Lisa Brown and Beth Marks — whose names have been changed to protect their identity — would like to marry someday. Lisa is in her mid-forties and Beth is nine years younger. They live together and are in the process of merging their finances. They are looking for a financial roadmap to help them transition into one household.
“While our financial challenges may seem steep, we think many of them are common place,” said Lisa. “We think our case could be instructive to others.”
Indeed, Lisa and Beth are committed to each other and want to spend the rest of their lives together. Their situation is complicated by the fact that they are a same-sex couple and Lisa is in the process of finalizing a divorce that has dragged on for three years. Lisa has two teenage children from her first marriage. Lisa and Beth live in a community property state where same-sex marriage is not currently legal.
Lisa and Beth have a slew of financial goals ranging from family trips to international travel to paying off credit cards. Their challenge is that together they have excessive consumer debt in relation to their assets and combined income. Another challenge is that Lisa looks financially vulnerable given that her debt is significantly higher than Beth’s and multiples of her annual income. Given that Beth earns approximately twice what Lisa does, their combined finances appear healthier. Even so, their challenge is to come up with a strategy to pay down their debt in an expedited fashion so that they can move beyond a “paycheck to paycheck” lifestyle and realize some of their more uplifting financial goals.
Summary of Goals
- Lisa and Beth would like to marry within the next year or two. They cannot plan exactly when this wedding would be as their state law would have to change to permit same-sex marriage. They are looking at an overall cost not to exceed $10,000 including wedding rings
- They are planning a family trip to Hawaii for an estimated cost of $6,000.
- Lisa and Beth would like to buy a home within two years. They would like to budget a down payment of $30,000 or approximately 20 percent of the anticipated value of their new home.
- Lisa and Beth would like to be able to travel regularly, with trips ranging from family obligations in Hawaii and the East Coast to vacations in Europe. Ultimately, they would want to budget about $5,000 to $8,000 per year for vacations.
- Lisa and Beth would like to pay off all credit cards and car/motorcycle loans. Together, this debt sums up to $140,000, almost equal to their combined annual income.
- Lisa and Beth acknowledge that they will have to update their estate planning documents. They recognize that planning can be more onerous for same-sex couples.
- Lisa and Beth would like to begin thinking about planning for retirement. They both have an adventurous streak and would like to retire when their finances permit. Beth works for the State and has a generous pension scheme which could allow her to retire before the age of 50. Lisa also is entitled to a pension which is significantly less robust. Both have 401(k) plans and they want to know how much they should be contributing to these plans given their prospective pensions and high debt levels that compete for same dollars.
- Lisa and Beth both want to know if they should pay into a Roth Individual Retirement Account (Roth IRA).
What's a young couple to do? We asked FPA member, Elizabeth Cox, CFP®, a principal with Cox Financial Services, LLC., to analyze their finances and create a plan.
From a planner's side of the desk, it's important to start at the beginning. Financial planners and clients mutually define a client's personal and financial goals, needs and priorities. This step is what financial planners call the data gathering: Financial planners will obtain all the quantitative information and documents about a client before any recommendation is made and/or implemented.
The discussions that follow are based on Lisa and Beth'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.
In the case of Lisa and Beth, it is critical to create a balance sheet — a snapshot of their wealth at a moment in time. The balance sheet reflects what they own (their assets), what they owe (their liabilities), and their net worth (the difference between assets and liabilities). A positive net worth indicates that they own more than they owe. A negative net worth would indicate that they owe more than they own.
Lisa and Beth’s combined balance sheet shows a modestly positive balance. However, if you take out the value of their cars and motorcycles, which are depreciating assets, they dip into negative territory. This is because of their high consumer debt (including $140,000 combined credit card debt and auto loans). It should be noted that taken individually, Lisa has a negative net worth and Beth is on a more solid financial footing. A way to increase net worth is to increase savings and pay off debt.
Another important document needed is a statement of cash flow. The cash flow statement typically reflects a household's annual income less its discretionary and non-discretionary expenses. Income minus expenses is what financial planners call net cash flow. Positive net cash flow is good because it can create savings and financial security. Negative net cash flow is bad as it creates debt and/or erodes savings. Beth and Lisa have, at the time of this analysis, negative net cash flow. However, with some budget work, they are able to cut back on some discretionary expenses, such as dining out and reduced bills from consolidating households, to achieve a break-even cash flow.
When it comes to creating a budget it's important to understand that there are two kinds of expenses; discretionary and non-discretionary. Discretionary expenses are typically non-essential expenses that can be avoided or trimmed. Non-discretionary or fixed expenses can be changed in some cases, but they must always be paid. Typically, non-discretionary expenses include a mortgage, taxes, minimum debt-service payments and the like. Lisa and Beth spend an unsustainable amount of their income on servicing their debt, including high-interest credit card debt. In fact, they are paying $1,200 per month on credit card debt with interest rates as high as 23 percent. They are also paying another $1,490 per month on auto loans. Their total consumer debt is approximately $140,000 (of which close to $97,000 is in auto loans and balance is mostly credit cards).
Lisa and Beth recognize that they will struggle to achieve their financial goals if they can’t create positive cash flow and reduce the head wind their debt payments represent. They have worked on their budget and cut down some of their discretionary spending. They also have put a priority on paying off their credit card debt and, as of this writing, have already been able to pay off some of their smaller credit cards with the highest interest rates.
Debt Management Plan
Lisa and Beth recognize that paying down debt has to be a top priority. If they do not employ a strategy to pay off their credit card bills and auto loans, they simply will not be able to achieve their other financial goals.
Debt Pay Down Plan: We worked with Lisa and Beth on a debt management plan that involved paying down their credit cards beginning with the balance on the highest interest rate first. They have earmarked $1,400 per month for paying off credit card debt plus a small personal loan to Beth’s parents. This concerted effort has already enabled them to pay off a couple of credit card balances in full. However, even at this rate, it will take more than six years to pay off their credit card debt of more than $40,000.
Lisa and Beth also have auto loans totaling more than $95,000 between two motorcycles and two cars. In each case, the value of the auto is close to the amount of the loan. We discussed selling these autos as a way of reducing this high level of debt, but Beth and Lisa consider keeping these cars and motorcycles a top financial priority. So they have budgeted $2,850 a month to service these auto loans, some of which doesn’t mature for another six years. Again, we discussed paying off those loans with the highest interest rates first.
This debt payment regime is long and arduous. It eats up approximately $4,250 per month, more than 40 percent of their after-tax income. It prevents them from considering other goals such as purchasing a home or traveling abroad. It can also present a constant worry. Lisa and Beth acknowledge this burden and are committed to paying off their consumer debt.
Expense Control: Lisa and Beth have significantly reduced their discretionary expenses in order to expand their ability to pay down their debt more quickly. By combining households, they have found that not only have they consolidated some household bills, but also that they dine out less and spend less on general shopping. This discipline has allowed them to achieve a positive cash flow even with their heavy debt burden.
Debt Management Ratios
Knowing how much Lisa and Beth spend on discretionary and non-discretionary expenses is important. But financial planners also tend to analyze the percent of money spent on various expenditures and liabilities. For instance, consumer debt (credit cards, auto loans, etc.) should not exceed 20 percent of net income (gross income minus taxes). In Lisa and Beth’s case, at the time of this analysis, it is approximately 40 percent. In order to afford these high payments, Lisa and Beth live in a rental home that costs approximately 16 percent of their gross income. The general rule of thumb is that monthly payments on a home (including principal, interest, taxes and insurance) should be no more than 28 percent of their gross income. Lisa and Beth must pay significantly less than this in order to pay down their consumer debt. Until their credit card and auto loan payments are under control, they will not be able to afford to purchase a home.
Lisa and Beth need to make paying down debt their top priority. But once that's down, they will need to come up with a savings strategy to build up an emergency fund and achieve their short- and medium-term goals including travel and buying their own home. Lisa’s two children are also approaching college age and may need some financial help.
Ideally, Lisa and Beth need to save at least 10-15 percent of their gross income for future goals, beyond what they put aside through retirement plans. At this time, much of these savings are being directed toward debt service and reduction.
Retirement Plan Savings
As with so many couples, Lisa and Beth’s top savings goal is to fund their retirement. Beth wants to retire before she turns 50 and Lisa wants to retire at around the same time, as she is nine years older. A rule of thumb is that Lisa and Beth may need to save up to 20 times their annual expenses for retirement. Financial planners generally recommend that you save at least 20 percent of gross income for retirement and an additional two percent for retirement health care costs. These savings targets are appropriate for Lisa and Beth, as Beth works for a government agency with a very generous defined benefit plan. In fact, in addition to a plan that would allow her to retire by age 50 with a pension equal to 90 percent of her gross income, Beth also has a defined contribution plan with a very generous company match of which we recommend that she take full advantage of. Beth’s employer also offers a supplemental 401(k) plan with no employer match. Given her other generous plans and continual need to pay off debt and build up savings for shorter-term goals, we recommend that she forego this 401(k) and contribute the consequential cash flow to savings and debt reduction.
A budget needs to include an allocation for emergency expenses. Typically, financial planners recommend that families have anywhere from three to 12 months of living expenses set aside in a rainy day fund, depending on their circumstances. Given that both Beth and Lisa are employed, which contributes to their financial stability, their target should be to build a fund with four to six months of living expenses, or about $50,000.
Financial Planning Challenges for Same Sex Couples
Same-sex couples, like Lisa and Beth, need to keep in mind that even though domestic partnerships or civil unions are recognized by some states (Vermont, Connecticut, New Jersey, Maine and Hawaii) and gay marriage is allowed in Massachusetts and New York, the Federal government does not recognize them as a couple. Consequently, they are not entitled to the nearly 1,000 Federal tax and other laws that benefit those allowed to marry.
Here is a brief description of some of the financial planning or legal tools useful to same-sex couples. We recommend that you seek legal advice on which of these would be most appropriate and how to implement a strategy.
Wills and/or Revocable Living Trusts: Lisa and Beth would need a will and/or a living trust to allow their assets to pass to each other. A revocable living trust holds title or ownership to your assets and your trustee distributes your assets per your wishes after your death. A living trust also keeps your affairs private because it avoids probate, unlike a will, which passes through probate and becomes part of the public record.
Beneficiaries: Be sure to review your beneficiary designations on retirement accounts, stock options, life insurance and any other assets.
Domestic-partner Registration: In certain states, you can register your other half as a domestic partner and be afforded state spousal rights, such as the right to inherit without a will. While it may be a good idea to take advantage of this registration option, it is still important to have an updated will and other current documents.
Advance HealthCare Directive (Living Will): An advanced health care directive, like a living will, allows you to appoint an agent (your partner) to make medical decisions on your behalf should you become incapacitated. It would also permit your partner visitation rights in an emergency. Without a health care directive, your partner may not be allowed visitation rights as they may not otherwise be considered a family member or spouse. It may also be advisable to give your partner Health Insurance Portability and Accountability Act authorization — a document that will authorize your insurer to release medical information to your partner.
Durable Power of Attorney for Finances: This document designates an agent, potentially your partner or an adviser, who will keep your partner's interests in mind and make financial decisions if you become incapacitated.
Domestic Partner Agreement: Similar to a prenuptial agreement, this document specifies who gets what in the event of a split or death.