How To Build Your Financial House
Tackling your personal finances can be overwhelming when you are unsure where to start. Much as building a home benefits from a blueprint, your financial house might be easier to construct if you use a similar strategy. In fact, a house is a good metaphor for thinking about the structure of a sound financial life.
A Firm Financial Foundation Matters Most
When building a house, the first thing you think about is a solid foundation. Without that, anything constructed above will be unstable and susceptible to collapse. In recent years, we are hearing more about sinkholes and the risks to houses built above them.
In terms of personal finance, unsecured debt like personal loans and credit card balances are the ultimate sinkhole for your financial house.
Don’t be confused about mortgages. They are a secured debt because the house is an asset which could be sold to pay down the existing loan. An auto loan falls somewhere in between because the loan may exceed the actual value of your car or truck — a depreciating asset.
To build a firm foundation, your first job is to eliminate unsecured debt.
Building the First Financial Floor
Once the unsecured debt is paid off, it’s time to construct your first financial floor.
Some rooms on this level might seem obvious, like health insurance. Everyone has heard stories about how quickly medical bills can result in massive debt and undermine (sink) the best-laid plans. Make sure you have enough health insurance to protect yourself from significant financial hardship.
Another important room on this level is your emergency fund. This should be a savings account set aside for unforeseen circumstances including:
- The loss of a job
- An injury resulting in temporary time away from work (and your paycheck)
- A leak in your water heater necessitating the purchase of a new one
Vacations, tax bills and predictable repairs (to your old roof for example) are examples of expenses you can plan for and schedule according to your cash flow.
An adequate emergency fund can be thought of as ‘debt sinkhole prevention’ because it allows you time to find a new job, pay for expenses while you recover from your injury and buy that water heater. This keeps you from taking on credit card debt and destabilizing your financial house.
An amount equivalent to 3–6 months basic living expenses is a good target depending on your financial situation. Find a high-yield savings account or money market account for these funds, and you’ll earn some interest too.
More Rooms on the First Floor
Life and disability insurance are additional rooms to consider on the ground floor of your financial house. Term life insurance makes sense if someone else (or your entire family) is dependent upon your income to maintain a reasonable standard of living.
If no-one is dependent on your income, you do not need life insurance. That doesn’t mean agents won’t try to sell you a policy which they’ll describe as a good investment. It is not. Life insurance exists to protect your family’s source of income.
Disability insurance is similar and often overlooked. It’s actually far more likely you will have a disability than dying prematurely. Consider a policy to provide income to you and your family in the event you are unable to work for an extended period.
It’s possible your employer offers these policies as part of your employee benefits package. Look into it first before deciding if you need additional coverage. If you are self-employed, look for highly rated insurance companies and shop around.
Finally, if your employer provides a 401k savings plan or a 403b plan and offers to match your contribution, add a “closet” to your first floor and participate in this plan up to the amount required to receive the full match. There will be more on retirement planning as construction of your financial house proceeds.
Once you have securely constructed your first floor, continue to build.
Constructing Level 2 of Your Financial House
You have a firm foundation and have built your first floor; now it’s time to create level 2. The rooms to consider on this level are retirement savings, home ownership, bucket list items and a small closet for legacy decisions.
The use of the word ‘consider’ is intentional but does not apply to all the rooms. Everyone needs to consider the fact that they will one day retire from active income generation, hopefully by choice according to their own terms. The other rooms are suggestions and depend on your skills, situation, and temperament.
Defined here as the termination of active income generation, retirement is something everyone must consider. Or at least everyone who isn’t already there. This is truly a case where earlier is easier. Time is retirement’s best friend.
Some people are fortunate enough to love their work and earn a decent living. But even they must plan for a time when they can no longer do it for one reason or another. Many people would like to retire as soon as possible — and there are few things more fun than plotting early retirement schemes!
If you are working and don’t already have enough assets saved to retire, you must contribute to a retirement plan of some sort. Find a way. If your employer provides a 401k/403b or another retirement plan, use it. Contribute as much as you can but at least 10% of your earnings.
If it isn’t an option or if you are self-employed, contribute to an IRA (Traditional, SEP or Roth depending on your circumstance) or a personal 401k plan to the allowable limit or at least 10%. And to fast-track your retirement, consider setting aside A LOT more. If you are not earning an income, you may qualify for a Spousal IRA.
There are some situations where other alternatives might be better for you, but that is best discussed with a coach or advisor. If you are saving for your kids’ college education in lieu of your own retirement, please reconsider this. Student loans exist. Retirement loans do not. Some of you may also have parents to care for and navigating this financially (and emotionally) speaking can be tricky.
Once considered the American dream, and it may still be for some. For others, homeownership can be a nightmare. It usually is NOT a wealth-building tool unless you have DIY skills, inherit a property or live in a market experiencing a real estate bubble.
The countrywide average growth of real estate values is 3% per year. The historical average inflation rate is 3% per year. Simple math will demonstrate that, on average, home values increase at about the same rate as inflation and thus have a real return of 0%.
There are other, more personal criteria by which home ownership can be measured, and those factors balanced with smart financing are important to consider. This article about housing when leaving a relationship explores this further. But owning rental real estate CAN be a wealth building tool and single-family home rentals can be a good passive income source if designed that way.
To this point, we have really only talked about the “should” of personal finance. These are smart, responsible and, let’s face it, a little boring. Now let’s get real and personal for a minute. None of us knows if we will even wake up tomorrow much less live to spend down our retirement accounts. All of us have goals and desires that fill our thoughts and inspire our dreams.
Maybe it’s a fast car, a spiritual trek or learning a new language. You shouldn’t be ignoring the “should” for these bucket list items, but instead, consider a special savings account for these personally meaningful objects or pursuits that are vital to a well-lived life.
This can also help keep you on track with the less sexy aspects of a financial house construction project. A fun challenge is to figure out how to make these dreams a reality with as little cash outlay and as much creativity as possible.
Finally, now that you have some assets, it’s important to consider what should happen to them if your time on the planet is shorter than expected. Legacy sounds like a grandiose concept, but it is really just the gift of money by will or beneficiary designation.
Most bank accounts, retirement accounts, and other liquid investments have a provision for naming a beneficiary, and this should be done when creating them.
Tangible property is described in a will, which can be done simply and inexpensively with LegalZoom, RocketLawyer, and other providers. Having an attorney review the documents may cost you more money, but it may also give you peace of mind.
A will does not allow your heirs to bypass your state’s probate process entirely but beneficiaries of your accounts can receive their portions directly long before they receive the government’s blessing on the remainder. A trust is a much more comprehensive legacy planning tool that does eliminate the need for probate.
A health care directive (power of attorney for health care), a living will and a durable power of attorney declaration should also be considered. These documents basically allow you to choose someone to make decisions on your behalf medically and financially if you cannot do so for yourself. And they clearly state your wishes with respect to life-prolonging treatment if you suffer from a terminal condition.
Make sure your family or close friends have copies of these documents and that your primary care doctor has the health care directive too.
The “staircase” between level 1 and 2 (and on up) in this model is mindful spending. This is a euphemism for ‘spend less than you make and make what you spend meaningful to you’ and without it, there are only a few ways to move from floor to floor. Windfalls from the lottery or a significant inheritance might be seen as elevators allowing you to speed up construction but they don’t change the fundamentals, and they obviously cannot be counted on.
Taking it Up Another Floor in Your Financial House
It’s impressive to consider the progress made in this financial house project.
You’ve got a solid, debt-free foundation; you’re adequately insured and have your emergency fund in place; you’re saving for retirement and considered home ownership, your bucket list is being funded and you’ve even thought about what should become of this ‘house’ should you not wake up tomorrow.
Along the way, you’ve developed a solid, mindful spending habit and now you are ready to take on the construction of the next level.
On the third floor of your financial house, you’ll look at funding your children’s education (if applicable), consider long-term care insurance, after tax savings and the possibility of an umbrella insurance policy for asset protection.
Saving for College
Let’s start with education savings. Many people have strong feelings about paying to or helping to pay to, educate their children and emotions always play a role in personal financial decisions. One important point to remember — loans are possible for education but NOT for retirement. Assuming you’ve considered that and still wish to set aside money for future college costs, then there are a couple of considerations.
Common vehicles for college savings is the 529 plan. These are federally tax-advantaged accounts with some state tax deductibility depending on your residence and are to be explicitly used for higher education. Thankfully, the restrictions once making these plans less desirable have eased in recent years.
And with the Tax Cut and Jobs Act of 2017, federal rules allow 529 plans to cover “qualified higher education expense includes expenses for tuition in connection with enrollment or attendance at an elementary or secondary public, private, or religious school.”
The other common vehicle is a regular after-tax investment account which has the highest degree of flexibility but without the tax advantages. There are a couple of others as well, and Vanguard has a very nice summary of the options.
Savings and Investing
If you don’t have children or are not considering paying for college, then the next room to consider on this floor is after-tax savings. In truth, you already considered this room, but we specifically labeled it “bucket-list items” and suggested the creation of a separate savings or investment account.
The after-tax savings here is more general in nature and might be thought of as your early-retirement account or your ticket to a personal sabbatical. As you know, your retirement savings generally cannot be accessed without penalty until you are 59 ½ except for some Roth accounts.
But your after-tax savings can be used for whatever purpose might arise, including the intention of retiring before 59 ½! Because these assets will hopefully accumulate significantly, tax efficiency should be a consideration in your investment portfolio.
You will be taxed on investment earnings whether or not you withdraw from these accounts, so you’ll want to consider what types of investments to hold in these versus your retirement accounts. Generally speaking, stock funds generate less taxable income than bond funds and should form the bulk of your after-tax investments.
Your bond fund allocation is best kept in your retirement accounts. As with everything, this can depend upon your specific financial situation.
Speaking of tax efficiency, and staying with the house metaphor, you might consider it the “insulation” around your entire financial house. Tax increases will likely impact you as you build up from the foundation so you should always ask yourself “how will this affect my tax situation?”
Remember that taxes are the most significant single bill we pay as citizens and minimizing them to the extent possible throughout our lives can have a significant positive impact on our wealth.
Long-term Care and Umbrella Insurance
The final two rooms on this floor are additional types of insurance. The first is long-term care insurance which covers the cost of nursing home care. Medicare and other insurance policies will only cover nursing home stays if there is a medical (rehabilitation) need.
If you have sufficient assets to cover a long-term stay in one of these facilities or you have children that are willing and able to assist you financially, you may not need this insurance. If not, it is something to consider. Be forewarned that it is costly — no doubt because of the rapidly increasing cost of this type of care. Shop wisely and as with any other insurance, look for a highly rated insurer.
Now that you have accumulated assets (rooms in your house), you might consider an umbrella insurance policy. You will find that the liability limits of your homeowners (or renters) and automobile insurance policies have a cap (i.e., $300,000) that your net worth has surpassed — which is a good problem to have!
However, we live in a very litigious society, and while you might not feel rich, the vast majority of the population is still living from paycheck to paycheck, and those with a deficit of scruples might find you a juicy target for a lawsuit. Umbrella insurance can help protect your assets above the liability limits of your other policies.
There’s Even an Attic — Estate Planning
Now that you have constructed the financial house of your dreams, it is time to add an attic. On this top floor, we will look at estate planning. This can be a challenging and emotional topic. But you’ve worked hard to get your house in order, and you deserve to be in charge of what happens to it.
You’ve learned about wills, health care directives and durable powers of attorney. These are considered part of estate planning. An attic is also a place for extra insulation (tax efficiency). Estate planning offers opportunities to minimize the impact of taxes that could affect your heirs.
Many people with complicated finances such as homes in multiple states, small businesses, underage children or many heirs will want to consider a trust. Trusts are used because they offer flexibility and control over the distribution of assets and certain types allow your estate to bypass probate.
Probate is the state-based governmental process which controls the post-mortem management of assets. Your will is used to direct the distribution. There are rules in place which lead the process in the absence of a will, and it is important to know these rules in your state. Wills and trusts can be used to specify what you want — rather than what the state thinks is best.
Trusts are expensive and complicated documents and are probably best created by an estate attorney. You may not need one — especially if your estate is simple and mostly limited to liquid assets (cash, mutual fund investments) which can be assigned beneficiaries. This allows assets to pass outside of a will or trust.
If you have no heirs, you might consider a charitable trust. Vanguard has a sister company which offers one. Their trust allows you to assign percentages of your estate to one or more charities of your choosing, distributed according to a specific formula and allows you to specify how your money is invested. These types of trusts generally do not require an estate attorney. This is also a good option for a secondary beneficiary if you have an heir you wish to designate as primary.
The Financial House That YOU Built
It may be apparent to you why estate planning is assigned a floor all its own. It is a big subject, and this article is a summary blueprint or model. In fact, many of the levels and rooms of this financial house can and should be explored further and tailored to your particular circumstances.
Unless you are just beginning your adult life, you will probably find that you already have a partially constructed financial house. Let this guide serve as a suggestion to supplement your current plan and consider some rooms you may not have thought about. Much of this can be done on your own but you might find consulting a financial professional can help with decisions around your unique circumstances. Happy building!
Article written by:
Carol Christie, a Women Who Money guest contributor, who has long been a Financial Coach and recently formalized this vocation for which she is passionate. She formerly wrote for the blogs Queercents and Fiscal Fitness for the Rest of Us. You can follow her at freetobefinance.com where she will post as inspiration strikes.
Originally published at womenwhomoney.com on August 8, 2018.