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Financial Tip

Financial Tip
Rich Best has spent 28 years in the financial services industry, as an advisor, a managing partner, directors of training and marketing, and now as a consultant to the industry. Rich has written extensively on a broad range of personal finance topics and is published on several top financial sites. Recent books include The American Family Survival Bible and Annuity Facts Revealed: What You MUST Know Before You Invest.

Why Your Budget is the Absolute Key to Financial Planning Success

Why Your Budget is the Absolute Key to Financial Planning Success

When thinking about long term financial planning most of us consider big goals, like retirement or funding a legacy, that are accomplished over a period of years or decades.

Budgeting is usually the realm of short term thinking. Questions like “how much money do I need to set aside every month?” or “how much mortgage can I afford?” are commonly associated with budgets.

While budgets and financial plans may deal in different time horizons and with different goals they are, in fact, closely linked. Poor budgeting has the ability to sabotage even the most thoughtful financial plan, and small short term decisions can have profound long term consequences.

At their simplest, most financial plans attempt to match an available pool of assets against future needs – both known and unknown. In other words, the money you set aside today should match the expenses of tomorrow.

Poor budgeting derails this process by either reducing the available money set aside or by growing the future stream of expenses.

Under-saving today can prove costly tomorrow

When it comes to budgeting money for things like 401(k) accounts, IRA’s and Roth IRA’s even a small change today can have a big impact years in the future.

As an example, assume an investor budgets for an annual contribution of $10,000 per year toward retirement savings for 20 years. Let’s also assume an 8% annual rate of return on their investment.

This saving behavior would result in a balance of approximately $457,000 at the end of the 20 year period. Not bad for setting aside just $200,000 in contributions!

Now imagine the same scenario, except that in the first year the contribution is reduced to $5,000 instead of $10,000 due to a one-time need for additional cash. In this instance let’s call it a down payment for a budget-busting luxury car, something fun to drive today but unlikely to last long term.

The same 20 years and 8% rate of return, but with a $5,000 year 1 contribution followed by 19 years of $10,000 contributions, results in only $470,000 in savings available. In this example the implications are clear; a one-time shortfall of $5,000 in savings resulted in a future savings decrease of around $24,000.

Compounding this wealth eroding effect is the thought that our example of directing $5,000 away from retirement savings toward the purchase of a luxury vehicle will likely leave sizeable car payments needing to be made for years to come. Ouch!

Living within your means today for a more secure future

It is true that not all budget-busting purchases are as obvious as luxury cars and exotic vacations. Sometimes it’s the little things that matter most, and it’s not at all uncommon to hear stories from cost conscious individuals who earn a good living yet for some reason always feel financially behind.

Luckily the process of diagnosing budget woes tends to be relatively straightforward. By comparing monthly income with expenditures it’s relatively easy to determine how you are balancing the demands of today with the needs of tomorrow.

If this exercise reveals potential budgeting issues then it probably makes sense to implement a spending plan. This simple step can make sure that you enjoy a lifestyle today that is commensurate with your earning power and stay on track to achieve the freedom that comes from meeting your long term financial goals.

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