Budgets and Financial Plans: The Dynamic Duo!

Two weeks ago, you dropped everything you were doing to create your very-own personal budget. Last week, you had a vision for your future and developed a long-term financial plan. Today, these two beautiful tools meet to form a powerful tag-team that will help you not only ensure you are in good financial standing today, but also set you up for prosperity down the road, including retirement. Let's dive into the details of how to make it all come together.

Photographer: "Now, fold your arms, but hold them uncomfortably away from your body.

One Without The Other?

As I mentioned in the first blog of this series, many think a budget is sufficient on its own. However, it's really just a snapshot of your financial situation today. An accurate budget tells you what's coming in vs. what's going out. Some people erroneously think that as long as you only spend what you make, you're all set... it's only the people that live outside their means that have financial issues. This couldn't be further from the truth! It's critical to have vision towards the future. Life has ups and downs, and just because your budget is balanced today doesn't mean you're financially insulated from a major setback in the future. This is where the financial plan comes in. Are you making progress towards long-term goals?

But, let's not disregard the value of the budget. You could come up with the most robust financial plan for your ideal house in your 40's, dream car in your 50's, and retirement plan in your 60's. But, without a budget that supports this plan, kiss your 2003 Ford Fiesta goodbye! While I hope your dream car is a little more exciting, the point is you have to align your budget to meet the targets in your financial plan. This is why it's critical to have both a budget and financial plan, working in tandem, to achieve your financial goals.

In Action

So let's break down a realistic scenario (one where your ideal vehicle isn't a "supermini" from the early 2000's)! Going back to our friends John and Sally, let's take their same budget and layer in a financial plan:

In this case, John and Sally both have solid incomes, own a home, have a child, and invest in their own 401(k)'s. Taking their budget (Income and Expense sections), we simply layer in the accumulation of an emergency fund, 401(k), and home equity to get a picture of their assets. I'm leaving out cars... as you should be well aware from my previous blogs, they depreciate over time, and should not be considered as part of a long-term financial asset. As you can see, John and Sally would have $97,136 in total assets after one year if they stick to their budget.

Are all assets equal? Not at all. The emergency fund and balance of their income minus expenses are immediately-available (liquid) asset to cover a major, unexpected events. The 401(k) should never be touched until retirement due to tax/penalties for withdrawal, barring exceptional circumstances. Home equity is accessible via refinancing, home equity loans, or outright sale, but otherwise is locked into the value of the home.

Keep in mind - this is just one year. A good budget/financial plan combo needs to be played out for your entire life. It's hard to envision how wonderful your financial future could be without seeing the numbers. As an example, let's help our pals J&S plan out a retirement. They've both decided they want to retire at 65 (in 30 years), spend a year traveling around the world, and find a nice place to call home. John wants the beach house in Georgia, but Sally dreams of a Colorado mountain retreat. Can they have it all? Let's take a look at the numbers.

To get an idea of what they would have in retirement, you have to make some assumptions. First, I assumed the budget remains the same - no increases in expense or income. Also, I assumed 401(k) contributions remained the same and investments grew at a rate of 7% annually, in line with average stock market returns. However, I assumed no interest gains in the liquid assets, just accumulation over the years. Finally, home equity is assuming paying off a 30-year mortgage, but no home value appreciation.

Well, their hard work paid off - millionaire status! Before we celebrate and break out that premium peanut butter whiskey, let's take a hard look at those numbers. Remember, the 401(k) is pre-tax, so any withdrawals have to be taxed as income. Also, the home equity is only realized once the home is sold.

So let's play the dream retirement out. After working all of 2050, they call it quits and take their dream year of travel (spending $70,000 above regular living expenses of $50,000/year) in 2051. In 2052, they decide to sell their home and find the perfect mountain retreat in Silverthorne, CO for $1,000,000. Of course, this is 30 years in the future, so who knows how much home that will buy. Meanwhile, we account for regular living costs with the 401(k)'s continuing to grow at 7% annually. Over the next few years, the liquid assets deplete to the point where they'll have to pull from their 401(k)'s to support themselves. Can they afford John's beach house? All of the sudden, we have to start thinking long-term. In 2055, they will be 70 years old. Hopefully, they will be healthy, but who knows? Will they live another 10-20 years and need the remaining funds to maintain modest living expenses and pay medical bills? Plus, all they did was save for retirement - no major home remodeling projects, no big vacations, no college fund for their daughter. What kind of life was this?

Afraid to Retire?

Before you walk away from this blog thinking this is all doom-and-gloom, let's take into consideration we were fairly conservative in our assumptions. Yes, 7% is right in the middle for a 401(k) annual return. But, we assume no appreciation of the liquid assets, when they would have hopefully sunk some of that excess savings into an interest-bearing account of some sort. Also, we assume their house does not appreciate; in reality, the house may double in value over 30 years! So why not make more realistic assumptions?

Well, when you pull the ripcord on retirement, do you want to have prepared for everything going perfectly, or be pleasantly surprised? This is not to say you can't adjust over time. In fact, revisiting these plans annually would be incredibly valuable. Just exchange your assumed values with actuals and adjust accordingly! If you're below your target, could you increase your 401(k) going forward? Reduce expenses? That's up to you. We know life situations will change, so it's normal to adapt to your new reality. The important aspect of having an accurate budget and financial plan is the exercise of putting it together.

With all this said, do you need to shortchange your current living circumstances just to enjoy life 10, 20 or even 50 years from now? No, definitely not - but by doing a budget and financial plan, you'll know if your truly living meagerly or just being fiscally responsible. Plus, you'll know if the things you hope to enjoy in the future are within reach. I will leave you with one of my favorite quotes: "Take care of the future, and you take care of the present".