Category Archives: Cash Flow Planning

Do You Know Your Living Expenses?

Do you know your annual salary? You probably do. Do you know your after-tax income? Assuming your payroll withholdings are reasonably accurate, you can check your recent paychecks to get this information. Do you know your annual living expenses? What you think might be your annual living expenses could be inaccurate. To find out why, read on!

Why do we need to know our living expenses anyways? Well, this information is the basis of all long-term financial planning. Your spending determines how much money you have left to save for future financial goals. It also helps you to estimate your living expenses in retirement, which allows you to estimate how much you need to save during your working years to meet your retirement goals. Finally, I believe that knowing our cash flow helps us to make better everyday financial decisions.

You might say, “I track every penny that I spend in Quicken, and I can just print a spending report for the last year.” Well, that is a great first step, but you are probably not accounting for some recurring expenses that do not occur every year. For example, say you always pay cash for your cars and do not take out auto loans. Then, you are probably not accounting for automobile replacement costs. What about home maintenance, such as roof repair or major appliance replacements?

So, how do you estimate your living expenses while properly accounting for all recurring spending? First, you need to estimate your spending on expenses that do recur at least annually. If you track every penny in Quicken or another computer program, than you are done with this step. If not, then I suggest this method. First, track all of your spending for a few months using a notebook or spreadsheet. This should cover regular monthly expenses, such as rent or mortgage payments, utilities, groceries, etc. Then, look over your bank and credit card statements or registers over the past year and make a list of any other expenses that you are missing, such as insurance premiums, property taxes, birthday and Christmas gifts, automobile maintenance costs, etc. Finally, put everything together in a spreadsheet and express all spending on an annual basis. Let’s say that you go through this exercise and find that your total annual spending is $50,000.

After you have finished the first step of accounting for all of your yearly recurring expenses, you need to account for recurring expenses that occur less frequently than annually. Here is how. Say you normally spend $20,000 to buy a car and you replace your car every ten years on average. Let’s assume that the salvage value is negligible after ten years. Then, you want to add $2,000 ($20,000 divided by 10 years) to your annual spending. That was not too difficult. If you own a home, what about home maintenance costs? Well, that is trickier. Think of it this way. Take a look at your home. Eventually, almost every part of your home will need to be repaired or replaced – the roof, the paint, the plumbing, the carpet, furniture, major appliances, etc. Home maintenance costs vary depending on the type of home and local costs. One rule of thumb that I have seen is 1% of the home value per year. So, if your home is worth $300,000, you would estimate home maintenance costs at $3,000 per year. Let’s say that your estimated annual spending on expense items that do not occur every year totals $5,000. Then, your fully amortized total annual spending would be $55,000 ($50,000 from the first step plus $5,000).

Now that you have the magic number, what do you do with it? First, compare your fully amortized total annual spending to your after-tax annual income. Which is higher? If you find that your fully amortized spending is higher than your take-home pay, than you have a problem. Consider ways to reduce your spending so that you can save for your future. Second, you can use this information to help forecast and analyze your future finances.

Year-End Financial Checklist

Can you believe that today starts the final month of 2011? Around this time of the year, many newspapers and magazines publish articles about year-end tax planning. While year-end is certainly a good time to do tax planning, it is also a good time to take stock of your financial situation and think about broader financial issues. The following are some things that you may want to consider. I will also throw in a couple of my favorite year-end tax tips as well.

  1. Evaluate your financial goals. Is buying a house one of your goals? If so, do you know how much income and savings you need to buy a home without jeopardizing your other financial goals? What if your goal is to get out of debt? Do you know how much debt you have right now? Do you have an action plan to accomplish your goal? Do you see the pattern? Get information. Make a plan. Execute the plan.
  2. Analyze your spending and saving patterns. Different people may have different goals, but many of these goals have one thing in common. You must save money to accomplish them. Do you know your average monthly spending? Can you estimate the recurring expenses that do not occur every month or every year, such as insurance premiums, home renovation costs, and automobile purchases? Do you know what percentage of your income is being saved? If you answered “no” to any of these questions, then now is a good time to get organized.
  3. Are you missing any necessary insurance policies? Do you rent an apartment but have no renters insurance? Do you have a sizeable net worth but no personal umbrella policy?
  4. Check every beneficiary designation. Life insurance policies and retirement accounts have beneficiary designations. You can also add beneficiary designations to regular bank and investment accounts through pay-on-death or transfer-on-death provisions. Check every beneficiary designation, especially if your family situation has changed recently (e.g., getting married, having children). These beneficiary designations override any provisions in your will.
  5. Contribute to a Roth IRA if you are eligible. Contributing to a Roth IRA is an excellent way to invest for retirement. Assets in a Roth IRA grow tax-free as long as you meet certain requirements when you withdraw the funds. You can contribute to a Roth IRA as long as you have earned compensation (e.g., wages or self-employment income) and your modified adjusted gross income (“MAGI”) is below certain limits. If you are single, you can contribute up to $5,000 to a Roth IRA if your MAGI is less than $107,000. If you are married, you and your spouse can each contribute up to $5,000 to Roth IRAs if your joint MAGI is less than $169,000. The $5,000 limit increases to $6,000 for those age 50 and older. You can contribute to a Roth IRA even if you participate in a 401(k) plan at work. You can make a Roth IRA contribution for tax year 2011 any time before April 15, 2012.
  6. Consider a Roth IRA conversion. If you are in an unusually low tax bracket this year (e.g., due to a break in your career or going back to school) and you have some extra cash to invest for retirement, then consider converting some of your Traditional IRA assets into a Roth IRA. You will have to pay regular income tax on the conversion amount, but that might be a good opportunistic investment if you are temporarily in a low tax bracket. Be careful, however, that the conversion does not push you into a higher tax bracket. Also, make sure that you have cash outside of your IRA to pay the income tax due on conversion. The deadline to make a Roth IRA conversion for tax year 2011 is December 31, 2011.