Recognizing the need for a financial plan is a significant first step toward achieving personal financial security. In this article, we’ll go into detail on what to think about when it comes to financial planning, as well as a step-by-step process of how to build a sample financial plan that aligns with your personal goals and needs.
Table of Contents
- What is a Financial Plan?
- Why is Financial Planning so Important?
- Crafting Your Personalized Financial Plan: A Step-by-Step Guide
- The Role of a Wealth Manager or Financial Planner
- Harness Wealth Can Help
What is a Financial Plan?
A financial plan is a comprehensive blueprint designed to help you meet your financial goals, whether that’s achieving a comfortable retirement, sending your kids to college, or planning for unforeseen events. It’s more than just investing—it’s a holistic approach that covers all aspects of your financial life.
Financial planning is about understanding and utilizing your assets in a manner that helps you and your family work towards achieving your goals and meeting your needs. While it may seem like a luxury that is only available to the wealthy, anyone is capable of building an effective financial plan and putting it into action.
Without effective personal financial management, you risk losing money to poor budgeting, poor tax planning, or even just to inflation. An effective financial plan helps you avoid these pitfalls and aligns your financial habits with your short-term and long-term goals.
Why is Financial Planning so Important?
There are several reasons why financial planning is crucial:
Sitting on Idle Cash Can Be Expensive
For many of us, financial planning begins with being taught the importance of saving money. On the surface, it’s a smart idea, but saving too much money can ultimately cost you.
Let’s consider the potential cost of idle cash. According to the FDIC, as of May 2023, the average interest rate on savings accounts was 0.40%. This is less than the average annual inflation rate, which averaged 2.5% per year from 2013 to 2022, according to the U.S. Bureau of Labor Statistics. Therefore, if you leave your money sitting in a traditional savings account, you’re ultimately losing money as the years go by.
There are many strategies for effectively managing idle cash, from high-yield savings accounts to bonds and other fixed-income products. If holding cash is an important part of your financial management strategy, sophisticated idle cash management could be worth considering, but you should still be aware of the impact that inflation and taxes will have on your returns over time.
Taxes and Inflation: The Silent Killers of Returns
Annual returns on investments are affected by both inflation and taxes, and they can drastically reduce the actual returns of your investments. A well-built financial plan can help you navigate these intricacies. Take, for example, the below chart, which highlights the impact that inflation will have on various returns based on historical data from 1926-2019.
The Impact of Taxes and Inflation on Investment Returns (1926-2019)* |
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| Gross Return | After Inflation | After Inflations and Taxes | |
| Stocks | 9.90% | 6.70% | 4.70% |
| Bonds | 5.50% | 2.40% | 0.40% |
| Cash | 3.60% | 0.80% | -0.70% |
*This chart reflects historical gross returns without the deduction of certain fees and expenses. Gross returns do not take into account the deduction of all fees and expenses incurred by investors, including management fees, performance-based fees, expenses, transaction costs, and other fees.
As you can see, both inflation and taxes can drastically reduce the actual returns of your investments. And while a nearly 10% return on stocks over a 1-year period may seem pretty good on the surface, it quickly erodes to not much more than what a high-yield savings account might advertise.
Rule of 72: Understanding Your Investment Timeline
On a similar note, the Rule of 72 is a concept used to estimate the time it will take for an investment to double, given a fixed annual rate of return. It involves dividing 72 by the annual interest rate. The Rule of 72 can give you a better understanding of your potential investment growth over time, aiding in the creation of a more precise financial plan. The table below provides an illustration:
The Rule of 72 |
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| Annual Interest Rate | Years to Double | ||
| 1% | 72 | ||
| 2% | 36 | ||
| 3% | 24 | ||
| 4% | 18 | ||
| 8% | 9 | ||
| 16% | 4 | ||
As you can see, the time to double quickly accelerates under what might on its own not feel like too big of a change on a percentage basis. Every penny counts when it comes to investing, and an effective financial plan can help you navigate these intricacies.
An effective financial plan can save you money
It may seem daunting knowing the impact that taxes and inflation can have on returns over time, but there are solutions. By effectively leveraging retirement accounts, charitable giving, and other tax-advantaged strategies, you can work to maximize your take-home income.
Exploring Illustrative Economics
Consider the comparison below between a pre-tax retirement account and a post-tax alternative. Assuming an average yearly return of 10% and an investment period of 30 years, the Roth IRA provides superior returns due to its tax-free growth and withdrawal benefits:
| Roth IRA | Ordinary Income | |
| Post-Tax Investment Account | $6,400 | $6,400 |
| Average Annual Return | 10% | 10% |
| Investment Period | 30 years | 30 years |
| Investment Value After 30 Years | $111,677 | $111,677 |
| Capital Gains Owned | N/A | 25% |
| Investment Value After Taxes | $111,677 | $83,758 |
| Scenario 1 | Ordinary Investment | |
| 2020 Income | $300,000; Tax Rate: 35% | $300,000; Tax Rate: 35% |
| 2021-2024 Income | $150,000; Tax Rate: 24% | $150,000; Tax Rate: 24% |
| Donate | $5,000 each year | $25,000 into a Donor Advised Fund with the ability to give over the same period |
| Tax Deduction | $6,550 (or less if you take the standard deduction in some years) over 5 years | $8,750 next year |
To achieve the same returns as a Roth IRA without the capital gains tax benefit, the initial post-tax investment would have to increase by approximately 31%.
Maximizing returns on startup equity
Financial planning becomes especially critical for those involved with startups—whether you’re an employee with equity compensation, an investor, or a startup founder. Effectively managing your equity can significantly reduce your tax burden in the event of an exit. One key strategy to consider is an 83(b) Election, a provision for early exercise of share that allows individuals to pay taxes on their equity when granted, not when vested.
To illustrate the benefits of this, imagine you were granted 100,000 shares at $1 each. Without an 83(b) Election, if the shares appreciate to $5 by vesting, you’d owe tax on $400,000. But with an 83(b) Election, if you paid taxes upfront on the original $100,000, you would only pay tax on any gains when sold. In this case, potentially saving $140,000 in taxes.
Making a Difference: Planning for Charitable Contributions
Your financial plan can also cater to your philanthropic goals, which can also come with tax advantages. Consider a scenario where you aim to donate $5,000 to charity annually for five years. You could opt to donate $5,000 each year or place $25,000 into a Donor Advised Fund with the ability to give over the same period. Each scenario offers different tax deductions, depending on your income and tax rate.
Goal: Donate $5,000 to charity for 5 years:
| Scenario 1 | Ordinary Investment | |
| 2020 Income | $300,000; Tax Rate: 35% | $300,000; Tax Rate: 35% |
| 2021-2024 Income | $150,000; Tax Rate: 24% | $150,000; Tax Rate: 24% |
| Donate | $5,000 each year | $25,000 into a Donor Advised Fund with the ability to give over the same period |
| Tax Deduction | $6,550 (or less if you take the standard deduction in some years) over 5 years | $8,750 next year |
Understanding these scenarios allows you to plan your charitable contributions in a way that aligns with both your personal and financial goals, while simultaneously maximizing your tax benefits.
Crafting Your Personalized Financial Plan: A Step-by-Step Guide
Now that we’ve covered how to think about financial planning, let’s go into step-by-step detail on how to create a personalized financial plan. Please note that the following is for informational purposes only and that this is not financial advice.
Step 1: Understand Your Current Financial Position
Your financial plan begins with a comprehensive audit of your finances.
First, gather all your assets, which should include all cash and investment accounts, as well as other assets such as your home, car, company stock options or equity grants, or perhaps even fine art and other valuables.
Next, gather all your liabilities, which, in simple terms, is any debt you may have, such as credit card debt or other high-interest debt, student loans, a mortgage, a car loan, etc.
Finally, to calculate your net worth, simply subtract your liabilities from your assets.
For example, if your assets are worth $500,000, and you have $100,000 in liabilities, then your net worth is $400,000 ($500,000 – $100,000). By knowing your net worth, you can gain a realistic perspective of your current financial position, and an understanding of what you need to change, starting today, to get to where you want to be. For real-time tracking of your net worth and other assets, consider the suite of tools offered by Harness Wealth.
Understand Your Current Cash Flow
You should also take a moment to understand your current cash flow, which is the money coming into and going out of your account each month. To do this, simply subtract your expenses from your income. If you have a positive number, you have positive cash flow. If you have a negative number, you have a good opportunity to learn and make improvements.
For example, if your monthly take-home pay is $10,000, and you spend $3,000 on rent and utilities, $500 on transportation, and $1,000 on living expenses, your positive monthly cash flow is equal to $5,500.
From the net cash flow calculated above, you’ll be able to quickly understand if any lifestyle or budgetary changes are needed. If you have a high positive monthly cash flow, perhaps you could dedicate more money each month toward paying off debt. Or if you have no debt, perhaps you could dedicate more towards a personal hobby, as taking care of your physical and mental well-being is just as important as your financial health.
Step 2: Outline your goals and needs
Now that you have your net worth calculated and your cash flows assessed, it’s time to set goals for your financial future. These could include predictable needs like accumulating significant retirement savings or investments, or loftier goals like buying a vacation home or starting a new business. To make things even easier, we recommend splitting your goals and needs into three distinct categories:
- Needs: These are your necessities: housing, food, emergency fund, healthcare, etc.
- Wants: These are realistic goals that you feel are very important to you, for example, buying a home.
- Wishes: These are dream goals that you can justify living without. For example, a long vacation or a luxury purchase.
Regardless of your goals, it’s essential to ensure your financial objectives are SMART: Specific, Measurable, Achievable, Realistic, and Time-bound. By applying the SMART approach to your financial goal setting, you can increase your chances of achieving your goals and overall financial success.
One example of a SMART goal could be saving for a down payment:
- Specific: You want to save enough money for a down payment on a vacation home
- Measurable: You need to save $100,000 for a down payment for a $500,000 home
- Achievable: It will take you 5 years to reach your goal if you save $1,666 per month
- Realistic: A down payment is a significant amount of money. If $1,666 per month is not realistic, you can explore ways to adjust your goal
- Time-based: Set a realistic time frame based on the factors above
Based on the above bullet points, your SMART goal would be: I will save $100,000 in 5 years for a down payment on a vacation home. I will achieve this goal by saving $1,666 per month. Setting SMART goals does not guarantee that you will be successful, but it provides the ability to monitor your progress toward the goals you set.
Step 3: Retirement Accounts and Tax Planning
When planning for retirement, it is crucial to understand the various retirement accounts available and their respective tax advantages. The following are some common types of retirement accounts:
- Traditional 401(k) or Traditional IRA: These are pre-tax accounts, meaning contributions are tax-deductible in the year they are made. However, distributions during retirement are taxed.
- Roth 401(k) or Roth IRA: Contributions to these accounts are made after tax, but withdrawals during retirement are tax-free.
Maximizing tax advantages can lead to significant savings and is an essential part of any robust financial plan. To this end, tax-efficient investing strategies can be particularly beneficial. These might include things like holding onto investments longer to qualify for long-term capital gains tax rates, investing in tax-advantaged accounts, and asset location strategies, i.e., holding different types of investments in different types of accounts based on their tax treatment. You should also note that there are certain restrictions on retirement accounts, such as contribution limits and early withdrawal penalties.
At Harness Wealth, many of our clients have investment exposure to startups, and opt to take advantage of an 83(b) Election or a Qualified Small Business (QSBS) exclusion. If you hold startup equity either through equity compensation or other means, such as angel investing, consider working with an advisor from Harness Wealth or another qualified firm on how to best minimize the taxes on your shares.
Step 4: Plan for life events (life insurance, health needs, estate)
Insurance, healthcare needs, and estate planning can present a challenge to investments, and it’s important to plan for those needs as early as possible, as we will all have them. For many, the plan offered by their employer may be sufficient. You should also evaluate any existing or potential healthcare needs and how best to incorporate those into your financial plan.
Estate planning is a crucial part of any comprehensive financial plan. It’s not just about distributing your assets after your passing, but also about providing for your loved ones should an unforeseen event occur. This becomes particularly important for those planning to start a family or have young children. It’s not just about setting up college savings; it’s also about ensuring that your children would be taken care of, financially and otherwise, if something were to happen to you.
A good estate plan will include such elements like writing a will, setting up trusts, and nominating guardians and trustees. It allows you to set rules for your assets ahead of time, reduce taxes on assets you pass down, and minimize the need for legal work down the road. While estate planning may not be the most enjoyable topic to think about, it’s an incredibly important piece of any financial plan.
Step 5: Implement the Financial Plan
Your hard work has paid off, and it’s time to implement your financial plan. Make sure you stick to the goals you’ve set for yourself, and be diligent about understanding how the changes you’ve put into practice are impacting your lifestyle. If something doesn’t feel quite right, ask your wealth manager or financial advisor for help adjusting.
The Role of a Wealth Manager or Financial Planner
While it’s entirely possible to create a financial plan on your own, the complexity of tax laws, investment products, and other financial considerations can make it challenging. This is where a financial planner or wealth manager can provide value. Both financial planners and wealth managers can be instrumental in helping navigate these complexities, although they play slightly different roles:
- A financial planner focuses on crafting a holistic financial plan that is tailored to your financial goals, risk tolerance, and life stage. They help you devise strategies to meet these goals but typically do not directly manage your investments. Instead, they empower you to execute the plan on your own, providing education, advice, and guidance along the way. Financial planners may charge a flat fee for their services or a retainer basis.
- A wealth manager, on the other hand, actively manages your assets and investments on your behalf. They provide a range of services, often including investment management, tax planning, and estate planning. Wealth managers generally charge a fee based on a percentage of assets under management (AUM). Given the comprehensive and active nature of their services, they may have a higher starting price or minimum asset requirement. Wealth managers are particularly valuable to individuals with substantial wealth or complex financial situations, such as startup founders or investors.
Harness Wealth Can Help
Creating a financial plan is the cornerstone of sound financial decision-making. It provides a roadmap to achieve your financial goals, and a plan for navigating life’s unexpected challenges. At Harness Wealth, we understand the importance of comprehensive wealth management and the impact it can have on your financial life. Our experienced team of financial planners and wealth managers work closely with you to understand your financial situation, goals, and risk tolerance to provide a personalized plan that aligns with your aspirations. If you need help building a personalized financial plan, get started with Harness Wealth today.
Tax services provided through Harness Tax LLC. Harness Tax LLC is affiliated with Harness Wealth Advisers LLC, collectively referred to as “Harness Wealth”. Harness Wealth Advisers LLC is an internet investment adviser registered with the Securities and Exchange Commission (“SEC”). Harness Wealth Advisers LLC solely acts as a paid promoter for unaffiliated registered investment advisers. Harness Wealth Advisers LLC’s registration as an investment adviser with the SEC does not imply a certain level of skill or training.
This document does not constitute advice or a recommendation or offer to sell or a solicitation to deal in any security or financial product. This should not be considered tax, legal or financial planning advice. Please consult a tax, legal and/or financial professional for advice specific to your individual circumstances. It is provided for information purposes only.
Past performance is not indicative of future results. All investments have risks and have the potential for profit or loss.
