Starting over is never easy. At 41, with four children to take care of, beginning a new life can put a pinch on anyone’s finances.
Six years ago Sara — whose name has been changed to protect her identity — started over. She found herself divorced and the sole supporter of four children (ages 6, 9, 10 and 18). She relocated from the big city to a small town and needed to work in a field outside of her education and passion. Being in a “hunkering down” period for some time, she lived paycheck to paycheck and did not plan for the coming weeks.
Now at age 47, Sara desperately wants to get her debt paid off, have a cash cushion for emergencies, and make sure her insurance is in order. But it seems there is always something that makes it hard for her to get ahead: school expenses from a deferred payment plan are coming due and Sara needs a new car.
Her desire for a financial plan comes from a fear of not being appropriately covered for risks and the eventual risk of not having enough to retire.
What's a single mom to do? We asked FPA member Robert Schmansky, CFP®, founder of Clear Financial Advisors, LLC, to analyze her finances and create a plan.
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 Sara's life today, and the information that she provided. Some of the recommendations will be very specific, others more vague. This approach is based on the assumed evolution of her personal and financial situations.
Balance Sheet & Cash Flow
In financial planning, we start with a few important pieces of information: a snapshot of what you own versus what you owe (balance sheet), and an overview of your cash inflows versus your outflows (statement of cash flow).
Since Sara is a renter, her major assets currently consist of the money she has been contributing to her 401(k) and her current car.
One of the areas of analysis and concern are the items on the negative side of the balance sheet ledger. She currently has five credit cards with balances, a retirement plan loan, and a deferred payment plan from the school where she received her master’s degree. This is not a student loan account, but rather money that Sara has agreed to pay back in the future.
With three of the four children still at home, Sara is worried if the money coming will be able to cover the needs of her family.
Her feeling is that there is nothing wasted and nothing to spare. We covered the expenses Sara was able to track. Admittedly she could do a more complete job, as we discovered that there is likely around $700 per month that is unaccounted for.
Counting the pennies and small transactions isn’t necessary in creating a cash flow statement, but having the major expense items available can make it easier to review the opportunities for improvement. One solution is to have a budget for ‘cash expenses.’ This may be money for any minor, regular expenses you pay cash for, such as children’s haircuts. By creating a budget for that amount, we are better able to understand where our money is going, without needing to break out our cash flow into too many minor categories.
Other major concerns are the addition of the deferred payment plan payback of $157 per month, and the need to fit a new car payment into the plan.
Buying a Car & Consolidating Debt
The primary driver for Sara seeking advice is the need to figure out a plan for paying off debt, while anticipating taking on an additional car loan on an already stretched budget.
Sara isn’t extravagant with her automobiles. She believes cars are simply transportation and has had her current car for more than 10 years. As repair bills are mounting, she will need to replace her current car soon with another gently used vehicle. She may receive up to $1,000 in trade-in value on her current car, and will need to finance the purchase.
She has been approved for a $9,000 loan at 3.75 percent through her credit union, which would add another $164 per month to her budget for five years.
One area of worry for Sara is the balances she carries on store brand credit cards. These cards all have interest rates exceeding 20 percent. The total balance of these loans is about $4,000. In addition, there is a current 401(k) loan of $2,100 and a balance of $3,775 due on tuition under a deferred payment plan with the university she received her master’s degree from. Since this was a deferred payment plan put in place by the school rather than more traditional loans, she has no choice other than to discuss an alternative payment plan with the school. Thus, Sara would prefer to tackle this debt with a plan to consolidate all debt.
The budget is tight, and Sara is now faced with the repayment of school tuition of $157.25 per month, which will begin immediately. With this new expense, the total cost of the debt repayments is roughly $325 per month.
Consolidated Debt Plan
We recommended that Sara consolidate her debt due to the relatively high payments and interest rates, and the fact that a car is a necessity.
The end result of our plan will be:
- A new car loan, which Sara’s local credit union has already approved.
- Refinancing the remaining debt of about $10,000 (50 percent of her current account balance) with a 401(k) loan at a fixed three percent rate.
Under most circumstances, it is not preferred to consolidate debt with a loan against a 401(k) account. While 401(k) loans are not preferred, there are a few factors that make this the recommended option.
- This is an emergency need in order for Sara to maintain her lifestyle. The monthly budget is tight and the extra car payment may not be possible at a higher rate.
- The fixed interest rate makes this a better choice than a 12 percent variable personal loan, or the variable rates on the credit cards.
The risk with this method is that if Sara loses her job, or finds another, she will have only 90 days to find a way to pay back this loan, or she will have to pay income taxes on the distribution, and a 10 percent early withdrawal penalty since she is under age 59 1/2.
Sara is cost conscious and not likely to continue to run up additional debt, which is critical if consolidating debt against an asset like a 401(k). She is also confident her job is not at risk, and is not worried about the possibility of having to repay the loan. To Sara, the extra breathing room over paying the high interest rate on the credit cards is worth the additional risk that comes with securing debt against her assets.
The ending scenario will be a debt payment plan of 60 months with combined payments of $344, including the car loan. This is only slightly more than the $325 previously paid without the car loan. The plan is to maintain the loans, while not taking on new debt. Any additional income from wage increases will be applied first to an emergency fund to backstop future emergency needs as outlined below in the budget and saving plan.
Budget & Savings Plan
Since cash is always stretched, Sara’s primary goal is to gain comfort with her savings and spending plan. However, she does not know what amount should be contributed to savings.
She knows that she needs a better handle on where everything goes in a month, but she doesn’t think anything is being wasted. Sara should continue to review her budget on regular intervals for prospective items to cut.
One area in particular that many people can review is their cable/internet/phone provider costs. Sometimes simply calling your provider will lead to options for discounts of six months to one year. In addition, online phone and television alternatives (like Skype, Google Voice/TV, or Hulu) can dramatically cut the costs of entertainment and communications.
Since Sara does not want to find herself back in this same spot after paying down the loans, the reworking of the debt and car loan is integrated with the savings goal.
Savings Plan: Savings Account for Goals
We recommended that any extra monthly cash, as well as increases in salary or other income, go toward building an emergency fund of at least six months of expenses prior to paying any additional amounts on debt. This may not seem intuitive, but by being able to pay for future items with cash, Sara should feel some comfort that eventually she can be debt free. An additional benefit to paying with cash is that spending will become more conscious. We want to get to a point where cash ‘shocks’ in the future, such as needs for a car, will be able to be drawn on from the saved cash reserves.
Sara has investigated savings accounts at her local credit union and will check her options there, as well as at online banks which may offer a higher interest rate.
The hardest part about getting a savings plan in place is getting started! It is easy to over think questions such as how much and where should you save. It often helps to ‘start small’ at a bank you are already comfortable with to get the ball rolling on a savings habit. The amount can be modified later once you have a better handle on how much additional cash you have each month.
Insurance & Risk Management
When there are immediate issues, it can be difficult to be concerned about the non-urgent, but important ones. Sara is thoughtful to recognize that she does not have a grasp on the risks that may not be covered by her work provided benefits.
By far the largest risk to Sara’s immediate situation is her ability to earn an income. The odds of someone age 45 having a disability of 90 days or longer are greater than 1/3.1
Sara’s employer provides generous insurance coverage for disabilities. After using all earned sick and vacation time, she would receive 60 percent of her income until age 67.
While any addition to the budget at this point is tough to consider, any coverage Sara can have while the children are young is a good thing. While a more ideal policy with inflation coverage and guaranteed renewable and non-cancelable riders would cost more than $100 per month, a more basic policy with a residual disability rider was quoted at about $30 per month to bring up income coverage by another $1,000 per month. In Sara’s case, any coverage is world’s better than no coverage.
Sara has $247,000 of life insurance, which appears to be an appropriate amount to cover expenses for the children until age 18. However, Sara may consider carrying another $200,000 of term life insurance for the next five years to cover the living expenses of the children as they themselves get started.
Carrying renters insurance is important — not just from the standpoint of insuring your items, but perhaps more importantly for liability purposes. Sara could be held liable for any injuries that happen on her property. Thus, she should try to fit renters insurance into the budget
One of the ways Sara might be able to decrease her expenses is by checking if her auto deductibles on comprehensive and collision are at least $500 or $1,000 — especially considering her costs may rise with her car purchase.
Currently, Sara does not have a will or other legal documents to provide her wishes for managing her affairs should anything happen to her. She should speak to a local attorney regarding these items, which include a discussion about her wishes for a guardian for her children, a living will and durable power of attorney.
Retirement & Career
Sara knows she’s behind the eight ball on retirement and needs to play catch-up. Starting over can do that. The good news is, since Sara is young, she has options.
While Sara’s goal of retiring at 62 would be difficult, if she extends employment to age 67, with Social Security and a small pension from a previous employer, the situation would not be quite as bleak.
Sara may need to count on her portfolio for possibly $25,000 or more annually to meet expenses for her current lifestyle. Reaching this goal by age 67 would require approximately an additional $10,000 annually in savings on top of the current savings (including employer match) placed into growth investments.
Since the budget is currently stretched, and her more immediate needs are to establish and maintain a cash reserve, we recognized this is a long-term target.
An obstacle in achieving financial independence for many is the lure of increasing standard of living in the face of additional spendable income. At this point in her career, Sara needs to save any increases in income or reduction in expenses, as opposed to living a grander lifestyle. Also, we discussed the savings opportunities and Sara’s long-term goals related to her career.
Retirement Savings Plan
Sara is saving just over five percent in her employer’s 401(k) plan. With a one percent discretionary contribution, and a four percent match on Sara’s five percent contribution, the total amount added to the plan on her behalf is equal to 10 percent of her salary of $46,500. She has made a smart first step in maximizing the matching funds.
Sara will also investigate the availability of a contributory Roth option under her 401(k) employer plan. With her current deductions and credits, she would pay little in taxes on her contributions to the Roth account. Also, she is not greatly benefiting by deferring the taxes under the traditional 401(k) plan. Since tax planning will change over time as her situation changes, this part of the plan should be monitored for changes in: expected income, deductible expenses, as well as new legislation. Being the head of a four-child household, Sara is on the border with many credits that may benefit her. While the Roth 401(k) seems like the right place to save today, there may be better options in the future.
Investments and Roth Individual Retirement Account (Roth IRA)
Sara is not adverse to risk in investing. During our discussions, we spoke about the importance of diversification over multiple asset classes, and how investing outside of her employer retirement plan can offer additional diversification benefits. Thus, she should invest with a weighting toward growth oriented mutual funds.
With the present circumstance, Sara may consider a Roth IRA once her emergency savings goal has been reached. The benefits of the Roth IRA are the ability to invest while complementing her other savings, as well as the fact that Roth IRA withdrawals are not subject to tax in retirement.
Career Goal Setting
There are two events that should help Sara in reaching her annual savings goal:
- The children becoming adults.
- Continuing to gain experience, advancing, and exploring a full-time or part-time position in fields she is passionate about.
Both of the above events will accelerate Sara’s investment plan, as well as her ability to keep debt under control.
In our conversations, Sara revealed that she is not currently working in her ideal field, nor making what she could be if she had a less constrained life. Perhaps her greatest assets are her dedication and work ethic. Even though her current position is not something she enjoys, Sara’s attitude is to be the best employee she can be.
I encouraged Sara to not only think about landing her dream job and retirement, but also what may be next in her life. Sara said that this could be sharing her passion in the field of leadership with others as a part-time instructor.
Part of Sara’s money makeover homework will be to continue to plan next steps, or small actions, she can do today to place her in a position to realize her goals. She has already found a training class she is excited about starting.
Career and retirement goals go hand in hand. Realizing there may be other options to continue earning some amount of money in retirement will lessen her portfolio needs at retirement. Opportunities in retirement can eliminate or reduce the amount of withdrawals needed from savings and investments, allowing those accounts to provide further into the future.
Sara is in a place many Americans can relate with. She has great potential to achieve the American Dream — defined by Schmansky as having a fulfilling family life and career, without daily and long-term financial worries.
She is in a place where it is difficult to look past the immediate and urgent expenses toward when she will be able to place her focus on the future. At the same time, she has begun positive financial actions by gathering an independent opinion about her current position, creating a plan, and saving for the future.
However, her situation is still fragile and success will require uncomfortable choices for a long-time. In needing to catch-up on her savings, she will have to save more aggressively than if she started her plan earlier.
Sara’s positive attitude and willingness to seek assistance with an assessment of what she needs to do for her financial future speaks volumes about her desire to become financially independent. It is essential that Sara continues to review her progress regularly, monitors her ability to increase savings, and maintains current spending levels. For many in Sara’s situation, working with a financial adviser can achieve the greatest results. Advisers are not experts at planning, but also coaches who can help hold you accountable for staying on the path for the future when the temporary stress of the present is gone.
FPA member Robert Schmansky, CFP®, is founder of Clear Financial Advisors, LLC in Bloomfield Hills, Mich.
1 1985 Exposure Draft Report to The Society of Actuaries