A Couple's Plan to Fix Their Financial Situation

The Problem/Goal

Isabella Ryan and Ethan Sloane have plans on getting married, some day. But in the meantime, they want to get their financial house in order before they book a honeymoon.

“Our financial situation is a little unique,” said Isabella and Ethan, whose names have been changed to protect their identity. “Or it is at least to us.”

Indeed it is. Isabella lives with her boyfriend Ethan and her eight-year-old son, Scott, from a previous marriage. Isabella and Ethan are working, but they haven’t saved up enough money to do all the things that they want to do as a couple and as a family.

“We plan on getting married one day, but we have to have money,” she said. At the moment, Ethan is the bread winner in the household and — because the current situation with the economy — Isabella is working only part-time as an administrative assistant.

Besides getting married, Isabella and Ethan have other big plans. They want to buy a house and Ethan wants to start a business in about eight years. But the finish line for those plans seems to move farther away rather than closer. “We have tried and tried to budget our money and it just never seems like we can,” she said. “It seems like we can never get ahead. No matter how hard we try there just never seems to be enough money.”

In requesting a money makeover from the Financial Planning Association® (FPA®), Isabella said she wanted to figure out “where we are going wrong.”

“I am really worried about finances — not just right now, but also for our future,” she said. “But in the mean time, we just can’t ever seem to get out of this rut we are in.”

According to Isabella, it’s not that Ethan and she are big spenders. They never eat out and they don’t buy “unnecessary things.” But she said they do live paycheck-to-paycheck and they want to break that cycle. “At this point, we are in desperate need of some help and some education about our finances.”

Summary of Goals

• Isabella and Ethan would like to buy a house together in the next one to two years. They want to move to the country, or buy raw land and build a home. They are looking in the $150,000-$160,000 price range.
• Ethan and Isabella are hoping to plan a wedding soon. They anticipate support from family, but expect to be on the hook for half of the overall cost. They are looking at an overall cost not to exceed $10,000.
• Ethan would like to own an auto body shop.
• Isabella and Ethan would like to establish a savings account to cover at least two to three months of expenses.
• Isabella and Ethan would like to move beyond the “paycheck to paycheck” lifestyle they currently live within.
• Ethan and Isabella would like to build some lifestyle expenses into their overall cash flow plan. They anticipate needing a new car, and hope to be able to take a vacation every year.
• Isabella knows they need to begin saving for her son Scott’s education. She would like to know the best education savings vehicles to meet these goals.
• Isabella would like to finish her own post-secondary education, with a focus on accounting to put her on a track to a Certified Public Accountant (CPA) designation.
• Isabella has shared that neither she, nor Ethan, have estate planning documents in place. She recognizes a need to put these in place, particularly to ensure Scott’s well-being.
• Ethan and Isabella would like to begin thinking about long-term goals, namely retirement. 
• Isabella has unpaid medical bills that total $2,300, and would like some help with a plan to pay them off.

What's a young couple to do? We asked FPA member, Michael A. Branham, CFP^®, a principal with Cornerstone Wealth Advisors, Inc., to analyze their finances and create a plan.

The Solution

Financial planning is an ongoing process, during which new information and life events often change the course of your plan. The discussions that follow are based on Ethan and Isabella's lives today, and the information that they provided. Some of the recommendations will be very specific, others more vague. This approach is based on the assumed evolution of their personal and financial situations. 

Data Gathering & Assumptions

From a planner's side of the desk, it's important to start at the beginning. Financial planners and clients typically mutually define a client's personal and financial goals, needs and priorities. The next step is what financial planners call data gathering: Financial planners will obtain all the quantitative information and documents about a client before any recommendation is made and/or implemented.

• Ethan and Isabella are each in their mid-20s.
• Isabella and Ethan share their financial obligations.
• Isabella is looking for full-time work. She is currently working part-time, three days per week. Her monthly income totals about $800.
• Ethan manages an auto body shop, and his income provides a majority of their financial support. His monthly income totals about $2,300.
• Isabella currently does not have health insurance. Ethan has health insurance through his employer. Isabella’s son, Scott, has health insurance through the armed forces, based on his biological father’s active duty status.
• Isabella receives $489 per month in child support payments.
• Ethan and Isabella have reported monthly expenses that total about $2,050 per month.
• Neither Ethan nor Isabella have any life insurance in place.
• Ethan has a private disability income policy, though details are sketchy about the policy.
• Isabella and Ethan rent their home. They do not have renter’s coverage on their personal property.
• Ethan and Isabella have three cars. Isabella’s vehicle is fully insured, Ethan’s two vehicles have liability coverage.

Cash Flow

As is often the case, many of your short- and long-term goals are dependent on your ability to effectively manage your cash flow. Finite income sources pose challenges to every budget, and living within one’s means is essential to a financially stable lifestyle. Currently you have done a great job of limiting your debt, but many of your goals will undoubtedly add to your overall debt load.

One of the best ways to manage cash flow is to adopt a “bucket” approach utilized by cash management systems such as First Step Cash Management™. With this approach you will use several accounts deliberately set up for specific purposes. For instance, you could have an account set up for your many monthly obligations, a separate account for rent/mortgage payments, an account set up for auto related expenses, and even an account for travel, or other lifestyle desires. We will discuss the specific accounts in more detail as we work through your various goals.

Before we can proceed further, it is important to understand the current financial picture as you have described it.

As you work towards your various goals, it will be imperative that you gain a better understanding of your monthly expenses. Much of what you have reported is simply part of sustaining a monthly budget, but there are more than $670 of expenses in your reported budget (under your misc. category) that need to be closely examined to determine if there is additional room for saving. You should also look for other expenditures that can be examined to see if you can get by with spending less. In order to reach the goals you have stated, you can do one of two things — earn more or spend less (and devote the extra dollars to the stated goals). You have less control over the monthly income than you do the expenses, so that seems like a good place to start. And, when income does increase over time, dedicate as much of those raises as possible to additional savings. For starters, you should target 10 percent of your monthly income to be saved towards your goals. For the two of you, that means carving out about $360 in monthly expenses and putting that money away. It won’t be easy at first, but you will be building the habits that will allow you to buy your first home, and fund the purchase of a business for Ethan.

In addition to monthly savings, you should look at your variable income sources as savings opportunities, as well. Currently, Ethan is eligible for a quarterly bonus equal to 10 percent of shop profits. He estimated that this averages $3,000 per quarter when things are going well. You should dedicate these bonus payments to your savings goals. This same treatment can be applied to other “windfall” payments, such as any tax refunds you may receive year to year (more on that in the tax section).

In the beginning, you will likely begin saving cash to a savings account or money market account that will be multi-purpose. Some of that cash may be needed for a home purchase, some for an engagement ring purchase or to pay for wedding costs. This fund would also be considered your emergency reserve fund for unanticipated expenses. As you become more comfortable with the savings plan, you can begin to increase the monthly amounts dedicated towards your goals. The most important step is that you are actually saving from your income towards these goals, and that the money is building up for future use. Once we get through some of the short-term goals, these savings habits will be used to begin putting money away towards your long-term goals, including education and retirement.

Short-term Goals

Buying a House

As you continue your life together, establishing roots will become more and more important. The ability to build this into your overall financial plan is considered a top priority.

Your initial thoughts on a home purchase suggest a price in the $250,000 range. We know that median prices in most localities have fallen in the last two years, so it will be important to keep up with trends in your local market as the actual purchase decision approaches.

Regardless of the eventual price tag, your home purchase will require two main funding sources — your down payment and your mortgage. The balance between them will weigh heavily on your overall cash flow planning for the foreseeable future. There are a few items to focus on as you move towards buying a house:

• Debt-to-income ratio: This is one of the major pieces of financial information a lender will look at when approving you for a mortgage, as it measures the relationship between the income you currently have and the debt you currently make payments on.  Your annual income is determined by the tax returns you file each year. Typically a lender will ask for tax returns, from each of you, over a two year period. It is important that you are both reporting your incomes on your annual tax returns, and it is equally important that you are paying down as much of your “other” debt as possible. Buying a house will have a financial impact on your other goals. For example, Ethan’s decision to start a business, or to stay with his current employer, could have an impact on both your annual income and your debt levels. It will be important to prioritize these goals, and to have in-depth conversations with financial professionals, as you make decisions along the way.
• Mortgage pre-approval: When you get to the point where you are actively searching for your new house, you will need to meet with lenders to get “pre-approved” for your eventual mortgage. This will help you determine how much of your purchase can be financed, and how much you must cover with a down payment. The lender will work with you to determine what Federal programs you may qualify for [i.e. Federal Housing Association (FHA) loan programs], and what those programs may require of you.
• Down payment for home purchase: When the home purchase becomes a reality, you will need a source of cash to make the required down payment. Whether you are required to make a 20 percent down payment, or you qualify for a reduced down payment through an FHA program, it will serve you well to begin saving for your down payment today. Based on our cash flow analysis, you should begin putting $350/mo into an account earmarked for your house down payment, and add savings through any bonuses Ethan receives as well.

Planning a Wedding

Your decision on the timing of a wedding brings considerations beyond the financial aspects, but you are right to ask the questions about how to pay for the associated costs. Having a plan in place, and resources to utilize, can mean the difference between a truly enjoyable day and one fraught with anxiety.

You have indicated that you will have some financial support from each of your families. Though without more definite plans, the extent of that support is hard to quantify. Given this uncertainty, it will be difficult to give you defined savings goals/amounts at this point in time. We can, however, develop some policies that may help you along the way.

• Engagement ring purchase: The biggest piece of advice I can give here is to take the rest of your future goals and plans into account when making decisions regarding the engagement ring. I recognize that the financial resources you devote to an engagement ring purchase have as much to do with tradition and personal preference as they do “cost,” but the two don’t have to be at odds. More money spent on an engagement ring may mean utilizing resources designated for actual wedding costs, or a house purchase. You should have an open conversation on the meaning of the engagement ring, and what each of you might be willing (or not willing) to sacrifice at different price points. Given your other financial goals, it may be wise to determine that the purchase of an engagement ring will not add the burden of additional debt payments. 
• Wedding Planning/Funding: Instead of setting a budget and then looking for the funding solutions, try to work in reverse. Once the engagement is set, have conversations with each of your families about the contributions they can realistically afford. From there, look at your own financial ability to contribute, in relation with your other financial goals. Once a final number is determined you will have a better sense of options available to you.

Owning a Business

Ethan has indicated the desire to own an auto body shop in about five years. Given his current commute and his desire to be closer to home, he hopes to start his business in his hometown. The estimated start-up costs are between $150,000-$200,000 (including real estate and equipment).

Quite frankly, this goal puts stress and pressure on the other two short-term goals (a house and a wedding). In order to make all of them work, you will need to be dedicated to a savings plan that makes use of all of your discretionary income and bonuses. It is very likely you will have to incur outside funding in starting this shop. The best thing you can do today is to begin saving money as aggressively as possible, and pay close attention to your credit ratings to ensure that they are strong enough to allow for debt associated with the house and business.

You should also develop relationships with the small town bankers in your community, and look into Small Business Association requirements for loans in your area. Having as much advanced knowledge of what will be required of you when you seek funding for your shop will protect against last minute surprises.

There are some non-financial things you can do in the next five years, as well. Continue to run the current shop as if it were your own. Pay close attention to all of the minor details involved in ownership, and constantly be developing your own business plan. Continually foster relationships with vendors and suppliers to ensure a smooth transition when you open your shop. And keep your eye on the existing shop in your town to know what is working for that business, and what they could improve on. You will ultimately be competing for the same business, and your name, reputation and quality of work will need to carry your shop in the long-run.

Long-term Goals

Education Planning

One of the more important issues for Isabella is Scott’s future education needs. Because of the uncertainty surrounding support from Scott’s biological father, it is important for her to save money over the next eight to ten years to help pay for potential college tuition expenses, or help him get a jump start on life after high school graduation.

Until things are more clear in the budget, and with the short-term goals in mind, it seems unlikely that you can afford to dedicate much in the way of savings here. However, the opportunity to save, if the right habits are built, could be just around the corner. There are a couple of issues to discuss in advance of any money being put away:

• 529 plans vs. other savings vehicles: There are a number of different accounts you could save money in to fund education expenses for Scott. One of the more popular options is the 529 plan. However, this account can only be used for education expenses, and carries penalties that apply if money is withdrawn for any other reason. If you are relatively confident that Scott will attend college, then a 529 plan will be a good option, in addition to other types of accounts. If you are less certain of his educational future, then you may choose to save to a different type of account. These accounts could include a Uniform Transfer to Minors Act (UTMA) account, a custodial Roth Individual Retirement Account (Roth IRA), or an account in your name (with the money earmarked for Scott’s use later). While there are advantages to all of these, keeping the money in your name for now, with the potential to transfer funds to Scott’s name in the future, offers you the most flexibility while you work towards the other goals.
• Who else will help? Does Scott have any grandparents (or other relatives/friends) who may wish to help fund some of his education expenses? Do they want to begin gifting each year in smaller amounts towards that goal? Can you have family/friends gift some of this money at birthdays and other holidays? For example, say Scott’s grandparents spent $100 on birthday presents for him in the past. Could they spend $50 on a present, and put $50 into an account for education? If you can say yes to any of these questions, then it may make sense to open a UTMA account for Scott, and have the money deposited there. A savings account would work as well. 

The overall goal is to begin saving for Scott’s education through the new savings habits, once some of the other goals have been funded and your cash flow is more clear.

Estate Planning

The landscape for estate planning is very fluid. We should have a better idea of what the long-term estate planning laws will look like in late 2010, but for now there are a few simple documents you should put in place:

1. Simple Wills: Each of you should draft a simple will spelling out your wishes at your deaths. This document can be drafted by a lawyer, but there are also some very affordable software programs that can help guide you through the process. A simple internet search can yield results in this area, but having a lawyer draft these documents is always the best way to ensure they are accurate and complete. Neither of you have considerable assets to distribute at this time, but there are other factors to consider:
   • Given that you are not currently married, the laws in your state may not recognize you as the proper “heir” to the other’s assets. Specifically leaving property to one another becomes even more important in these instances.
   • Much thought and care should be given to the legal guardianship of Scott in the case of Isabella’s death. Isabella’s wishes should be very specifically recorded in her will.
2. Durable Power of Attorney: This document will identify the person who will act on your behalf regarding your finances should you be unable to act for yourself. You could each choose to name one another, or choose another person. You can have a lawyer draft this document, or use a standard form which can often be found at your state’s bar association web site or governmental agency web sites. 
3. Living Will: This document will identify medical treatments you wish to receive, or do not wish to receive, if you are unable to act on your own behalf. You can also name a person to make decisions for you should you not be able to make them on your own. 

Investment Planning

Much of your early investment planning revolves around saving money for an emergency reserve fund, a house, a wedding, and the start of Ethan’s body shop. Given the short-term nature of these goals, an equity (or stock) portfolio isn’t likely the best bet. Money saved for these purposes should be kept in a higher yielding money market fund that provides some safety assurances. Two such funds are:

• ING Direct
• This is a money market fund that is currently yielding about 1.1 percent, depending on your balance.
• This fund is Federal Deposit Insurance Corporation (FDIC) insured, meaning that your money is protected even if ING were to go out of business. This protection is also offered on your bank accounts.
• GE Interest Plus
• This is another money market fund that is currently paying between 1.4 percent and 1.7 percent, depending on your balance.
• This fund is NOT FDIC insured at this time.
• Either of these options will pay you more interest than a basic savings account at your local bank.
  

Once the short-term goals have been funded, you will look to begin saving for your long-term goals. Because this long-term savings is out in the future, we will not make specific recommendations on the type of allocation desired, but such an allocation will include a mix of equities (stocks) and fixed income (bonds) of varying degrees. You should consult with a financial planning professional to help determine the best allocation choice for you when this saving begins. The financial planning professional will also help you determine the correct types of accounts to save to for your various goals. Such accounts could include 401(k), IRA, Roth IRA and taxable brokerage accounts.

In the near term, Ethan should talk to his employer about the potential to set up a retirement savings plan at work. This can be done through a variety of options, some of which are low cost to administer and would limit the need for funding by the employer themselves. To the degree Ethan is successful at this, you can get assistance from the plan administrator on choosing investment options and contribution amounts.

Retirement Planning

As important as planning for retirement is, a serious focus in this area can likely take a back seat for the two of you for a while. There are a couple of things that you can focus on, however:

• If/when given the opportunity, save to your 401(k) plan at least to the point of an employer match!
• The savings habits you build for your house and wedding can carry on long past the point of realizing those goals. Once you have funded those items you can continue your monthly savings towards long-term desires, including retirement.
• Once cash begins to build in your emergency reserve account, beyond the desired levels of emergency cash, you can periodically move the excess into a long-term investment account or retirement planning account.

It is the little things in your early years that go a long way towards successful retirement planning. Putting small amounts of money into a Roth IRA each year, and making wise saving vs. consumption decisions, will set you up for the future. Not too far down the road you will be ready and able to take a more serious look at your retirement planning process!

Tax Planning

Tax planning is a year-by-year job that often requires the help of a financial professional. You should seek out the assistance of a financial planner or CPA in the area given the large refunds you have been getting on your annual returns. Ultimately, you should match your tax withholdings to the expected liability, and if a refund still exists save that money toward your other financial goals!

Asset Protection

Asset protection is an area where diligence and a continual focus are important. Many of the solutions can be very cost effective, but the amounts and types of insurance needed will be ever-changing. For example, when you finally buy your house, renter’s insurance will no longer be necessary and will be replaced with a home owner’s policy. Working with a financial planner along the way will help you to answer the myriad of questions that will undoubtedly arise.

Life Insurance

• It will be important for each of you to maintain affordable life insurance coverage, which is typically used to protect your spouse in case of an untimely death.  
• Ethan provides a majority of the financial support for your family at this time. Given this, we feel he should have insurance sufficient to provide his current income level. With an annual income of $42,000, he would need to buy a 15-20 year level premium term life policy with a death benefit of $750,000-$1,000,000.
• Isabella’s income is equally important to insure, and she has the added consideration of making sure Scott has the necessary resources for health, maintenance, education and support. We feel Isabella should purchase a 15-20 year level premium term life insurance policy with a death benefit of $350,000.
• $175,000 of this benefit will cover her current income for 30-40 years.
• $175,000 of this benefit will be used to provide for Scott’s well-being, including his potential costs of education.
• Isabella should name Ethan as 50 percent beneficiary, and set up a trust for Scott in her will as 50 percent beneficiary.
• Term life insurance will offer the most affordable solution to your life insurance needs.
• The 15-year or 20-year policy you would purchase will expire in those respective time frames. You should periodically revisit your insurance policies to make sure they continue to meet your personal needs.
• The amount of needed insurance will change as your incomes increase, and other obligations exist.  
• Also, discuss the impact buying a house may have on your needed life insurance amounts.

Disability Income Protection

• While life insurance will protect your family in the event of an untimely death, you will also need protection from loss of income due to disability.
• Typically you should purchase an insurance policy, or maintain a combination of insurance policies, that will provide 65 percent of your current income in case you become disabled and are unable to work.
• Many employers offer disability insurance as a benefit of employment. We will want to examine those options before looking at private insurance solutions.
• As you might expect, the loss of a job means the loss of “group” insurance policies. Each job loss/change in the future would necessitate a re-examination of your disability income protection.
• The information provided for Ethan’s coverage with his current insurer is somewhat vague about what it actually covers.  
• We would like the opportunity to review the full policy before making specific recommendations in this area.
• It is possible that additional insurance would be needed to protect you from full disability.

Renter's Insurance

• As a renter, the structure you live in is insured by the owner(s) of the property against loss from fire, weather, etc.
• However, your personal property is often not covered by their policies, leaving you at risk of significant loss in such cases.
• You should contact a property/casualty insurance agent about obtaining renters insurance right away.
• This insurance is typically very affordable.
• Be very specific about the value of larger items, as they may need special consideration in any policy.
• Keep photos or video records of your valuables in a fire-proof box to aid in any claim situations.

Auto Insurance

We welcome the opportunity to more fully examine your auto insurance policies to ensure that your coverage and deductibles are appropriate given your current situation.

Liability Protection

This is also known as “umbrella” liability insurance. Liability protection will become more important once you own a home. This type of protection will supplement the liability limits of your home and auto policies. Having said that, you should approach your auto insurer to see if additional liability coverage is available to you at this time. A $1 million umbrella liability coverage would be sufficient in covering additional liability needs. If/when Ethan owns his own auto body shop, it will be important to weigh the additional liability needs at that time.

Health Insurance

• Maintain Ethan’s health insurance through his employer.
• Inquire about whether Ethan has the option of adding Isabella to his group policy. If not available now, this will become possible at the time of marriage.
• Maintain Scott’s health insurance coverage through the United States Air Force (USAF).
  
• It is important that Isabella get health insurance coverage for herself. Any major medical issue while uninsured could be financially devastating!
• If inclusion in Ethan’s group policy is not possible, first approach Isabella’s employer about possible insurance options.
• When all other options have been examined, it will be necessary to look at private coverage, or a public option, to guarantee Isabella is covered.
• Examine all private options first, including more cost-effective high deductible plans that will offer catastrophic coverage.
• As the public health care solutions are solidified in the coming months, care should be taken to examine options available under new legislation.