If you want to improve your personal finance, you should have a financial plan. The financial planning process is also a self-discovery process that can help you understand yourself, your priorities, and your needs and wants. Here are the 16 steps you should take to create your financial plan.
How to create a good financial plan: Frequently asked questions
Before we dive in, let us go through some frequently asked questions first!
What is a financial plan?
You may ask, “what exactly is a financial plan”?
A financial plan is a document that contains your current money situation, long-term money goals, and strategies to achieve these goals. It begins with a thorough evaluation of your current financial state and future expectations.
What are the characteristics of a financial plan?
A financial plan contains both quantitative and qualitative factors
When there is money involved, there are numbers. A financial plan usually starts with a calculation of your current net worth and cash flows. As you can imagine, there are many numbers involved.
However, on the other hand, a financial plan also contains many qualitative factors. These qualitative factors are incredibly important because they show the owner of the financial plan where the money is going toward. Typical qualitative factors include the lifestyle you want to live/retire on, your expectations and your long-term monetary goals.
A financial plan is comprehensive
The second characteristic of a financial plan is that it is comprehensive. To have a proper plan for your finances, you want to make sure you consider every aspect of your life, going from a grocery budget to retirement or even estate planning. The plan should capture all aspects of your money journey to bring you maximum benefits.
A financial plan is highly individualized
Finally, a financial plan is highly individualized. Although financial plans may cover similar key sections (and each will correspond to a step I will talk about below), they should all cater to your individual needs and wants. Your financial plan should reflect your personal and family situation, your risk tolerance, and your prospect for the future. No two individuals are identical, so no two financial plans should be identical, either.
Why is a financial plan important?
A financial plan is a key document in your money journey. A solid financial plan is like a lighthouse that shows us the way. It motivates you to save money, purchase items that truly bring you joy, builds wealth and helps you achieve your long-term goals like saving for your children’s college tuition and your own retirement. It provides the key principles that guide your financial journey.
Steps to building your financial plan
Now that we have talked about the what and the why of a financial plan, let’s dive in and see how we can build a financial plan. Depending on your preferences and circumstances, you can decide to create a financial plan by yourself, with your significant other, or find a financial advisor or a financial planner (see here for the differences between the two).
Section 1: Understanding your current financial situation
Understanding your current situation is the foundation of building a financial plan. You will want to be honest with yourself here: I know we all want to be millionaires already, but we need to know where exactly we are today so we can map out how we can get to where we want to be.
Here are the quantitative and qualitative factors that you should consider:
Step 1: Calculate your net worth
Your net worth is your total assets minus your total liabilities. This tells you what your current financial health is.
Your assets include:
- Cash in the bank (or under your mattress if you have any)
- Money invested (e.g., in a 401(k) plan, TFSA, RRSP, or anything you own). The money can be in stocks, bonds, mutual funds, GICs, any form of investment that has value
- Cryptocurrency or any other alternative investments
- Your home
- Your car
- Any valuables that you own (e.g., paintings)
Your liabilities include:
- Credit card debts
- Student loans
- Outstanding mortgage
- Car loans
- Lines of open credits
- Any private loans if you have any
Step 2: Calculate your cash flow
The next step in building your financial plan is to calculate your cash flow. You can’t really create a financial plan without knowing where your paycheques are going every month and how much you have left in your pocket after meeting all the obligations. Understanding your current monthly cash flow will be instrumental in building your budget.
There are usually two categories of cash flow: regular earnings/expenses and one-time/ad hoc earnings/expenses.
These are typically paid at regular intervals, usually monthly. Earnings include your regular paycheques and dividend payments if the stocks have a good and stable history of paying them. Expenses include things like your utility bills, property taxes, insurance premiums, taxes, groceries, etc.
These could include freelance gigs, sponsored posts for a blogger, etc. One-time expenses include holiday gifts, annual vacations (don’t forget to rely on a comprehensive vacation packing list to stay organized), special occasion expenses, etc.
Track your expenses for the last 12 months
If you want to get an accurate picture of your cash flow and you haven’t been tracking your expenses religiously, you will need to put in the effort. So book a day with yourself, get a favourite drink (perhaps your all-time favourite from Starbucks), and go through all your checking accounts and credit card statements at least for the last 12 months to capture any annual expenses.
I recommend that you bucket your expenses into key categories by month. My Excel expense tracker has the key categories that I personally use. I recommend that you give my template a try. Alternatively, feel free to find another template online, or create your own.
During the process, you may be surprised or even embarrassed to find out that you spend way more than expected on entertainment, vacations, or any other non-essential aspects while neglecting some of the key components such as saving for a down payment. That is completely okay. We all deserve to have some fun. I do want to emphasize again the honesty principle: please document your cash flows honestly based on what you actually spend in the last 12 months. You can decide to cut back on some categories once you have a complete picture and can do a thorough evaluation of your plan.
Step 3: List out your dependents
After you have a good understanding of your net worth and current cash flow, you will want to consider qualitative factors that will have a big impact on your financial plan. Your dependents are an important qualitative consideration. They can be your kids (or future kids), your parents, extended family, or anyone else whose are dependent on you.
Step 4: List out any other qualitative factors that impact you
These factors may include:
- Your risk tolerance
- Your knowledge about money (including key personal finance terms) and how much time and effort you realistically can put into educating yourself about money
- Culture norms you may want to adhere to
- Your responsibilities towards certain entities or organizations
- Your financial weaknesses (e.g., do you tend to overspend when you are under stress?)
- Your health care decisions
- etc, etc.
Section 2: Understanding your priorities/goals
After you have gained a thorough understanding of your current situation, you want to move to the next stage, which is understanding your priorities and goals.
Your priorities and goals can typically be divided into two categories: short-term and long-term. The time horizon for short-term goals is typically less than 1-2 years. Long-term goals have a longer time horizon.
Step 5: List out your short-term goals
Here are some typical short-term goals:
- Setting up your emergency fund
- Paying off your credit card debt
- Saving for your vacation next summer
- Reducing tax
- Getting insurance to protect your loved ones if they are dependent on you
Step 6: List out your long-term goals
Some common long-term priorities and financial goals are:
- Retirement savings
- Increasing your income through careful career planning
- Saving for your kids’ college tuition
- Saving to start a business
- Buying a first home (or upgrading to a larger home)
- Paying off your mortgage early
- Leaving a legacy
You can certainly have more than one goals. As well, your goals can change depending on what stage of life you are in.
I also recommend that you set target dates for each of your goals. These target dates help hold yourself accountable for the said priorities. They can also impact your strategies. For example, if you have a long time horizon, you may be able to take on a bit more risk to achieve a higher return.
Note that inflation will change how much money will be worth in the future, so you must build in reasonable inflation assumptions to determine how much money you will need in the future to satisfy your needs and wants.
You should also be assessing how realistic it is to achieve your goals. You want your goals to be challenging but achievable.
Step 7: Prioritize your goals
Once you have a list of things you want to achieve both in the short-term and long-term, you will next want to assess and prioritize them.
How you prioritize them is largely based on your personal circumstances and preferences, but there are some overarching rules that you may want to follow:
- You are looking to pay down debt, start with the ones with the highest interest
- “Don’t put off until tomorrow what you can do today.” – Benjamin Franklin
Section 3: Assessing what you already have, and building the components that you don’t yet have based on your priorities
Although you may not have done a formal financial planning session for yourself, chances are, you may already have pieces of a financial plan here and there. It helps to assess what you already have against the list of things you should have below to figure out what components are missing.
Even if you already have the components below, it still helps to re-assess them just to make sure that they are still up-to-date.
Here are the items that should be on your financial plan:
Step 8: Build a budget
A budget is a cornerstone of a financial plan. It gives you control over your money and helps you understand exactly. where your money is going.
Step 9: Set aside an emergency fund as part of your savings strategy
An emergency fund, also known as a rainy-day fund, is a sum of easily accessible money that is set aside only to be used in emergencies. Emergencies include unexpected bills (e.g., medical bills) or a sudden layoff.
The key to an emergency fund is that it must be easily accessible. You really shouldn’t be investing or locking up the emergency fund in an attempt to earn a higher interest (though laddering your GICs could be a good workaround), because you cannot plan for when an emergency is going to happen.
I park mine in a high-interest savings account, and I recommend you do the same, too. You can wrap your high-interest savings account in a TFSA if you are a Canadian resident so you don’t have to pay a hefty tax on the interest.
Your cash flow calculation and your budget will help you figure out how much money you need each month to meet the minimum obligations.
I recommend that you set aside an emergency fund that can support at least 6 months of essential living expenses, though if you are conservative, you may want to set aside more.
Step 10: Have a debt management plan
When you calculated your net worth in step 1, you would have a list of liabilities that you own. Now is the time to create a plan to pay off all the debts.
Your debts can include credit card debt, lines of credit, student loans, etc.
There are in general two ways to pay off debt: a snowball method and a debt avalanche method.
This method involves making the minimum of all your outstanding accounts, then focus on paying off the high-interest debt first. This method saves you the most interests.
This method still requires that you make the minimum of all your debts. However, the difference is that after meeting the minimum requirements, you then focus on paying down your smallest debt balance before moving onto the larger ones. Once you pay off the smallest debt balance, you then redirect all the money onto the next smallest balance, and so on. This strategy builds momentum and allows you to have small wins along the way.
Either method is a solid strategy, so pick whichever one you like more. The key is to stick to your plan.
Step 11: Have a plan to pay off your mortgage
If you have a mortgage, you need to have a plan. Chances are that the bank has already established a payment plan for you. However, there are still a few things you need to consider on top of the regular plan:
- Look at your payment schedule and consider switching to bi-weekly payment if you are on a monthly one. It helps you save interest
- Consider if you want to pay off your mortgage faster
- Plan scenarios on what would happen if the interest rate increases or drops
If you have covered all the basics, you may also think about what you want to do with the equity you have built in your house. Would you want to open a home equity line of credit (HELOC), for example?
Step 12: Ensure you have adequate insurance coverage
Once you take care of all making plans for all your debts, you want to consider insurance. Insurance is especially important if you have dependents.
If you are employed, you may already have basic insurance through your employers, such as life and disability insurance. It helps to read the pamphlets that your employer has provided you to understand exactly what the coverages are and whether they are adequate for your circumstances. You will then want to evaluate whether you want to add additional coverages through individual plans.
Here is a list of insurance products you may want to consider:
- Life insurance
- Disability insurance
- Critical illnesses coverage
- Personal liability insurance
- Home insurance
- Car insurance
- Property and casualty coverage
- Long-term care
Step 13: have a tax reduction strategy
Oh, the good-old taxes.
In this world nothing can be said to be certain, except death and taxes.— Benjamin Franklin, in a letter to Jean-Baptiste Le Roy, 1789
Although we cannot avoid taxes, we can use effective tax planning to reduce taxes legally and ethically.
If you are a regular employee, you want to make sure that you claim all the tax credits available to you. I have written a blog post on the most common personal tax credits you cannot miss.
If you are an entrepreneur, you want to make sure that you claim all the applicable expenses. Here is my guide on tax deductions for small businesses.
You may also want to investigate other legitimate income splitting opportunities such as spousal RRSP, paying family members a wage if they help you with your small business, or even establishing a trust fund.
The tax reduction strategy is directly linked to your investment plan, your retirement strategy and your estate plan, which I will talk about below.
Step 14: Have an investment plan
Once you take care of all the items above that have an immediate impact on your present, you want to switch gears and focus on your financial future. Investing is key to building wealth.
The two most important factors in your investment plan are the time horizon and your risk tolerance level. The general rule of thumb is that the longer time horizon you have, the more risk-tolerant you may be.
For any short-term goals, I recommend that you just use a safe vehicle like a GIC. This ensures that you do not lose your capital in case of a serious financial crash.
For long-term goals, you may want to use a mixture of cash, bonds and stocks. If you are a beginner investor, I recommend that you invest in index funds. These funds help you diversify, thereby reducing your exposure to risk.
Once you become more comfortable, you may even want to invest your hard-earned money in individual stocks, or even more speculative investment like cryptocurrency. You may even want to get exposure to other alternatives such as real estate, paintings, or peer-to-peer lending.
Before you consider opening a brokerage account, such as one with Acorns, and investing in anything, however, I highly recommend that you conduct your own analysis thoroughly. If you are interested in investing in anything highly speculative, you should limit your exposure to what you can afford to lose. SEek investment advice for next steps if necessary.
Of course, if your company offers employee stock purchase plans or other employment perks, you may want to take advantage of them.
Impacts of your tax reduction strategy on investment
Your tax reduction strategy will also have an impact on your investment plan. For example, interests are subject to personal tax rates, whereas capital gains are subject to the capital gain inclusion rule, which states that only a portion (50% as of now) of your gain is taxed at your marginal tax rate. You may also want to investigate the various tax savings investment options available, including Indexed Universal Life (IUL) Insurance, Roth IRAs and Roth 401(k)s, Health Savings Accounts (HSAs), 529 College Savings Plan, TFSAs and RRSPs, and more.
If you are curious to know how various investment vehicles are taxed, you will not want to miss my post on taxation rules for savings vehicles!
Step 15: Have a retirement strategy
Your retirement plan is likely part of your overall investment plan, but it is worth having its own section because of its importance and longer time horizon compared to your other financial goals.
Typically, your funds in retirement come in three streams:
- Government pension
- Company matching pension programs like 401(k), group RRSP or pension
- Your self-funded programs
You should know how much you are expected to get from these three sources of income streams. You should also have a good understanding of the general lifestyle you want to have in your retirement and your ideal age of retirement, and see if your income can cover all the expenses.
Step 16: Have an estate plan
Finally, you want to have an estate plan. An estate plan goes beyond just a will (though this is a crucial first step), and it is not just for the rich. Although none of us likes to think about having an estate plan, a lack of planning can lead to excess estate taxes, family disputes, and long court litigations. A plan can save a lot of trouble.
How to make a financial plan: Follow-ups
After you go through all the steps and build yourself a solid financial plan, you will want to review and follow up on all your items regularly to keep track of your progress. Here are a few key items you should keep in mind.
Never give up. Learn from your mistakes
Following through on every single aspect of your financial plan is hard. For example, you may splurge on something you later regret or make an investment choice that is beyond your actual risk tolerance level. These are all okay. It is all part of the self-discovery process. Make sure you reflect on your mistakes, learn from them, and move on.
Make a plan to review your financial plan regularly
Circumstances do change. For example, you may get married or have kids. You may need to relocate because of your job. You may also discover a great charity that you want to support. As such, you want to commit to reviewing your plan regularly.
I recommend that you review your overall financial plan at least once a year and whenever there is a significant change in your life. I also recommend that you have a monthly routine to review your earnings and expenses.
Steps to take during your financial review
Here are some key steps to take during your financial review.
1. Review your income and expenses
You want to review your income and expenses by category. Understand where you overspend and where you are under. If you are paid bi-weekly, make sure you account for the two extra paycheques!
2. Reconcile your bills and bank payments
Mistakes can happen, even for established credit card companies and financial institutions. Double-check the charges on your credit cards and chequing accounts to make sure that an income didn’t get incorrectly booked as an expense, and an expense wasn’t charged twice.
If you find an error, you will want to alert the bank right away to get your money back!
3. Review your progress towards your financial goals
You want to document where you are in achieving your short-term and long-term goals. If you under-contributed to your goals one month, you will want to increase your contribution in future months.
4. Review your net worth
This again involves stacking up your assets against your liabilities. See if your net worth is trending positively or negatively, and adjust your plan accordingly.
Financial review self-reflection questions
Here is a list of questions to help you in your financial review. You can set up an Excel spreadsheet or a journal to track your progress.
- Did any unexpected things happen that caused me to deviate from my original plan? What can I do to protect myself from them in the future?
- Did I spend money on things that I regret or do not value?
- What money mistakes did I make last month? Why did I make them?
- Did I take any steps to help me get closer to my goals?
- Am I still on track to achieving my short-term and long-term goals? If not, should I adjust them?
- Do I expect any big changes in expenses or earnings?
- What concrete steps can I take to be better next month?
Creating a financial plan is critical to achieving your definition of financial success and long-term financial goals. I hope the above steps help you understand what to do to make a comprehensive financial plan for yourself.
As well, if you have successfully built your financial plan and want to share your experience, feel free to leave a comment or send me an email at firstname.lastname@example.org!