Living Below Your Income: The Mechanics of Personal Cash Forecasting

I once knew a man who worked for a major oil company. He managed a large wholesale territory that sold fuel and oil products to airlines and other big accounts. Some years ago, the company decided to pull out of his territory. They offered him the opportunity to buy the wholesale business “for a song,” which he readily accepted. He worked diligently and set specific financial goals for his company. He committed these goals to writing on 3x5 cards and kept them in his shirt pocket so he could frequently review them. Everything he did with that business was aimed at fulfilling these goals.

My office was located near a main freeway, and from my window I could see the traffic. As the years passed, I saw his fuel trucks more and more frequently driving up and down the freeway. They bore his name in the colors of the oil company from which he purchased the business. Needless to say, his company was very successful. Eventually, he sold it for a substantial sum of money and retired. He attributed his success to committing his goals to writing and reviewing them on a daily basis.

After years of experience as a financial planner, I find myself frequently sharing these principles of writing, reviewing, and fulfilling financial goals, implemented through a process called personal cash forecasting. This financial planning tool can help you reach your financial goals by: 1) applying cash management principles, 2) developing a cash management plan, and 3) forecasting cash use beyond necessities.

Personal Cash Forecasting

Budgeting resources from financial goals is a concept corporations use all the time. Departments are given and expected to live within yearly budgets. Any extra need beyond the budget reduces or supplants spending in another area. Ultimately, the corporation has a fixed annual amount it can spend if it intends to make money. Planning for this budgetary need is usually the job of the corporate controller.

This concept of planning what to spend before it is spent can easily be applied by individuals. I call the process cash forecasting rather than budgeting because “budgeting” has a negative connotation to some, while cash forecasting is a more positive description of the process of allocating cash to needs.

The key to cash forecasting is knowing the mechanics of the process. Your personal cash management plan becomes a tracking system like that used by a corporate controller, only simpler. At the beginning of the year, you should write down your financial goals, and use them to determine the annual amounts to be spent in various needs and wants categories. The amounts should be divided into monthly and/or semi-monthly allocations, which you should make each time you are paid.

Cash forecasting is an effective tool, but it doesn’t eliminate the fundamental principal of personal discipline. You must be willing to tell yourself no when your plan disallows an unplanned purchase. Sometimes opportunities arise and wants become needs. In this situation, you simply have to weigh the benefits and consequences of buying now and trimming some other need or buying on credit. If you are wise, buying on credit should only be used as a last resort and for an extreme need.

Applying Cash Management Principles

Most people’s financial planning needs are simple involving prudent planning and wise use of take-home cash. Managing cash wisely allows you to live not within, but below your income, building savings and planning for the future.

Cash management principles are universal. The time-tested adage is to spend only what you have and keep an adequate reserve. This reserve is the accumulated amount that comes as a result of living below your income. Personal motivation, or the lack thereof, is the primary barrier to making these concepts work. “Get rich quick” schemes don’t work. Patience, hard work, and saving do.

Many people go into debt to satisfy their wants and consequently live above their income. Many never pay off debts, but live off an ever-increasing credit balance, not fully realizing that interest never rests. The ultimate result of this situation is personal bankruptcy, which is sadly at an all-time high in the United States.

Cash is a wonderful medium to be used and not abused. If we satisfy every want without consideration of need, we fall victim to overindulgence and spiraling debt. We must learn to deny ourselves many immediate wants and practice delayed gratification.

Needs and Wants

Living below your income takes discipline. Every time you are paid, ask yourself, “What are the absolutes, and what can I live without?” It helps to make a tangible list of your needs and wants. Such a list might include rent or mortgage payments, food, clothing, tithing, charitable donations, tele-

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Investing alternatives

Typical investments are stocks, bonds, and mutual funds, which are investment organizations that professionally manage a diversified portfolio of securities, such as stocks or bonds. Generally these nonbank investments are not insured and are called marketable securities because they are liquid and can be sold quickly without making a price concession. Cash in an investment account typically refers to taxable or tax-exempt money-market mutual funds. Taxable money market mutual funds invest in money market investments such as treasury bills, commercial paper, and bank certificates of deposit. Tax-exempt money market funds invest in very short-term securities issued by municipalities. Money market mutual funds are liquid and considered low risk because the principal value generally does not fluctuate with the market.

Allocation

The investments you purchase should be dependent on personal financial goals and objectives and your time frame until cash is needed. As you move from money market funds to bonds to stocks, you take on added risk of principal valuation fluctuation.

Funds needed to cover expenditures over the next three years should generally be put in low-risk investments, such as money market funds, short-term bonds, or mutual funds that invest in short-term bonds. Generally, funds that will satisfy needs during the next three to seven years should also be invested conservatively but can include money market mutual funds, intermediate-term maturity bonds, or mutual funds that invest in intermediate-term maturity bonds and even stocks and mutual funds that invest in stocks. For time horizons greater than seven years, an allocation to stocks and mutual funds that invest in stocks is appropriate.

Your asset allocation among the various asset classes or types of investments should reflect your willingness and ability to take risks and lose principal value. The performance of your investments should be frequently monitored. Investment allocation should be periodically rebalanced, and those with unusually inferior performance over time should be sold.

Professional Advice

Various professionals can provide advice on asset allocation and investment performance. Generally, professionals who provide investment advice for a fee are registered as investment advisors with a state or with the Securities Exchange Commission. These professionals may also hold certain certifications that evidence they have successfully completed training on investment matters. These certifications include Certified Financial Planner® (CFP®), Certified Investment Management Analyst (CIMA), and Chartered Financial Analyst (CFA).

phone and utilities, property taxes, health and property insurance premiums, transportation, gifts, grooming, repairs, maintenance, and long-term savings for items like a car or house, furniture, computer, and college tuition for children. If you are in debt beyond your mortgage, one category should be for debt repayment. Anything beyond this list is a want.

Wants may include cable, lawn service, weekend trips, car upgrade, boat, dining out, etc. Many luxuries are nice to have, but are not necessary to sustain life. Needs sustain life; wants sustain lifestyle.

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Accounts and Allocation

Once your needs list has been established, look at the balances in your checking, savings, and investment accounts—three accounts everyone should have.

Checking accounts allow you to see what you’ve spent and pace future spending. Savings accounts are a place to save for future needs. I recommend storing cash in this account that you anticipate using in the next sixty days. Any need beyond sixty days should be preserved in an investment account. Checking and savings accounts are in a bank or credit union. Investment accounts should be at a brokerage firm either managed by you or by a professional money manager, oftentimes a mutual fund manager (see Investing and Before-Tax Savings Vehicles sidebars).

To begin the forecasting process, you’ll probably need to do some reallocation to prepare your accounts. Before you deposit your next paycheck, transfer all, if any, remaining cash in your checking account to your savings and investment accounts. Transfer cash into savings that will be needed in the next sixty days. Transfer cash into your investment account that will be needed beyond sixty days.

Now look at the balances in the savings and investment accounts. List the needs you have in the next sixty days and allocate the balance in your savings account across those needs. Remember that you will be adding cash to each need category over the next two months every time you are paid. Next, do the same thing with the investment balance for those items needed beyond sixty days (see Monthly Cash Allocation chart).

Developing a Cash Management Plan

Once you’ve established your list of needs and prepared your accounts, estimate how much you pay for each need in one year. There are many software programs that can track your spending, such as Microsoft Money and Intuit’s Quicken. These programs can help you estimate future expenses based on historical spending. They are backward
looking; personal cash forecasting is forward looking.

By listing your needs ahead of time and tracking spending against those needs, you create a forecasting system. Alternatively, you can program an electronic spreadsheet to do the detail work for you. Either way, you are creating a cash management plan. From your take-home pay, record 1/24 (if you are paid semi-monthly) of each annual need per category. Add these allocations to the previous balances. If you don’t have adequate funds for each need, reexamine your list and consider whether each is a true need.

If you have money left over, allocate it to a category titled “unallocated.” This category could become your emergency fund, savings for retirement (if you don’t have a retirement need category), or for some particular want that you can afford. It represents and measures the amount by which you are living below your income. Next, subtract from each category your spending needs in the next two weeks before you are paid again. Once that is done, strike a balance in each need category (see Monthly Cash Allocation chart):

Beginning balance

Deposit all take-home pay in your checking account. Add up all the spending needed over the next two weeks leaving only the sum of those needs in your checking account. For current allocations required within the next sixty days beyond these immediate needs, write a check for their sum and deposit it in your savings account. For current allocations required beyond sixty days, write a check for their sum and deposit it in your investment account money market fund. Do this twenty-minute task each time you are paid.

Spend according to the needs you have determined. When your checking account reaches a zero balance, you are finished spending until your next paycheck. Meanwhile, the allocations for your future needs are in reserve in your savings and investment accounts. They remain “out of sight and out of mind.” If you have unforeseen emergencies in the meantime, you can draw on your unallocated balance. Resorting to a credit card or home equity line of credit should be done only in true emergencies. Never do so without a plan to pay off the balance you borrow (See Credit sidebar).

By tracking your needs from beginning balance to allocation and finally to spending, you’re prudently apportioning your take-home cash to meet necessary expenditures. You’re also curtailing spending on wants by eliminating excess cash “lying around” to be spent frivolously. Preserved cash is earmarked for needs in either savings or investment accounts.

Forecasting Beyond Necessities

Beyond just meeting everyday living needs, each of us want to afford those items that enhance our lives. Maybe we want to retire at fifty-five, travel, take a sabbatical, make a major charitable contribution, or prepare financially to serve a mission. Whatever it is, each of us has unique desires. You should write these down and call them your financial goals.

Credit

Credit can be in the form of a term loan or line of credit. A home mortgage is an example of a term loan that is paid back systematically over a given period. An astute personal cash manager will avoid term loans other than for a home, education, or business. A credit line is a pre-approved credit limit against which money can be borrowed and repaid at the borrower’s option then reborrowed within the credit agreement terms. Both credit cards and home equity lines of credit are examples of credit lines. Credit can be either secured or unsecured depending on whether collateral is attached to it.

Home Equity Credit

Home equity lines of credit (HELOC) have interest rates much closer to general market rates than credit cards, but are secured by a mortgage on your house as collateral. In addition, the interest paid on them is typically tax-deductible on borrowings up to $100,000. Unsecured credit card interest is generally not deductible. From a planning standpoint, it is more economical to borrow for bona fide emergencies from a home equity credit line.

Credit Cards

Credit cards are a payment convenience and an insurance policy. There is nothing inherently wrong with credit cards as long as they are used prudently, which usually means paying them off monthly. Charge cards require payment in full at the end of each billing cycle, usually one month. Credit cards allow you to carry a balance beyond the end of a billing cycle and incur interest on those balances not paid off at the end of the month. Interest on credit card cash advances is charged from the time of the cash advance. Beware that the interest rate charged on a typical credit card is extraordinarily high—up to 20 percent or more on an annual basis.

As soon as you can afford it, establish categories in your cash management plan for needs that reflect your financial goals beyond your absolute necessities. These are not necessarily wants; they represent additional needs that reflect your goals. Though they may be small allocations, add to them each time you are paid. You’ll be surprised how quickly they accumulate. Maybe the interest you earn on your various accounts can be used to partially fund these financial goals. Whatever they are, make them part of your regular thinking by committing them to writing and start saving toward them.

Rewarding Yourself

In your goal setting, remember to reward yourself for your discipline and for achieving your goals. This will help motivate you to achieve financial success. A reward might be a dinner out, an overnight escape, or day of recreation funded from the unallocated portion of your savings or investment account. Whatever you choose, your reward should be immediate and attractive enough to keep you on track.
Before-Tax Savings Vehicles*

401(k) and 403(b) Plans

Employer-based savings accounts like 401(k) or 403(b) plans allow you to make pre-tax contributions. These are legal wrappers to investment accounts of mutual funds, stocks, bonds, and cash allowing preferred tax treatment to encourage saving and investing for retirement. To take advantage of this tax-deferred option, establish an account with a financial institution selected by your employer and make regular deposits up to an annual legal limit—$12,000 for 401(k) and 403(b) plans in 2003, $14,000 if you’ll be 50 by the end of the year. These deposits are not subject to federal income tax at the time they are made. Employers often match employee contributions to a pre-determined percentage.

Generally, these accounts are established with one or more mutual fund companies. The funds belong to you but usually cannot be withdrawn until you leave your employer or reach age 591/2.

When funds are withdrawn, ordinary income tax is incurred on the amount withdrawn in addition to any penalty owed, which may apply if you’re under age 591/2.

IRA and Roth IRA

Traditional Individual Retirement Accounts (IRAs) operate similarly but without the possibility of employer matching contributions. However, the $3,000 ($3,500 if you’re 50 or older) annual contribution ceiling for traditional IRAs (in 2003 and 2004 under current law) is subject to a deduction limitation depending on the level of your income and whether you, or your spouse, participate in an employer-sponsored retirement plan.

Earnings are also tax-deferred. Withdrawals cannot generally occur before age 591/2 without incurring a 10 percent penalty and must begin no later than 1 April following the year you turn 701/2.

Roth IRAs are subject to the same contribution limits as traditional IRAs but the contributions are not tax-deductible; however, the earnings are tax-free if certain requirements are met. Also, there are no minimum withdrawal requirements for Roth IRAs at age 701/2, though withdrawals prior to age 591/2 generally incur a 10 percent penalty for any income they include.

To the extent you can take advantage of before-tax savings vehicles, you are deferring the tax impact of the earnings on the funds and, in some cases, the contributions, until retirement. In retirement, individuals may be in a lower tax bracket than when they are working, so the tax on these funds is not only deferred but lower.

*There are also other tax-advantaged savings vehicles available under the law (e.g., SEP IRAs and Keogh accounts). Consult a financial or tax advisor for more information.

In Summary

Setting and achieving goals is key to your forecasting success. This process allows you to forecast your current and future cash needs according to your goals—spending against allocated needs and avoiding unnecessary debt. Mechanically tracking achievement of your financial goals helps you measure your progress. Following these simple principles requires personal discipline, but will result in a healthier financial lifestyle allowing you to live below your income.

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Written by Robert M. Haynie
Illustration by Simon Shaw

About the Author

In 2002, Robert M. Haynie was recognized by Worth magazine as one of the top 250 financial advisors in America. A principal for Ernst & Young LLP in Seattle, Haynie is a Certified Financial Planner®, Certified Public Accountant/Personal Financial Specialist, and Certified Investment Management Analyst.

Haynie is president of the Puget Sound (Seattle) chapter of the BYU Management Society, past board member of the University of Washington Gift and Estate Planning Council, and a member of the Investment Management Consultants Association and the American Institute of Certified Public Accountants.

For more than six years, Haynie has shared his expertise as a presenter at BYU’s Education Week. He earned his MAcc from BYU in 1978. Financial planning concepts in this article are excerpted from Haynie’s upcoming book, to be published in 2004.