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Empowering your money

What is financial planning? Here are the basics

At a glance:

  • What is financial planning?

  • The financial planning process

  • The major areas of financial planning

  • Summary of principles of financial planning

  • Practical ideas you can start with today

People who are serious about becoming successful with their money rarely ever achieve success by just earning and spending money. Even those who earn a million dollars a year have been known to fail with their money.

Serious people take matters into their own hands by looking closely at how they use their money. They use a defined process to guide themselves to their goals. Though this may seem dry and unexciting at first glance, it is normally challenging and rewarding (and energizing), and the reward only increases when you find that the goals you once only dreamed about are now within reach.

Financial planning should be done with the understanding that you are investing in yourself in order to achieve what you want in life. Seeing rewards roll in can transform even the driest exercise into something fun.

If you don't know where you are going, how will you know when you have gotten there?

What is financial planning?

Financial planning is the method of managing one's finances in order to achieve one's goals and dreams. While everyone already does it to some extent, the term in its professional use involves a set of procedures that individuals can use methodically. (In its simpler use, a financial plan can be as short as a single page with a small set of goals and actions—such as paying off debt, starting a retirement account, and opening an emergency fund—and a way to monitor them.)

The goals and associated action steps in a professional plan are defined, measurable, documentable, flexible, and reviewable. They serve as a guiding light that you can use to achieve financial success in your life. A financial plan subjects your income, spending and goals to a process that can provide insight and discipline to your financial life. In modern times, most of it is done with the aid of special software.

Why it is important

Financial planning is therefore important because it is a rigorous discipline that directs the way you use money and helps achieve efficiency with it. Like any plan, financial planning requires that you set goals. By seeing the end goal you want to achieve, you can see how you need to allocate the money you earn.

By reviewing your plan periodically, you can see where you have gotten off track and where you need to make changes.

What it covers, and the tools it uses

Financial planning covers a number of life areas such as your assets and your income, taxes, and retirement planning, among many others. It addresses a number of specific goals, from removing debt, to funding a retirement plan, to allocating income to major purchases. It even helps you plan for where your money will go after you die.

Financial planning has a lot of tools that individuals (and their financial planners, if they choose to work with them) can use to set goals and gauge progress. For example, a budget is a simple tool that you can use to plan your spending. Budgets are among the most important tools you can use in your financial plan. You also have personal balance sheets, statements of cash flow, and income statements that can be constructed to give you a sense of how your money is doing.

You may have financial forecasts, what-if scenarios, and several portfolio scenarios graphed out for easy viewing. These statements are usually offered by professional financial planners as part of their services. They involve various financial calculations that are typically made with financial software.

Although financial planning can be done on your own to some extent, there are professionals who specialize in it. Many of these professionals have undergone extensive education and experiential training to hone their skills. They know how to gather information and present it mathematically in order to give you an accurate roadmap to your finances. Many have designations such as CFP® (Certified Financial Planner™) behind their names that attest to their knowledge and experience.

Write it down

A financial plan is especially effective if it is written down. The act of writing makes you think through your goals and resources and plan their use methodically. Here are some typical sections in a professionally written plan:

  • Disclosure information. Assumptions, explanations, methodology, engagement agreement

  • Summary of goals and resources. Personal information, net worth summary, investments and other assets, liabilities, current portfolio, etc.

  • Risk and portfolio information. Current vs. target portfolio, risk assumptions, investment scenarios, retirement distribution chart

  • Risk management. What-if scenarios, disability needs, insurance needs, etc.

  • Estate plan. What do you wish to happen when you die? Analysis, calculations, and what-if scenarios.

  • Appendix and notes. Risk assessment questionnaire, assumptions, indexes used.

Professionally written financial plans may be quite long—upwards of 100 pages or more. But no two plans are the same—they differ according to who is writing them and what is being covered.

How financial planning works

The financial planning process is not set in stone, but most planners use a fairly uniform process. As described by the Certified Financial Planner Board of Standards, it uses the following six steps:

1. Establishing and defining the client-planner relationship

The process begins with the financial planner explaining the services that he or she will provide. These services are normally written down in a document. The responsibilities of both parties are also included, as are how you will pay for the services.

Both of you will agree on the extent of the relationship and how you will make decisions. The scope of the engagement between both of you can be changed by mutual agreement.

2. Gathering data, including your goals

The planner will gather information (data) from you about your financial situation in order to start crafting a plan. This data normally includes income, expenses, employment benefits, insurance coverage, your investments, your tax situation, your retirement plans, your risk tolerance, your time horizons, any estate plans, any anticipated lifestyle changes, your health, and any other financial resources (such as patents).

With this information, the planner can, in the next stage ahead, construct a story about your financial position; this will include defining your goals in a number of personal and financial areas, such as retirement, cash flow, and investing. This will guide him or her in creating the financial plan you will follow to help fulfill those goals.

3. Analyzing and evaluating your financial status

The financial planner will analyze your data to determine what you must do to help meet the goals that you have set down. Your assets and liabilities, your spending, investments, taxes, insurance, and other relevant information will be studied.

Financial statements such as a statement of financial position will be drawn up so that you can see your financial status on paper. From these, you can also get a sense of what your future income, insurance, and other needs will be, and what strategies would make sense for you to adopt.

4. Developing and presenting financial planning recommendations

Your planner will present some recommendations to help achieve your goals, based on the data you provided. He or she will explain each one and answer any questions or concerns that you pose. Here is where your risk tolerance will come into play, because you will need to look at investments that can provide the money you need to meet your goals.

Your planner will discuss investment choices with you and help you choose investments based on your financial needs, goals, risk tolerance, and time frames.

Accountant Mike McGirr (L) helps a customer at Liberty Tax Service in San Francisco. (Photo: Justin Sullivan/Getty Images)
Accountant Mike McGirr (L) helps a customer at Liberty Tax Service in San Francisco. (Photo: Justin Sullivan/Getty Images)

5. Implementing the planned recommendations

In this step, your planner and you agree on how to carry out the actions you agreed on. The planner may work with an investment advisor or stockbroker to help you begin investing.

In some cases, the planner will do this work for you; in other cases, he or she will act as a coordinator. Which manner he or she acts in is usually determined by credentials and job title.

6. Monitoring the financial plan

You and your planner must monitor and review the plan periodically. Goals and timeframes will change, strategies will need revising, and targets will shift. The performance of the investments in the plan will need to be reviewed to make sure they are on track.

You will meet with your planner to review the plan and make any needed changes to it. Your financial plan will be a living document that may last a long time, possibly even for a while after your death.

Even if you do not use the services of a professional planner, these steps can guide your personal planning.

The major areas of financial planning

Financial plans differ a lot among different people. But financial planning as a discipline is meant to cover all areas of life. As a discipline, it generally focuses on six areas:

1. Your financial position

Your financial position examines your available resources. It creates a picture of your net worth and your cash flow. Your net worth is made of your assets minus your liabilities. This can be expressed on a personal balance sheet (net worth statement). It represents your position as of a certain point in time (such as the last day of the year). Your cash flow is a total of all your sources of income within a year, minus all your expenses in that year. It therefore covers not a particular point in time, but the activity over a whole range of time. The cash flow statement gives you a sense of where your money is coming from and where it is going to.

2. Risk management

Many things can destroy your hopes and dreams and all that you have worked for. The purpose of risk management is to reduce the possibility of that happening. Risks can be in the form of disability, death, health problems, property loss, and liability, among other things. Though you can cover risks to some extent on your own, you may also need insurance to cover others. The cost of insurance will need to be factored into your cash flow.

3. Tax planning

Taxes typically take the biggest bite out of your income and your wealth, and more so the more you earn. There are many legal ways to reduce this bite and free up more money for other uses. Luckily, the government provides deductions, exemptions and credits for such things as retirement contributions, business expenses, and certain personal and family expenses. Because tax planning is complicated, many people find that the services of tax planners are well worth the money paid for them.

4. Investment

To achieve your goals, you need the means, and that usually means investing money and letting it grow. Your goals may include financing your retirement, buying a major item, opening a business, or paying for something for someone else. Whether you earn your money, win it, receive it as a gift, or inherit it, you must invest it in some way. You will need to stay ahead of inflation, and that requires taking on some risk.

This is where asset allocation and investment strategy come in. You will also have a time horizon to take into account, as well as tax implications. Investing is complex, and many people find that the services of investment advisors are worth the money they pay.

5. Retirement planning

Retirement planning provides for your post-employment years. It helps determine how much you may have at the beginning of retirement, how much you may need to have to make up for any shortfall, how much you may need to live on each year, and what you must do in order to keep the plan on track (including working part-time, if need be). Retirement planning includes using tax-advantaged plans such as IRAs and 401(k)s to save money.

6. Estate planning

Estate planning helps provide for your wealth to be handed down to others after your death. It can also help you begin preparing for the possibility of incapacity. Effective planning can ensure that your wealth will go to the people you want it to go to, with little or no interference from the state. It can also help minimize taxes.

There are several ways to make this happen: beneficiary designations, wills, life insurance, and trusts. Estate planning is among the most complicated areas of financial planning, and there are professional estate planners who help clients plan their estates as they want. You will also need the services of an attorney.

When making your own financial plan, consider including all areas of your life that are or will be touched by money.

Summary of financial planning

If the description of financial planning that is presented here appeals to you, you may be ready to sit down with a professional and make a real financial plan. People who have thought seriously about their long-term plans for their wealth are in a good position to take the next step: to make a full plan that can guide their lives for years and years to come.

If you are not in this position, there are less-comprehensive means of making a financial plan, such as the many off-the-shelf software products that are available to consumers.

Whether or not you are ready for a fully involved plan, here are some resources that can start you on the path.

Practical ideas you can start with today

  • Contact your financial institution to ask about financial planning services.

  • Use the Financial Planning Association's "Find a Planner" site to find available planners in your area.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

Read more information and tips in our Planning section

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