Personal financial statements

Creating Your Personal Financial Statements

When constructing your financial plan for retirement, there are some key personal financial statements that you will want to draft prior to performing an analysis of your situation. Most of us are familiar with a personal balance sheet and income statement, which track your net worth and monthly or annual cash flows. From small businesses to global corporations, these statements are used in measuring the financial health and in conducting financial analysis and can be just as useful for individuals seeking to develop their own financial plan. In addition to these two primary financial statements, some others that come in handy are tax and cash flow projections. In this article, I’ll explain why these personal financial statements are important and how to use them as a starting point for creating your financial plan.

Balance Sheet

Calculating your net worth is the best way to find your starting point for any financial plan. The balance sheet is essentially a picture of what you own and what you owe. Two ways to increase your net worth are to increase your assets or decrease your liabilities. You can increase net worth by increasing your cash or increasing the value of any asset you own or you can decrease liabilities by paying down debt. A personal balance sheet will look something like this:

Assets on the balance sheet can be sorted into 3 main categories:

  • Short-Term Assets: Cash, CDs, Money Markets, T-Bills: These are assets that are typically earmarked for short-term spending purposes such as the remodel of a new home, purchase of a new car or to keep an adequate emergency fund. They typically offer the stability of principle and are very accessible with little to no penalty to liquidate proceeds. As with most investments, the lower risk will result in a lower return, so these are not good vehicles for longer-term investment horizons.
  • Long-Term Assets: IRAs, Roth IRAs, SEPs, SIMPLE IRAs, 401ks, 457, 403B, Defined Benefit Plans, Annuities, Brokerage Accounts, Life Insurance Cash Values: These assets represent the primary source of retirement income for most Americans and are typically held with longer time frames in mind. Any income needs in retirement that aren’t covered by fixed income sources such as Social Security and Pensions tend to be met through these financial resources.  Earmarked for a longer time horizon, these accounts will typically hold your higher risk and higher return types of assets.
  • Property: Primary Residence, Vacation Homes, Rental Properties, Other Use Assets: Other assets on the personal balance sheet include property such as your primary residence, vacation home, and rental properties. Personal use assets are other types of tangible property used for personal consumption such as cars, jewelry or antique collection. While real estate and personal use assets are classified as capital assets, they are treated differently for tax purposes upon liquidation.

After totaling up your assets, the next step is to list all of your liabilities. Generally speaking, you can sort your liabilities into two main categories: Short-term and long-term debt.

  • Short-term debt is generally classified as debt that is held for one year or less. Some common examples of short-term debt are credit cards, personal notes, and bridge loans. When used wisely, short-term debt can be useful when cash positions may be low and you want to avoid tax liabilities from liquidating capital assets such as stocks or mutual funds.
  • Long-term debt is debt used to finance longer-term goals such as a mortgage, home equity loans, business loans, student loans, and commercial real estate loans. These types of debt are mostly associated with the goal of accumulating wealth or in the case of student loans, to attain a degree with the goal of securing higher career income. As with all debt, it’s important to understand how your liabilities fit within the context of your goals, asset, and income picture.

Income Statement

Your personal income statement is a snapshot of all of your inflows and outflows and nets these two items together to determine whether you are operating at a surplus or a deficit. This is the most important financial statement when you retire since it gives you a clear depiction of how much you can spend and whether your withdrawal rate is too high, increasing the risk of outliving assets. Your income statement is directly related to your balance sheet since surplus cash flows increase your assets and cash flow deficits reduce them. In retirement, it’s important to not only run an income statement for the current year to determine income needs but also in future years since income sources and spending needs constantly fluctuate in retirement primarily due to the difference in ages between spouses. The three main categories on your income statement are inflows, outflows and net flows.

1. Inflows

Includes: Salaries, interest/dividends, social security, pensions, real estate income

One of the most dramatic shifts upon retirement is the challenge of replacing employment income through a combination of retirement income sources and withdrawals from savings. Due to age gaps, these sources of income typically begin at different times for most spouses. For most folks retiring today, age 67 is the full retirement age (FRA) for Social Security. Drawing your Social Security benefit before your FRA means that your benefit will be permanently reduced. Conversely, a delay of your benefit causes the benefit to increase. Therefore, deciding when to take Social Security is one of the most important decisions in retirement. There are also a number of other strategies that you should be aware of such as spousal benefits.  Of course, when to draw Social Security should be coordinated with other income decisions such as initiating a pension or even working part-time. Don’t forget about interest and dividends from your taxable accounts and don’t forget to account for any other sources of income such as rental real estate. A primary consideration when making these decisions is doing so in a tax-efficient manner. Understanding what your inflows are every year will allow you to determine how much you’ll need to withdraw from savings to fulfill your spending needs. Anticipating changes to your income from year-to-year allows you to anticipate your income shortfalls and be better prepared to plan for your income needs.

2. Outflows

Includes: Expenses, liability payments, taxes, savings

The other side of your cash flow statement that will offset your income are your outflows. Some outflows are fixed, such as mortgage payments, while other outflows will constantly change such as taxes and living expenses. Since spending needs can change dramatically in retirement, it’s important to create a budget and tally up what your fixed and discretionary expenses will be. Next, you need to list all of your liability payments. If there is still one spouse working, another outflow could be contributions to accounts like 401ks, IRAs and other retirement accounts. Lastly, you need to have an understanding of what your anticipated tax liability will be every year. This is certainly the most complex piece of putting together your cash flow statement since all of your decisions around initiating your fixed income sources and selecting which accounts to take withdrawals from will have a direct impact on your tax liability. For example, if you determine that you will have a net shortfall between income and expenses of $20,000 and this amount is withdrawn from a tax-deferred account, then you have to anticipate paying additional tax since the entire amount is added to income in the eyes of the IRS. Don’t forget that you HAVE to take distributions from all qualified tax-deferred accounts beginning at age 70 ½.

3. Net Flows

Includes: Determine shortfall/surplus, relationship with balance sheet, planning opportunities

Probably the most important metric to monitor throughout your retirement is your yearly net flows. In other words, what is the amount you can withdraw from savings without the risk of outliving your assets? The most common rule of thumb amongst financial planning professionals is 3-4%, but the truth is that this amount can fluctuate and be higher or lower at times. For example, early on in your retirement, it may be okay for your withdrawal rate to be 5%. Maybe you delay taking social security and you need to draw more from savings early on, but in later years when you start taking your benefits your withdrawal rate is only 2-3%. Again, since inflows and outflows fluctuate every year, you must run your cash flow statement at least annually so you can make good, informed decisions to create tax-efficient income in retirement.

As you can see, gathering all of your personal financial statements so you can construct a personal balance sheet and cash flow statement are important steps in determining where you currently stand in relation to your retirement goals. In addition to these two personal financial statements, you will want to start running some cash flow and tax projections. Looking at a cash flow statement every year for the next 20-30 years will give you a big-picture view of how your income, expenses, and shortfall will change over time. Understanding the long-term picture will allow you to make better decisions in the short-term. A multi-year tax projection will also allow you to see what your tax liability looks like long-term to enable you to formulate a good tax-efficient withdrawal strategy. You will also want to run a tax projection every year to help determine what your end-of-year taxable income looks like so you can determine which accounts to withdraw income from and what the appropriate tax strategy is for the current year. Now you have the requisite information to start coordinating your retirement plan. Don’t forget to download your Free Retirement Checklist to ensure you don’t miss any of these important steps as you prepare for retirement. Your next steps will be to coordinate all of your strategies together around cash flows, taxes, investments & wealth protection/transfer.

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