The STEPS Cycle of Financial Independence
Using the STEPS cycle of financial planning can help you become more aware of your financial assets and increase your wealth.
It consists of the following stages: “Starting point,” make a thorough inventory of your financial position; “Team,” form a group of trustworthy advisers; “Evaluation,” map the path to your goals; “Plan,” create your tactics; and finally, a return to the “Starting point” for a progress report and re-evaluation.
Yes, this is a much more formal kind of financial planning for financial independence.
Step One: Calculating Your Starting Point
This is basically where your fiscal standing currently are.
To determine your fiscal position, use financial statements that clearly outline your monetary flows and net worth.
Together, the following three kinds of statements will give you a comprehensive picture of your budgetary position:
- “Income statement” – Lists income and expenses. The statement includes three kinds of income: earned income, portfolio income and passive income. Earned income is the money you receive in exchange for your labor, time or services – in other words, your pay. Earned income is taxed at the highest rate, which is sometimes more than 40%, depending on how much you earn. Portfolio income is the money you make from interest, capital gains and dividends – “the money your money makes for you.” Passive income is the money you make from investments, such as real estate. With proper tax management you can pay no tax whatsoever on passive income.
- “Balance sheet” – Shows your liabilities, assets and net worth. While the income statement shows your progress over a period of time, the balance sheet is a snapshot of the moment. When you draw up a balance sheet, avoid these five common mistakes: overstating asset values; counting illiquid assets (those you can’t convert into cash right away, such as your home); ignoring liabilities; counting possessions that do not build wealth; and failing to differentiate between “good debt,” which finances an appreciating asset, and “bad debt,” which finances a depreciating one.
- “Statement of cash flows” – Shows your actual cash position, independent of your income and balance sheet positions. The income statement and the balance sheet depend on accounting conventions and technicalities, and your net income is not the same thing as cash. For example, passive income may not be cash income. In the final analysis, “cash is king.” Small businesses and individuals rarely prepare cash flow statements – a serious omission.
“The plan of your parents – work hard, save your money and collect your retirement – was effective for them, but it doesn’t work now.”
You need discipline, even courage, to prepare a frank, honest set of financial statements and to look dispassionately at your financial position.
Step Two: Forming a Team of Advisers
Be careful about whose advice you seek. Friends and acquaintances may discourage you from taking actions that will result in your financial independence.
Like crabs in a box, people often pull each other down.
They can’t see why you would do something different from what they are doing. Do not listen to naysayers or others who insist that you’ll never achieve your financial goals.
“The biggest expenses for the average citizen are interest and taxes. Both of these expenses put your money in someone else’s pocket.”
Instead, assemble a team of knowledgeable advisers whom you trust. Depending on your business, they may include specialists in insurance, accounting, corporate structure, law or finance.
Cast a wide net.
Ask other business owners for advice, ask advisers whom you already trust to recommend advisers in other areas, and check with local licensing and certification boards. In this technology-enabled age, you can work with advisers who are geographically remote and stay in close touch with them through e-mail or fax.
Keep the following points in mind when you work with your team:
- Trust the trustworthy – If you have picked a good group of advisers, do the logical thing and allow them to do their jobs.
- Learn the language – Lawyers and accountants speak a technical language in which words have very specific meanings. Learn their jargon so you can make sense of the advice they give you.
- Ask the right questions – Ask your advisers about your actual situation. Don’t ask hypothetical questions and don’t ask questions that are so specific that they limit the answers. Ask people questions in their area of expertise. That means ask your attorney legal questions, ask your accountant accounting questions, and so on.
- Keep your advisers informed – Give them the information they request. When your advisers ask you questions, your job is to answer them.
- Clean up after yourself – When you make a mistake, don’t point the finger or make excuses. Accept responsibility.
Step Three: Evaluating Your Strategy
Your most important sources of tax loopholes are:
- Business – Starting a business can reduce the amount of tax you pay – but because some people have used “sham businesses” to create losses they can offset against earned income from other sources, the U.S. Internal Revenue Service (IRS) has a fairly strict definition of “business.” You must have the appropriate experience; operate in a businesslike manner, with a bank account, records and filing systems; document reasonable losses; and, at some point, make a profit. The appropriate business structure can minimize your taxes. For example, a corporation, which limits liabilities and offers tax advantages, is often preferable to a sole proprietorship. Meet your business tax obligations on time, because penalties are costly and the IRS has enforcement powers that other creditors lack.
- Real estate – Investing in real estate has numerous tax advantages, particularly because you are allowed to use depreciation to offset the income you receive from a property. Depreciation is a “phantom expense” that does not cost you actual cash.
- Home – If you want your home to provide you with a tax advantage, you must structure the purchase properly. Protect your home equity by using the homestead exemption, hold your home in a limited liability company and use debt strategically.
“Free advice may be the most expensive advice you ever get.”
Step Four: Following Your Path
The most important part of having a plan is implementing it. Your particular plan and implementation will depend on your circumstances.
No matter what plan you follow or what actions you take, prioritize keeping good business records in these three categories:
- “Temporary files” – Records of annual income and expense items. When you pay an invoice, record the date, check number and amount. Accountants call these records “temporary” because they apply only to a particular tax year. But “temporary” does not mean “discard.” Keep temporary records for at least five years, and as many as 10, if you are at risk of lawsuits.
- “Permanent files” – These document your business’s assets, property, debts and structure. Keep these records in good order; if the IRS audits you, your ability to produce them quickly will show that you have run your business responsibly.
- “Financial statement files” – Many business owners use programs such as Quickbooks to generate financial statements.
“Always avoid standard advice. People are different and circumstances are different. Don’t get caught when someone just assumes you are average.”
Step Five: Re-evaluating Your Starting Point
Periodically revisit your strategy to check its status and progress.
Touch base with your advisers at least quarterly or even more frequently, depending on the nature of your business. Even if meeting with them costs you money, the meetings will help you make more in the end than you will spend on your advisers’ fees.
Make prompt adjustments to your strategy, plan and actions when circumstances warrant.
“The best advisers know what they need to know…They should ask you more questions than you ask them.”
Keep track of what works and what doesn’t. Because feeling assured and strong can help you succeed, emphasize your “wins.” Write down “five things that you did that worked” each day. Share your wins with someone close to you, such as your spouse, an adult child or a friend.
“The best plans in the world don’t mean a thing if you never implement them.”
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