Part III. Personal Balance Sheet
Your personal balance sheet summarizes two things: what you own (e.g. your assets) and what you owe (e.g. debt).
Managing your balance sheet boils down to two things: First, ensuring that you're managing debt appropriately. Second, deciding how you want to allocate your financial assets.
What do I mean by financial asset allocation? I mean how do you want to deploy your resources between the different thing you own. Both those things you own today, as well as things you might dream of owning in the future. Those things (e.g. assets) include homes, vehicles, second homes, bank accounts and investment accounts. And one of the most important things to think about when navigating asset allocation is assessing how much liquidity you have.
Liquidity: The Anxiety-Slaying Life Hack
What the heck is liquidity anyway? Liquidity measures how easily you can convert any given asset into cash. Cash is inherently liquid because, well, it's already cash.
On the other hand, real estate (like your home, if you own it) is quite illiquid. You can't convert real estate into cash quickly, and you'll usually incur a lot of transaction costs (e.g. realtor fees) along the way. Retirement funds are another example of pretty illiquid assets. Until your reach age 60 (technically age 59 1/2... don't blame me, ask Congress about that age), you can't access assets held in tax-advantaged retirement account unless you pay a painful early withdrawal penalty.
What's so great about liquidity?
Liquidity reduces stress and anxiety. Life happens. Unexpected expenses always have a way of showing up. Sometimes we need to step away from earning income with little warning. If you have sufficient liquid assets to rely on when these things happen, you literally will sleep better at night.
Yes, I mean quite literally this will allow you to sleep. Without adequate liquidity, you may find yourself up all night worrying if you need to start driving for Uber, take out a second mortgage or rack up credit card debt just to get by.
Liquidity gives you time to take a breath and make thoughtful decisions about the future. If you're under tremendous emotion strain, you won't be doing your best thinking - it simply isn't possible. And you may end up making some decisions you look back on with regret. Liquidity can help prevent that from happening.
Finding the Right Balance ⚖️
None of this means you should avoid illiquid assets like real estate or illiquid investment vehicles like retirement funds. What it does mean is that you likely will want to balance you assets between liquid and illiquid ones.
What's the right balance? Well, personal finance is just that: personal, so there is no one right answer. But in general, I like the idea of having around one year's worth of living expenses in liquid assets. 3-6 months of that should be in your emergency fund (discussed below). That emergency fund should be held in a bank account or other very stable investment like a money market fund.
The remainder of your one year's worth of liquid savings could be invested in alignment with your overall investment allocation. (Which I discuss on the Investing Page.) Admittedly, if the stock market is down, you might end up having to sell some investments at a loss. That isn't ideal, but you'll still have money readily available, and that's the most important thing.
I would caveat that while you're building up to that one year's of liquid savings, you still could (or perhaps even should) be contributing to retirement accounts. A simple approach might be to split your savings 50/50 between retirement accounts and more liquid investment accounts. It's true you won't have easy access to retirement accounts until you're older, but most retirement account contributions generate tax savings and saving for retirement is generally a prudent strategy. That approach won't be right for everyone, but it's something to consider.
Thinking about Home Ownership 🤔
Once you have around one year's of expenses saved up, then you can start thinking about investing in less liquid assets like real estate. You might be thinking that sounds like a long time to wait before buying a house. Yes, it might be. And waiting might not be the right move for you. But I believe it often is.
"But Dave," you might be thinking, "buying a home is the best investment I could possibly make! I've been told buying a home is the first thing I should focus on!"
Yes, I hear this a lot. Many people, including many financial professionals, believe that investing in real estate (aka buying your first home), is the best long-term financial move you can make. And, yes, it's true that home ownership can yield some substantial financial returns.
But in general I don't think buying a home is a slam dunk. I think there is a bit of a cult of home ownership in this country, and that (maybe cultish) thinking shows up everywhere from cocktail party chatter to the tax code. Home ownership isn't a bad goal AND it has to be viewed in context of your overall financial life. And home ownership certainly isn't a panacea for a secure financial future.
I dive into this in more detail in the "Is Real Estate a Good Investment" section below. For now, the key point I want to drive home (sorry... 🤣) is twofold. First, home ownership isn't the end all be all of personal finance. You don't need to own a home to be financially successful, stable or astute. Second, if you choose to buy a home, be thoughtful about how it fits into your overall financial plan, including how it impacts your desired level of liquidity.
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Let's Talk about Asset Location
The who and the what now? I know it’s another fancy finance term being thrown at you, but it is a fairly useful one. Asset location is something that many people haven't heard of.
Asset location refers to the types of accounts you hold your investments in. In other words, in what type of account in the investment located.
What are these different types of accounts?
One type of account is a normal brokerage account, often called a taxable account (because it offers no tax advantage, unlike retirement accounts).
Then there are a wide variety of tax-advantaged accounts, including retirement plans, HSAs and 529 plans. Of course, retirement plans come in a wide range of flavors, including SEP-IRAs, 401(k)s and pension plans to name just a few. And many of these retirement plans come in two different varieties: traditional and Roth. And each of these different incarnations of accounts offer slightly different tax characteristics.
If your head is spinning, that's normal. 🤯 I've dedicated years of education and study to understanding all the nuances here. And as soon as I feel caught up, Congress has a habit of going and changing some of the rules. Not nice. You don't have to be an expert, just know these different types of accounts are out there, and that they are tools available to manage your asset location (when you get to that stage of your financial planning journey).
What's the benefit of diversified asset locations?
It can be a huge benefit to have your assets located (or divided) among different types of accounts. Why? Because the diversity of tax characteristics gives us flexibility down the road when you begin to take distributions out of the accounts. We can pick and choose which accounts to draw from based on how we want to manage your taxes. This may not sound super exciting, but trust me it can be a nifty trick to reduce your tax bills down the road.
Don't sweat the small stuff, especially when getting started.
Now that I've belabored the importance of asset allocation, let me talk out of the other side of my mouth. If you are just getting started with saving and investing, don't worry about this too much. It's something that can be tweaked and modified along the way.
After you've been saving for a number of years, asset location is something you should begin to think about. In the beginning though, just start saving. And split that savings between your taxable accounts (that's just an ordinary brokerage account you can open anywhere) and your retirement account. Again, this will not be the perfectly correct approach for everyone, but it is for a lot of people. If you suspect your circumstances are different from most, please seek professional guidance from me or someone else you trust.
Saving into a retirement account naturally begs a somewhat thorny question. What type of retirement account should you open? I have some resources below, but again don't sweat the small stuff too much: virtually all retirement funds can be moved into one another through roll-overs. If you want to change things down the road, usually not a big deal. Just be sure you're opening an actual retirement account, and not some BS annuity or whole life insurance policy.
Retirement Plans Page!
Retirement plans... wow, are they confusing. And I say this as someone who LIVES FOR confusing details like this.
You might not be as keen as I am, but let's help you think through what type of retirement plan makes most sense for you.
It won't be as painful as you're fearing! But it IS a fair amount of information, so I've put the information on its very own: Retirement Plans Page.
Resources for Managing Your Assets
Click on the orange section headings to expand
The first thing you likely will want to direct your savings into is an emergency fund. What is this emergency fund?
An emergency fund is three to six months worth of your non-discretionary expenses.
The idea is that if you lost the ability to earn income tomorrow, you'd still be able to live without financial stress for 3-6 months. What do I mean by non-discretionary? I mean those bills that you absolutely can't avoid: rent, mortgage, car payment, food, insurance payments and the like. Discretionary expenses that you could do without for a short-time period (e.g dinners out, entertainment expenses) can be excluded.
An emergency fund is best kept in a savings account, checking account, or perhaps a money market fund.
The point is, don't put your emergency fund in the stock market where - if the stock market suddenly nose dives 📉 - 6 months of expenses could suddenly become 2 months. Yes, of course, if the stock market sky rockets 📈 your funds could also magically become 12 months of expenses. But we never know what the stock market is going to do. No one does. (See the Investing Page for more thoughts on that.) Anyway, the point is an emergency fund is really a form of self-insurance... and we don't want to gamble with it.
But don't just take my word for it, here are what some of my fellow personal financial planners have to say about emergency funds:
Real Personal Finance Podcast: Do I Need an Emergency Fund?
Workable Wealth Blog: How to Handle Your Year End Bonus (hint: one of the things is establish an emergency fund)
The Balance: Learn About an Emergency Fund and Why You Need One
As I mentioned above, buying a home can be a good financial move. AND it's not required. I think too often home ownership is pushed as the end all be all of good personal financial management and that is simply not true.
Buying a home is not a slam dunk. Why do I say this? Three primary reasons:
1. Real estate isn't a Liquid Asset (at all)
If push comes to shove and you need money, it's hard to access the cash from any real estate investments you hold. Typically, you would have to sell, refinance your mortgage or structure some type of a home equity line of credit. All of these solutions take time to put in place, will cost you money in the form of fees and charges and none of them are certain to be available.
2. Long-term residential real estate returns aren't all that.
Residential real estate in general hasn't been the best investment. Have there been certain areas that offered enormous returns over limited time periods? Absolutely. However, when looking at decades worth of data, the rate of return on residential real estate is about the same as the rate of inflation. The stock market is a much more rapidly appreciating class of asset.
3. Real estate contains a lot of very concentrated risk.
That one, specific piece of real estate you own is subject to a lot of unique risk. Earthquakes, changes in school districts, changing neighborhood dynamics to name just a few could tank the value of your investment. And the occurrence of any of these idiosyncratic risks is entirely unpredictable.
Are there counter-arguments to each of the points I've made above? There sure are. Not everyone will agree with me here. But when coming up with recommendations and beliefs I always want to know what the data say. And the data say that identifying the real estate marketing that will appreciate substantially in the future is VERY difficult.
My key message is that you don't HAVE to own a home to be financially successful. At all. Often times, being a renter is a better financial bet. And buying a home can absolutely fit into your personal financial plan. As always, personal finance is personal: what's right for you depends on your unique circumstances AND what kind of life you want to live and what you most deeply value.
Personally, I'm what I call a strategic renter. Could I purchase a home? Yah, probably. Would it require a big financial sacrifice? Also yes - I live in Los Angeles and real estae here is expensive af. Is my overall life better because I'm a renter? Yah, I think it is! I have the freedom to move around and spend more money on things like travel. Will that change at some point in the future? I dunno, maybe! But my financial planner and I agree that not owning a home is the right approach for me right now.
The last point I'll make here, is buying a home usually only makes sense if you plan to own the home for at least five years. That's a rough rule of thumb, but any shorter than five years and the value appreication of your investment likely won't be big as all the transaction fees you'll incur when both buying and selling. The resources I link to below also have more thoughts on this type of time-frame thoughts.
If you'd like to hear the perspective of some of my financial planner industry peers, here are some blogs and pods for ya!
One of my all time favorite posts about the subject of home ownership is from Paula Pant of Afford Anything. This article is such a great overview, and she is really, really smart about real estate ownership and investing. Her post also walks through the (not so simple) math you need to perform before you conclude renting is a bad financial move (hint: often renting is the smart financial move).
Money Owners: Home Ownership... is it right for you?
Money Owners Podcast: Real Estate Myths
Real Personal Finance Podcast: Hidden Costs of Home Ownership
Real Personal Finance Podcast: Is Real Estate a Good Investment?
Real Personal Finance Podcast: What Issues Should I Consider When Buying a Home?
If you're saving for your children's education, a 529 Plan is likely a good option for you to consider. There are other tax-advantaged plans you could use, such a Coverdell. And while not always the perfect solution, you can even use a Roth IRA to pay for educational expenses. Typically, however, 529 Plans offer the greatest degree of flexibility. I'll be adding more of my own thoughts on this in coming weeks. For now, here are some things to keep in mind from sources I trust.
Here's a solid overview of 529 plans from Investopedia.
Real Personal Finance Podcast: Everything You Need to Know About 529 Plans
Real Personal Finance Podcast: College Savings Options When College Isn't Far Away
Real Personal Finance Podcast: How can I save for college?
Work Your Wealth Podcast: College Planning for Your Kids
A HSA is a tax-advantaged vehicle which allows you to save for (primarily) healthcare expenses. You must belong to a High Deductible Healthcare Plan (HDHP) in order to contribute to an HSA. You can check with your insurance provider to find out if you have an HDHP policy, they should know exactly what you're asking about.
If you're eligible, the great thing about an HSA is that it offers three layers of tax benefit: a tax deduction in the year you contribute, your savings grow tax-free within the HSA, AND qualified distributions from the HSA are also tax-free. This is an unheard of tax-free triple threat.
I will add, that an HSA is a tax-driven refinement to your overall financial plan. If you're just beginning, this is probably not the right place to burn a lot of calories figuring out. If it feels like an easy thing for you to do, great! But my generic suggestions is that don't let things like HSA's distract you from doing more important, foundational things like establishing an emergency fund, putting core insurance policies in place, understanding your personal cash flows and getting a retirement plan established.
If you're looking for more information on HSAs and if they might be right for you, here are some additional resources:
Real Personal Finance Podcast: What is an HSA?
NerdWallet: What is an HSA?
Investopedia: Health Savings Accounts: Advantages and Disadvantages
I should probably call this section Personal Capital, because it's the only tool I'm aware that does a decent job.
Personal Capital is a technology-enabled, wealth management and financial planning firm. Their free technology tool is certainly a lead generation effort, so expect to get some sales pitches, but it IS a quite good tool. And it's the only one I know of that easily and fairly automatically creates a personal balance sheet for you.
There is real power in having your entire balance sheet summarized on one page. It clearly outlines your net worth - and yah, that might be a bit scary to look at. And if you're willing to move through that discomfort, the clarity it brings I believe can be very clarifying and empowering.
Tiller is another service which can create this balance sheet, or net worth summary. It's a bit more manual, and you have to enjoy (or at least tolerate) working in spreadsheets. Tiller works with both Google Sheet and Microsoft Excel. If you love spreadsheets like I do, it's worth checking Tiller out.
Resources for Managing your Debts
Click on the orange section headings to expand
This is always a tricky question. It's impossible to give an accurate answer that will fit everyone in every situation. It simply depends on so many things, including your overall life and financial circumstances.
With that caveat out there, I will say that aggressively paying down debt when you don't have a nice cushion of liquidity is risky. An adequate cushion of liquidity to me means (at minimum) a 3 month emergency fund, if not more. Debt is a tool to help create liquidity when you don't have any. Prematurely paying down debt will only put you back in that illiquid (and anxiety-generating) trap.
I'll be adding to my thoughts on this one in the future, but for now, here is some content from other financial planners to help you frame this question.
Real Personal Finance Podcast: Should I Get a 15 or 30 Year Mortgage?
Real Personal Finance Podcast: Is it a good time to refinance my mortgage?
Real Personal Finance Podcast: A Deeper Dive on Refinancing (Rates, Points and everything else)
I love student loan debt. Ok that's not quite right. I love learning about the complexity of student loan debt and using that knowledge to help folks better manage their student loan debt.
And it is CHALLENGING to manage student loans. I honestly was blown away by the complexity when I was taking coursework on this subject. I'm going to be adding more content here soon, but for now, you might start with this Money Owners Podcast: Student Loans with Guest Jantz Hoffman!
If you want to really dive in to the details, check out Student Loan Planner. They offer so many great resources, and I use their content to help me stay up to date on the latest changes in the world of student loans. Their content gets technical quickly, but they have a TON of information to help you think through the best repayment options for your situation. They also offer 1:1 services to evaluate how best to manage your debt. That's also a service I also offer, but it's good to have some choice of who you work with, right?
One more excellent option for one-on-one work is Ryan Frailich of Deliberate Finances. He's an exceptionally kind, thoughtful and smart guy with outstanding student loan chops.
Need a break? Ciao for now! 🧘♀️
And if you're still raring to go... 🚀
Let's get learning about Investing!
Standard Not Advice Disclaimer
Just a friendly reminder that none of the information included anywhere in this guide is financial, legal or accounting advice. I don't know the specific financial circumstances of your life (or your private practice), so there's no way I can make blanket statements about what's right for you.
What I offer in this Guide is a suggestion on how you might think things through and then decide (for yourself) what's right.
For some topics, I've also included what I've learned works well for most people. But you're not most people, you're you. You might be in that minority where the general suggestions are the wrong approach.
Take everything said here (and anywhere else online) with a grain of salt, and seek out professional advice if you suspect you need it. Of course, I'm always happy to have a no cost introductory conversation with you to see if I can help.
I know this sounds like a legal CYA (that's cover your ass) statement. And yah, it is that. AND it's also an extension of loving kindness to you, the reader.
The way I cover my ass here is by making sure I don't encourage you to do anything that ends up causing you harm. I don't want that for you, and you don't want that for you. Take your time, think things through, be deliberate and seek out professional advice if you suspect you need it.