“Rules of Thumb” Can Make Financial Planning Simpler

November 13, 2013

One of the many hats I wear around the Financial Finesse office is that of a fact checker.  Before we publish an article or release new content, I am frequently asked to verify any factual information it may contain.  In some instances, the information I am asked to verify is absolute. For example, the IRS has recently released 401(k) and IRA contribution limits for 2014: $17,500 (or $23,000 if age 50+) and $5,500 (or $6,500 if age 50+), respectively. At other times, the information we include in our publications is based on generally accepted financial planning principles—what we typically refer to as “rules of thumb.”

The expression “rule of thumb” is believed to have derived from carpenters of antiquity who used their thumbs to make rough estimates of length rather than using a more precise instrument such as a wooden ruler.  The idea was to provide a quick and easy way to make measurements when such precision was not practical or necessary.  In the same way, financial planners love to use rules of thumb when discussing financial behavior.  That’s because people often don’t have the time to do precise calculations, and instead end up doing nothing—something we refer to as financial inertia.  For this reason, rules of thumb can be a good starting point.

I’ve asked our team of CFP(R) professionals to weigh in with some of their personal favorite rules of thumb.  I’ve compiled a list of what they said, organized by the financial discipline it applies to:

Cash Management

One rule of thumb that immediately comes to mind is how much someone should keep in an emergency fund.  Most financial experts, including our team of planners, suggest 3 to 6 months of expenses.  The idea behind this rule is to provide enough income replacement in the event of a loss of income due to an illness or a job loss.  That said, you may want to keep a larger emergency fund if your ability to find work might take longer or if you are a landlord and run the risk of vacancies for extended periods of time.

Another common rule from our planners is to save 10% of your income, or put another way, learning to live on 90% of your income.  If you can save more even better, but this is a good place to start.

Debt Management

When it comes to debt, our finance geek Linda Robertson, CFP®, AFC®, ChFC®, Masters in Financial Planning, CEBS (where does it stop?), thinks you should follow the rule of no more than 10% of NET pay for car payments and no more than 25% of NET pay for housing (rent or mortgage).

Retirement Planning

There are a myriad of rules when it comes to retirement planning.  Here are some of the most common:

  • If your employer offers a match you should contribute at least enough to get the full amount—otherwise, you are leaving money on the table.
  • You should contribute at least 10-15% for retirement—if you had a late start, you may need to contribute more.
  • If you want to maintain your current lifestyle in retirement, you should plan on replacing 80% of your pre-retirement income—use this retirement calculator to see if you are on track.
  • Save for retirement BEFORE saving for college—you can borrow for college but you cannot borrow for retirement.

Another rule suggested by one of our recent additions, Doug Spencer, CFP®, is to save in a Roth retirement account early in your career when you are more likely to be in a lower tax bracket and to save in a traditional retirement account when you’re near the end of your career and more likely in a higher tax bracket.

Investment Planning

Just as there are many rules for retirement planning, there are equally as many rules when it comes to investing.  One common rule suggests subtracting ones age from the number 110 as a good proxy for how much should be invested in aggressive positions in a retirement account.

Erik “The Maverick” Carter, JD, CFP®, suggests following the rule of thumb of not investing more than 10-15% of your investment portfolio in any one company, especially if it’s your employer.

Senior planner Bruce Young, CFP®, AFC®, likes following the rule that you should only buy real estate if you plan on holding it for at least seven years.

College Planning

I’ll offer my own preferred rules about college planning.  When it comes to paying for college expenses, use tax-free dollars from accounts like 529 plans and Coverdell Education Savings Accounts to pay for things like room and board, and use after-tax dollars from student loans and income to pay for tuition and fees.  That’s because tuition and fees qualify for educational tax credits, while room and board expenses DO NOT!

Tax Planning

When it comes to rules of thumb about taxes, Diane Winland, CFP®, CPA, suggests keeping tax records for up to ten years.  The only reason you would need to keep them longer is if you commit fraud or do not file a return.  Otherwise, shred tax documents when they are no longer necessary to be kept.

Estate Planning

While not necessarily a rule of thumb, all of our planners agree a basic estate plan should include a last will and testament, a durable financial power of attorney, and a healthcare directive.  As I did some fact checking for this blog post, I came across this list of estate planning rules of thumb from Oberlin College.

My colleague Michael Smith, MBA, CFP®, subscribes to the rule that you should review your estate planning documents at least once every 3-5 years just to be sure no changes are necessary.  He also suggests not eating yellow snow, but we already knew that, right?

Insurance Planning

We are frequently asked how much life insurance an employee should have, and most of our planners agree a good rule of thumb is seven to ten times your annual income.  That means if you are making $50,000 a year, you should have between $350,000 and $500,000 of coverage between employer-provided coverage and personal coverage.  For a more precise estimate of how much coverage you should have, check out this Life Insurance Needs Worksheet.

Another insurance rule of thumb is the rule that your annual premium for long-term care insurance should not exceed 5% of your annual income.  So for example, if your annual income is $75,000, you should spend no more than $3,750 a year on LTC insurance premiums.

There are certainly many other rules of thumb, and perhaps you have a few favorites of your own that you wouldn’t mind sharing with our readers.  The most important thing to remember is that these are just guidelines, and while they may help get you started on the right path, a more personalized review of your financial picture may be needed to determine if in fact you are on track to reach your goals.  If available, you should take a financial wellness assessment to identify your financial strengths and vulnerabilities or work with a financial professional that can do the same—and that’s a rule of thumb we should definitely all live by.