diversify out retirement tax strategy.  We contribute to our Traditional 403B accounts to reduce our annual taxable income. We also contribute to our Roth IRA accounts to have money that can be withdrawn tax-free later on in retirement.

What if you want to contribute to a Roth IRA account, but do not qualify.  For those folks, there is a Backdoor Roth IRA method that could be used to convert a traditional IRA into a Roth.  That approach is more complicated based on taxation.  It might be wise to check with a CPA before trying to implement this strategy.

Unlike a Traditional IRA or 401K, there are not any Required Minimum Distributions (RMDs) with a Roth IRA.  In a Traditional IRA account, the money has to start to be withdrawn at age 70 ½. That is not the case with a Roth IRA.  The money never has to be withdrawn.  It can remain in the Roth IRA and the money can keep growing.

Since the money never has to be withdrawn, it is recommended by many financial professionals to drawdown Roth IRA accounts last.  We have added that strategy to our retirement drawdown plan.  Based on our age and different types of investment accounts, we will be following a Buckets Approach to funding our retirement.

We will first drawdown our taxable accounts.  The second source of retirement income will come from our Traditional IRAs based on the RMD schedule.  If we live long enough, the last source that we plan on drawing down is our Roth IRA accounts.

There are many benefits with passing on a Roth IRA to a surviving spouse.  They are not forced to take RMDs. They can roll the inherited Roth IRA over into their own Roth IRA.  They can also continue to contribute to the Roth IRA with new earnings.  These benefits do not apply to someone who inherits a Roth IRA who is not the spouse.

Another benefit of a Roth IRA is that you can withdraw money from the account prior to being age 59 ½.  With a Traditional IRA, there is a penalty for early withdrawals.  The money that a person withdraws early is taxed as ordinary income.  There is also a 10% penalty unless it is considered a special circumstance.  With a Roth IRA, there are not any penalties if the money that is taken out is limited to contributions.

Over the past 20 years, the Roth IRA has become a very popular type of retirement account.  According to the Employee Benefit Research Institute, more than 29% of all individuals have a Roth IRA account.  That is an amazing statistic since so many Americans struggle with saving money for retirement.

There are few things in life that most people agree on.  In the world of personal finance, I cannot think of anyone in the financial independence community who does not like the benefits of investing in a Roth IRA account.  It is hard to not see and embrace the ability to build wealth in an account that allows people to have tax-free income at retirement.

Do you invest in a Roth IRA account?

This post might contain affiliate links.

Please be sure to read the Disclaimer Page.