VISTA, Calif. – Personal financial planning is about how to pace one’s income so that there can be enough to last a lifetime. The process takes into account of all the financial needs of a person from cradle to grave.
Prudent financial planning addresses the needs and risks at various stages of life.
Middle-class parents bear the burden of providing for the young. Able-bodied adults work to provide a living for the family and a reserve for retirement. Retired adults may spend 10 to 15 years actively pursuing their interests, then finally settling in retirement.
In reality, the path of life is rarely smooth. Events such as divorce, job layoffs, illness and death occur all around.
Studies cite the odds of divorce as high as 75 percent. In “The Divorce Culture,” Barbara Dafoe Whitehead reported that mothers and children in families that were not poor before separation suffered an average decline in income of 50 percent after divorce.
In two-income families, there is a one in 16 chance that a job layoff would occur in a given year. Some industries have higher employee turnover than others. The U.S. Department of Labor reported that involuntary worker turnover in the construction industry reached 43.1 percent between September 2003 and August 2004. Despite the boom in housing and construction, four in 10 positions laid off workers.
Disability and death statistics are tracked by the U.S. Census Bureau. Between the ages of 35 and 65, three out of 10 working people are disabled for 90 days or longer. Nearly one in five people will become disabled for five years or more prior to age 65. Sixteen percent of all Americans die prior to age 65 today.
When financially preparing for these disasters, think of how the family can sustain the household and set aside six months’ living expenses.
Take a hard look at the fixed household expenses. Which are the greatest outlays? Are they mortgage and car payments? What about groceries and other expenses?
Transfer risks. The loss of income due to disability and death can be covered by insurance. State unemployment insurance offers a fraction of income for a specific period of time (maximum 26 weeks) or until the worker finds a new job. Benefits range from a maximum of $205 per week in Arizona to $405 in New York. There is no direct insurance program to offset financial losses due to divorce.
For example, Sam and Laura are both 35 years old. They have two boys, ages 7 and 1, and a girl, 3. Sam works as the environmental director for his tribe. Laura had been a grant writer, but she stayed home during the past year. Sam and Laura live in a small house on the reservation. They are looking for a larger home off the reservation because of their growing family. Together they have $18,000 in retirement savings.
Recently, Sam got a raise to $54,000. They make a $600 monthly mortgage payment for their HUD home and $1,500 for their two new pickup trucks. Groceries and utilities average $900. The anticipated mortgage for their dream home is $2,400 per month.
Analysis: While the hypothetical couple has plenty of disposal income because of their relatively low fixed overhead, they do not have a six-month reserve. Their retirement accounts are dedicated for retirement in the long term. This sum does not count. Therefore, the couple is not adequately prepared to pursue their dream home.
When Sam and Laura move off the reservation, they will have to pay additional state income tax. Monthly overhead with state taxes (of 10 percent) will be approximately $5,000 per month. Based upon Sam’s current salary, this is a shortfall of $500 each month.
Advice: Before the family makes the move, three milestones must be reached.
The family must begin to save an additional $30,000 in anticipation of the move.
Sam should purchase disability income protection to cover 60 percent of his current income and at least $600,000 of life insurance. The disability policy can potentially replace up to $2,700 of earnings. If premiums had been paid with after-tax dollars, this sum can be received as tax-free income. With life insurance, assuming an interest rate of 5 percent per year, it can provide $2,500 of taxable income to the family.
Assuming these insurance policies are in place, Laura must return to work and earn a minimum of $3,000 per month. Together, the family can have a base income of $5,500 per month to function.
In general, long-term loans can hinder one’s financial freedom. Opt for payment plans with the highest payments within the shortest period of time.