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Peggy James is an expert in accounting, corporate finance, and personal finance. She is a certified public accountant who owns her own accounting firm, where she serves small businesses, nonprofits, solopreneurs, freelancers, and individuals.
Fact checked byGina LaGuardia has more than 25 years of experience in senior editorial roles, and is an expert in personal finance topics, including banking and lending. She has created content for financial powerhouses such as Chase Bank, American Express Canada, First Horizon Bank, BBVA, and SoFi.
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Financial planning is key to reaching your monetary goals. When you have a plan for getting out of debt or building wealth, for example, it's much easier to get from point A to point B. But planning your finances can seem a little overwhelming if you don't know where to start. Debunking some of the mystery that surrounds financial planning can help you prioritize your goals and create a blueprint for achieving them.
Financial planning is the process of evaluating someone's financial situation and creating a plan to help them achieve their short- and long-term money goals. Financial planners are professionals who work with clients to help them create a financial plan, but this is something you can also do on your own.
Finance planning is comprehensive and covers virtually every aspect of someone's financial life. A well-rounded financial plan typically includes strategies for saving and investing money, budgeting, debt repayment, retirement planning, taxes, and insurance. Financial planning for families may also include things such as homebuying and saving for college.
If you're considering working with a professional financial planner, ask for verification of their credentials and a detailed breakdown of their fees.
Planning finances is important for improving and maintaining your long-term financial health. Financial planning can help you to:
When you skip financial planning, you risk shortchanging your future self. For example, if you're not saving or investing regularly, you're missing out on the power of compounding interest.
Compounding interest is the interest you earn on your principal and accumulated interest. So, for example, say that you invest $500 a month into an individual retirement account (IRA). You do that every year for 30 years, earning a 7% annual rate of return. At the end of those 30 years, your investment of $180,000 would grow to $566,764 due to compounding interest.
Financial planning is also important for understanding the time value of money, or the belief that money now is worth more than the same amount would be in the future. Following this principle, the only way for money to grow is to invest it. If you don't invest, you miss out on growth and you also run the risk of your future purchasing power being eroded by inflation.
The more frequently interest compounds, the faster your money can grow.
A big part of financial planning is understanding how to prioritize different goals and areas of your financial life. Creating a sound financial plan is similar to building a house in that you start with the foundational areas first before moving on to the other sections. Here's how to create a financial plan, step by step.
A budget is simply a plan for how you'll spend your money each month. There are different budgeting methods you can use, but the mechanics are the same:
Ideally, you live within your means and have money left over each month. If you've run the numbers and there's more going out than coming in, you'll need to address that before tackling the other parts of your financial plan.
Cutting expenses can help bring your budget into alignment. Increasing income is another option. Once you have your budget balanced, you can move on to the next step. You may benefit from meeting with a nonprofit credit counselor if you're struggling to get your budget in shape.
An emergency fund is money you set aside for unexpected expenses or unanticipated life events. For example, if you lose your job or your car breaks down, you could tap your emergency fund to cover your expenses.
According to the Federal Reserve, 36% of Americans wouldn't be able to cover a financial emergency of $400 or more in cash. If your emergency fund is on the thin side or nonexistent, consider how you can build up that savings.
In terms of how much to save for emergencies, the amount can depend on your situation and needs. An often-cited rule of thumb is three to six months' worth of emergency savings, but you may save more or less based on your monthly expenses and how easily you'd be able to replace lost income.
A high-yield savings account can be a great place to hold emergency savings if you want to keep your money liquid while earning a competitive APY.
Debt can be a hindrance to reaching your other financial goals when all your extra money goes to your outstanding balances rather than saving and investing. In terms of which debt to prioritize first, it usually makes sense to choose the ones with the highest interest rates because they're costing you the most money. For many people, that means credit card debt.
If you have credit card debt, there are two approaches you can take to paying it off: by highest interest rates or the debt snowball. The highest-rate method advocates prioritizing debt repayment from the highest APR to the lowest. The debt-snowball method has you paying off debt from lowest balance to highest.
Once you tackle high-interest debts, you can focus on paying off lower-rate debts, such as student loans, auto loans, or personal loans. You may consider refinancing private student loans if it allows you to reduce your interest rate.
Retirement planning is an important part of financial planning because there's no guaranteed safety net waiting for most people. Social Security benefits can provide one stream of retirement income, but that alone may not be enough to meet all your expenses.
The first step in creating a retirement plan is deciding how much to save; the second is deciding where to put it. How much you'll save can depend on your age, when you plan to retire, your desired retirement lifestyle, and your risk tolerance. Using an online retirement calculator can give you an idea of how much you need to set aside monthly or yearly.
In terms of where to keep your retirement savings, a 401(k) plan offered by your employer is an obvious choice. You can defer part of your salary into the plan and the money grows tax-deferred until you're ready to retire. You can also supplement your savings with a traditional or Roth IRA, both of which offer tax advantages.
Insurance is designed to protect you and your family financially against worst-case scenarios. The types of insurance you may need as part of your financial plan can include:
If you're unsure what type of insurance you need or how much coverage is appropriate, talking to a financial planner or advisor, or an insurance agent can help. An insurance expert can evaluate your situation to determine what kind of policies you might need to fill gaps in your financial plan.
Investing in a 401(k) or IRA can help you build wealth for the future. But you're not limited to those options alone. You could also invest through a taxable brokerage account. Depending on the brokerage, your investment options might include:
Each of these investments has a different risk and reward profile so it's important to understand your goals and how much risk you're taking on. If you're ready to open a brokerage account, you can do so online.
Tax planning is also important to your financial plan. The more you can minimize your tax liability, the more of your hard-earned dollars you can keep to save and invest for the future.
There are different areas of tax planning that can come into play as you move through different life stages. For example, you may be interested in finding ways to reduce your income tax liability or business taxes if you run a business. If you're investing, you may be concerned with ways to reduce the taxes you pay on capital gains.
Tax planning can also play a part in how and where you save for retirement and college. In addition to tax-advantaged accounts such as a 401(k) and IRA, you may also choose to invest in a health savings account (HSA). HSAs offer triple tax benefits in the form of deductible contributions, tax-deferred growth, and tax-free withdrawals for qualified medical expenses.
While a 529 college savings account generally doesn't offer a tax break for contributions, the money in it grows tax-deferred. Withdrawals are tax-free when used to pay for qualified higher-education expenses.
Planning finances isn't a set-it-and-forget-it project. It's a good idea to review your financial plan at least once a year to make sure you're still on track to meet your goals. You may also want to review and update your plan when you experience major life changes such as getting married (or divorced) and having a child.
You can probably do most basic financial planning yourself, including setting a budget and chipping away at your debt. Once you accomplish those standard financial goals on your own, a certified financial planner can help guide you with investing, retirement planning, and more. Be sure to ask about the fees you might pay and the services a financial planner provides before agreeing to work with them.
Investing is important for building wealth through the power of compounding interest. If you're following the basics and contributing to a 401(k) at work or participating in a similar retirement plan, you're already investing. As far as buying mutual funds, stocks, or other types of investing, after you've paid off debt and followed the other basics, you may want to expand your portfolio to other types of investments.
Making a budget and sticking to it is the most important part of financial planning—without that, nothing else is possible. Following close behind is living within or below your means, which allows you to have more money to pay down debt, save, and invest.
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