Getting a handle on cash flow, and why it’s so important

Cash flow, or budgeting, is one of the biggest challenges facing both financial planners and their clients. How can you get a handle on your spending needs, and why does it even matter?

I have conversations with my clients all the time about this topic and it is of somewhat universal frustration. Why is it so hard to understand our spending? What is the best method for tracking? How useful is tracing to begin with? And what difference does it make if I spend $6,000 per month or $8,000 per month?

Why should you care?

As a financial planner, I am here to tell you IT MATTERS. How much you spend is one of the single biggest factors in your control. Whether you spend $6,000 or $8,000 per month might mean the difference between retiring at 60 vs. 65. It might mean your money easily lasts to age 90 or that you run your savings down and have to subsist on Social Security income only.

Knowing how much your lifestyle costs is an extremely important variable in terms of long-range planning. When I work with clients on determining what the figure is, I find people chronically underestimate their sending. It’s very much like the experience of tracking what you eat; if you’ve ever used an app to track your intake, or followed a weight loss program like Weight Watchers, you’ll know what I am referring to. You may think you eat about 2,000 calories a day, but as soon as you start tracking and writing things down, more often than not the number is much higher. 

This phenomenon holds true with spending. When I ask clients how much they spend each month (I’m looking for discretionary spending, not things like your mortgage payment or car insurance), I will often get an answer that is, by the client’s own admission, “a bit of a guess”. 

The client may tell me their spending is about $8,000 per month. If I see that their take-home pay is closer to $10,000 per month, but their savings account balance hasn’t increased in the last year, I can logically conclude their sending is probably much closer to $10,000 per month. Most of the people I work with are not terribly intentional about their spending. I frequently hear clients say something like “I really love not having to worry about money and being able to afford the things I want to do.” I get it, I really do. That said, it is a very rare situation where a clients’ spending level isn’t important. In other words, even if you have $10 million dollars, you likely still need to keep an eye on spending. It’s very easy for lifestyle creep to occur, and as nice as it is “not to worry”, I strongly encourage people to have a reasonable idea what their spending level is, and then work with their planner to ensure that level is sustainable.

OK, OK, so it’s important to track, but HOW?

Way back in the days before I became a financial planner, and before I had kids, I used to track every. Single. Penny. Spent in our household. I used Quickbooks at the time, and I would go through and manually enter every credit card transaction (with detail!). I can tell you every restaurant I ate at in 2003, and every cup of coffee I bought in 2006. Honestly, I found it endlessly fascinating but it was incredibly time consuming. Once we had our first daughter, I abandoned the practice.

As much as I loved having that level of detail, my approach now is far simpler and, while not as detailed, still incredibly informative. This is what I do:

  • Once per year (that’s right, just once!) I sit down with my husband and our year-end credit card statement. Most companies provide this and some call it something slightly different. We use Chase and they call it a “year end summary”.
  • I print it out and then pull out my checkbook/bank statements to make sure I’m factoring in anything that wasn’t paid by credit card. Note: in our house we use credit cards to pay for almost everything (and pay the full balance each month). But there are some things I pay for by check (i.e. house cleaners) and still others that get paid by Venmo or similar.
  • Once I have all that data, I take the TOTAL. Let’s say $72,000 spent on our credit card for the year, plus another $12,000 paid by check or Venmo (I’m using these numbers for simplicity). That gives me a total of $84,000 per year or $7,000 per month.
  • While it’s not necessary for the sake of this exercise, I still look at the categories on my year end summary. Chase does a pretty good job of categorizing things, but there’s an awful lot of “miscellaneous” charges (i.e. everything we order off of Amazon.com). I think it’s incredibly important to know where your money is going. But that’s another conversation. For now, I am looking simply for your discretionary spending number.

Many clients do something like this, but they pull out larger expenses. They might say, oh, well we did a bigger trip last year or one of our cars needed some major work so I excluded that. I would caution you not to do that for almost all cases. There is always going to be an unexpected house/auto repair or other one-time expense.

The main exception to this would be expenses related to a wedding or moving houses. There truly are some major items you likely purchase once when you have a child or relocate, and it’s reasonable to exclude these things.

What about Mint or You Need a Budget (YNAB)?

I am all for tracking more regularly then my once/year style. If you have a system that works for you, stick with it! Whether it’s an excel spreadsheet or a software program, the method itself doesn’t matter. If you have the time and inclination, I find this level of detail to be very informative. Is it necessary for you to track on a regular basis? No, but helpful, yes. And I certainly wouldn’t recommend you stop if you’re already doing it.

For those people who are less interested in tracking, something like my system is adequate, An even simpler version would be to look at your savings account balance 1 year ago and compare it to your savings account today. Has it increased or decreased? Compare that with your take-home pay over the past year and you’ll have a very rough estimate of spending. 

For example, your savings account balance on February 15, 2020 was $20,000 and one year later it’s $30,000. Let’s say your take home pay for the prior 12 months was $100,000. You’ve effectively spent $90,000 of that (as your savings account grew by $10,000), thus your average monthly spending is $90,000/12 or $7,500.

But there are so many fluctuations! And my RSUs make it so confusing!

One of the biggest issues around tracking cash flow is that it is always changing. The pandemic has had a tremendous impact on people’s spending habits. Things like travel and entertainment are way down, but home improvement and “toys” (i.e. paddleboards and bikes) are through the roof. Pandemic aside, your spending changes every single month. 

Add to that things like vesting RSUs, which you may be selling to support your lifestyle, and the process gets a whole lot trickier. In addition, if you use credit cards to pay for things and don’t pay the balance in full each month, it’s very hard to keep track of things. I definitely encourage looking at a minimum of 6 months of spending, and ideally 12. Looking at any one month really isn’t terribly informative. Having a strategy around RSUs can also make this process more straightforward. 

Getting on the same page as your partner

One of the things I love about sitting down with my husband and reviewing our spending, is that it usually invites quite a conversation about what we did/didn’t do over the prior year. How much money did we give away to charity? Is there any number we’re surprised about? Is there anything we spent a lot of money on, but don’t enjoy? One of our conversations several years ago was on the cable bill. We looked back over the prior year, realized we’d spent upwards of $1,000 on cable and noted we almost never watch it (and certainly don’t enjoy it). We’re just not big TV watchers. It was a pretty easy decision to cancel it. We’d much rather spend our money on travel.

Having a conversation about what’s important to you and then seeing if that’s where you actually spent money is a vital exercise to help you remain cognizant and intentional about your spending. The vast majority of couples that I work with have slightly different (or significantly different) ideas about how much to spend and on what. This is totally normal. The key is to set some guardrails around spending that each person is comfortable with.

It may sound silly, but I actually like the idea of an “allowance”. Each partner has the ability to spend X dollars per month without having their spouse’s approval. Alternatively, I also love the idea of each couple determining a spending limit whereby each person can spend up to X dollars without running it past the other partner. For example, you might set a limit of $500. If you want to go out and buy some fancy shoes or stereo equipment, you are free to do so within that limit. But if it’s over $500, you would have a conversation together prior to making the purchase.

Takeaways

I could talk about cash flow endlessly. It causes a tremendous amount of stress and anxiety for people. Just the sheer fact of knowing how much you spend is powerful. Once you have that information, you can choose to make modifications, if necessary. Or maybe you’re one of the lucky few whose spending is sustainable. I’ve worked with a handful of people that spend almost nothing and I have to encourage them to spend more! 

The first step is knowing where you are. By working with a financial planner, you can then evaluate any changes that need to be made. Should you be saving more? How much can you afford to spend on house projects? Those are questions that a professional can help you answer.

Breaking down the Mega Backdoor Roth contribution

You may or may not have heard of a Mega Backdoor Roth, but they are becoming increasingly common, especially in the tech world. It is often confused with a Backdoor Roth IRA contribution (which is similar) or a Roth 401(k) contribution. It shares some similarities with both of those terms but is somewhat unique for a few reasons. 

Standard 401(k) Review

First, let’s review 401(k) contributions in general. Many of us are familiar with a 401(k) plan, sponsored by an employer, which allows you to defer up to $19,500 in 2020 (and a catch-up contribution of $6,500 if you are over 50). An employer may contribute a match on top of this, but employees are limited to the standard IRS annual limits. In a pre-tax 401(k), you are able to put your contribution into the plan and not pay any federal income tax on those contributions.

A relatively recent newcomer is the Roth 401(k)- added in 2006-  which allows you to put money into your 401(k) on a post-tax basis. It doesn’t help reduce your taxable income now, but withdrawals in retirement are tax-free. The Roth 401(k) is subject to the same limits as a pre-tax 401(k); you can even do some of your contribution on a pre-tax basis and some as Roth.

So that’s the 401(k) structure most people are used to seeing at their jobs. The Mega Backdoor option allows you to save IN ADDITION to the normal limits. Say you’re already maxing out your regular 401(k) contributions at $19,500. The Mega Backdoor allows you to put additional money into the account on an after-tax basis (note: this is NOT the same thing as the Roth contribution). Then within the plan, you make an election for the contribution to be automatically converted to Roth. NOW you have funds in a Roth 401(k) which function like the Roth 401(k) contributions above (in other words, you do not pay taxes when the funds are withdrawn). 

Here’s an example. 

Let’s say you work at Microsoft, which was one of the first companies to offer this option. You’re maxing out your pre-tax 401(k) at $19,500 this year. Microsoft matches 50% of this for $9,750. You are now able to contribute another $27,750 to the after-tax 401(k)! This gets you to the annual IRS limit of $57,000 TOTAL contributions to your 401(k) account. That’s:

  • $19,500 pre-tax 401(k)
  • $9,750 employer match
  • $27,750 after-tax 401(k)

After you contribute the after-tax dollars, the plan allows for an automatic in-plan conversion to Roth. In the case of Microsoft they do this conversion daily, but in some cases it may be monthly or even quarterly. Note: the conversion itself may generate a small tax liability as you are required to pay tax on any growth from the time between contributing and the conversion itself.

And why does this help you?

There are a couple great things about this option. First, if you happen to make too much money to be eligible for a Roth IRA contribution, this is a great way to save money on a tax-free basis. Second, it greatly expands the amount you can save in a tax-advantaged manner. 

The Mega Backdoor Roth is the latest in a series of benefits that tech companies are offering to lure top talent. As mentioned, Microsoft has had this option for years, but Facebook, Google and Amazon have all jumped on the bandwagon in recent years. 

So if you have enough income to be able to afford to save that much to your 401(k), should you do it? The answer is quite likely yes, but there are certainly other factors to consider. In the case of Microsoft you also have the option to save into a Health Savings Account (HSA) or Employee Stock Purchase Plan (ESPP). Determining which of these to take advantage of can be a complex process. As with most things it’s wise to work with a financial planner who can help you determine if this is the right option for you, in light of your unique situation. 

Should I refinance my mortgage?

Xena Financial Planning blog refinance

It seems like everyone I know is asking this question right now. Mortgage rates are at an ALL TIME LOW As of July 2, 2020, Freddie Mac reported that 30-year mortgage rates are at 3.07%, on average, the lowest rate since they began tracking in 1971.

As you can imagine, there are a lot of people scrambling to buy or refinance while rates remain this low. How do you know if it makes sense for you?

Like most things, it really depends on your situation. The absolute most important question to ask is how long you plan to stay in your home. If the answer is less than 3 years, there’s a good chance that refinancing won’t make financial sense.

If however, you plan to stay for several years, it’s probably worth looking into. Some of the other questions to consider are:

Refinancing may be a great option for many people during this time. Keep in mind that it may be even harder to get approved, especially if you (or your partner) have had a change in your income due to the pandemic. Check out the refinance calculator at bankrate.com. And as always, feel free to schedule time to chat with me if you have any questions.

How much emergency reserve do I really need?

Xena Financial Planning blog rainy day fund

The conventional wisdom for an emergency reserve is about 3 to 6 months of living expenses, typically kept in a liquid, FDIC-insured account. So just how do you calculate “living expenses” and what exactly is “essential”?

In the current global pandemic environment, most of us have noticed a shift in our spending. Travel budget: $0, eating out: minimal. Your spending now is probably fairly representative of the minimum needed to survive. Things like your rent/mortgage, basic transportation expenses, food & utilities should absolutely be included. Now take that minimum monthly number and multiply it by 3. This is the smallest number you should target for an emergency reserve.

If anyone in your household is self-employed or has variable income (i.e. a real-estate agent, or an artist), you will want to target the higher end of the 3-6 month range. COVID and its effects have hit certain industries particularly hard. Even professional athletes are facing a significant cut to their expected income. Given the circumstances, it’s understandable to lean towards caution and keep as much as you can.

That’s a reasonable strategy for the short term, but don’t sacrifice saving for retirement or other goals in favor of sitting on oodles of cash. 

On the flip side, if you’re just starting to save, these amounts may seem daunting. At the very least, aim to have a couple thousand dollars set aside in the event you have a major house repair or other unexpected expense. It won’t get you too far but it’s a great start. Plan to set aside a little bit from each paycheck until you reach the goal.

One of the benefits of working with a financial planner is that they can help you prioritize saving for an emergency reserve, paying down debt and saving for other short and long-term goals. All of the recommendations here are simply that.