A Simple Way to Build a Strong Financial Foundation

In the new year, many friends have asked me to give them advice on financial planning, including retirement, estate planning, building a cash reserve, etc. So, here are some simple ways to build a financial plan.First, think of your financial life as a house, and just as with any house, you can't build the second floor without the first floor--you need a solid foundation. The first floor of your financial house consists of two things: a cash reserve and adequate, appropriate insurance policies.Cash Reserve: No, this is not actual dollar bills, but assets you have built up in a checking, savings, or money market account that is used for emergency purposes. The general rule is that you should have three months of your living expenses (rent, utilities, food, bills, etc) if you are renting, and six months if you own a property. Usually it takes about three months of rent to break a lease, if you need to, and can take up to six months to sell your house. The other reason you want at least three months of living expenses saved up is because most disability insurance policies have a 90-day waiting period, which leads me to the other side of your financial foundation...Insurance: It is critical that you had adequate, appropriate insurance policies to protect you in case of major loss or catastrophe. Most people have health insurance and have it for a good reason: it covers your medical expenses in case of emergencies, including hospital stays and the like. Most people have car insurance and homeowners (because it's mandated by mortgage companies) or renters insurance. But the other types of insurance policies are just as critical.

• Disability Insurance: This is a policy that is in place to provide you with monthly income, in the event you are injured and unable to work. One out of six people in the United States will suffer a debilitating condition at some point in their lives, so this is a good insurance policy to have. As I mention above, most have a 90-day waiting period until the policy kicks in, so make sure you have at least three months of a cash reserve saved.
• Life Insurance: Many people think that you only need life insurance once you get married and/or have children...because, then you have something to protect. However, it's important to get life insurance as early as possible because you're healthy and are much more likely to get a lower rate. You also never known when something could happen to you that makes you uninsurable. Unlike health insurance, life insurance is allowed to consider pre-existing conditions when the actuaries make their judgments about your insurability.

So those are the two "foundations" of your financial house: cash reserve and insurance. Once you've got a strong foundation or an adequate reserve and protection, you can start to build your second floor: retirement and investments. Let's start with retirement, first.Retirement: The most important thing to consider about saving for retirement is that you can never beat the time value of money. Simply put, that means that you have to start saving as early as possible, no matter how little it may be, because the money you save will compound over time and be worth far more than if you try to play catch up later in life. Most people should save at least 10% of their income into qualified retirement accounts including a 401(k) for private companies, 403(b) for non-profits, or the Thrift Savings Plan for government/military personnel. And a special note: that 10% does NOT include any matching contributions by your employer; it's 10% of YOUR pre-tax income.Brokerage: Sometimes, people don't know what the term "brokerage account" actually means. Simply put, it's a taxable account that can buy and sell investments and is not insured by the government for losses. So, you might say, why do I need this if I already have a retirement account? The purpose of a brokerage account is to help you build a nest egg for other priorities than retirement. For example, if you want to buy a house, you'd want to save money and invest it via a brokerage account, because if you put it all in a retirement account, you wouldn't be able to pull money from that account to buy your house. You can also use it to build an investment for a car or any other major purpose you foresee in the future. How much should you save into a brokerage account vs. a retirement account? That's the next point.Determining how much to save: The first thing to do in determining how much to save is building a budget. Don't have a budget? Here's how to do it: On the first of the month, start tracking every expense you have, including the big things like your rent/mortgage, but also the things you wouldn't think of like payroll deductions for insurance, 401(k), medicare, etc, as well as small things like sodas, a pack of gum, etc. Basically, track everything. At the end of the month, add it all up and categorize everything. How much do you spend on monthly bills, groceries, dinners out, etc.Tracking your expenses will lead to two things: first, you'll have a better understanding of your expenses, but you'll probably also figure out areas on which you want to cut back some spending. If all goes well, at the end of the month, you'll have money left over...your expenses will be less than your income. Subtract your expenses from your income and take a look at that number. Let's say, for example purposes, that you made $3,000 a month and spent $2,000 (including retirement savings in your 401(k), of course). You'd have $1,000 leftover. Whatever that amount is, ask yourself how much you would be comfortable saving. Is it $500? $600? $300? Whatever it is, that's the amount you're going to start saving every month, on the first of every month. Basically, you're going to pay yourself, first. After you save, you can spend the rest of your money for the month without concern, because you've already saved what you needed.Where do you put the savings? Go back to the start of this post to answer that question. Do you have three months of living expenses saved up? If not, save the money into your savings or money market account until you have. Once you have, you're set for emergencies. But since you still have that money to save, then what?That's when you take another look at your retirement savings. Are you getting all of the matching contribution from your employer? Are you saving at least 10% of your pre-tax income into retirement? If not, increase your savings into that account. If you still have money left over that you should/can save, then consider a brokerage account. That's where you can begin saving for a down payment for a house, car, or another large purpose you'd like to make.But, wait, how do I invest all this stuff? My number one recommendation for that is to talk with an investment adviser who can help. If you choose not to do that, I'd tell you to consider things three things. EVERY investment choice you make should take into account your risk tolerance, time horizon, and cash flow needs. Basically, how risky are you, when do you need the money from the investment, and how much do you currently need to pull from that investment. If you're young, you probably can be more risky, and you're time horizon (for retirement) isn't for 30 or so years, and you don't need any cash flow from the investment. If you're close to retirement, or perhaps in retirement, you're risk averse (because a big hit to your investment could lose you a lot of money), your time horizon is in the present, and you currently are pulling from the investment to supplement your retirement income.The final thing to consider is estate planning, including wills, powers of attorney, and beneficiary forms. The most important reason to have these documents in order is because, if something happened to you without these documents in order, a probate court would have to settle your estate and will take a small percentage of your assets as a fee. Having your beneficiary forms in order, as well as completed, signed, and notarized wills and powers of attorney can reduce any fees your estate will pay.So, there it is: how to build a strong financial foundation with a cash reserve and adequate protection, then building your financial future with brokerage and retirement accounts, and ensuring it goes to the right places with estate planning.Of course, this is a very high level picture of what it takes, but all of these rules and principles apply, regardless of age, marital status, etc.