by Brian Hufford, CPA, CFP
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Have you ever noticed a large gap between your income and the financial results you achieved? By financial results, I mean the overall sense of satisfaction in your financial life. Have you ever thought: “Based upon my level of income, I should be able to ____ (fill in the blank), afford a nicer home, send my children to private school, save more for retirement, pay these outrageous taxes ....“ For most of us, there never seems to be financial outcomes commensurate with what appears to be a large income. I call this gap of income vs. results the Financial Outcome Gap.
Most financial writers exploit the emotional frustration of this gap with what I call make-more strategies or spend-less strategies. I have rarely seen a financial book that couldn't be categorized into one of these two descriptions.
Debt-based books are about spending less. Rich Dad books are about making more. For me, it always has seemed that my hoped-for financial outcomes could be realized if I could just make about 20% more than what I was earning at the time. But once I attained the 20%-more goal, I found the gap was still there. I finally decided that there should be a solution to the gap problem regardless of one's income. I began to wonder if perhaps the gap was created not by insufficient income or over-indulgent spending, but by improper balance among my competing financial priorities.
In trying to figure out ways to group my financial priorities, I discovered there are five categories that must be properly aligned and managed to eliminate the Financial Outcome Gap. These five categories are saving, lifestyle spending, debt repayment, large purchases, and taxes. Anyone, regardless of income, must properly align these five competing financial priorities to avoid living in the gap. To the extent the demands of any of these financial priorities is too large (other than savings), one experiences the frustration of the Financial Outcome Gap.
I also discovered that, for the levels of income for most people, perfect alignment of the five financial priorities was savings of 20% of income, loan payments of 25%, taxes of 25%, and a combined lifestyle spending and large purchases of 30%.
By separating loan payments, such as mortgage loans and auto loans from other lifestyle spending, I found I was better able to isolate which priorities were out of alignment. Likewise, by creating a category for large purchases, which I define as any single expenditure of more than $3,000 that is nonrecurring, I was able to isolate a unique priority that must be managed differently than lifestyle spending.
Finally, even though one may have an income of $500,000 per year and be in a marginal tax bracket of 35% federal and 8% state, it would be rare that total income and Social Security taxes be much more than 25% of income because of the graduated brackets that currently exist. The current administration may change this percentage.
The percentage guidelines illustrated provide a solution to the Financial Outcome Gap. For instance, a dentist with an income of $250,000 per year, who has no savings, is likely experiencing the emotional frustrations of the gap. A dentist with the same income who is saving $50,000 per year or 20% is not likely experiencing any frustrations.
To escape the gap, the first dentist must analyze which of the other four financial priorities is out of alignment with the ideal percentages. Suppose that income taxes are 26% of income and loan payments are 20% of income. The total of these two priorities is 46%, less than the ideal amount of 50%. No problem with these two priorities.
Suppose this dentist has two children in college at a total cost of $50,000 per year. This is the culprit and barrier that eliminates the ability to save. In my five financial categories, I would define the cost of college as a “large purchase.“ This large purchase is creating the misalignment of priorities. It is not a good idea to quit saving because of a large purchase.
The strategy to fix the problem could be to make more or spend less; however, these would likely be impossible at this point. It would have been better to start saving for college when the children were born. But now that time is past.
What I would recommend to the dentist is to consider using student loans to keep the large purchase of $50,000 from sabotaging savings while the children are in college. While this may seem like outrageous advice, the dentist could perhaps be $1 million ahead at retirement if he or she could keep financial priorities aligned.
To avoid the Financial Outcome Gap and its emotional frustrations, you need to always know where your money goes compared to where it should go when properly aligned with the five financial priorities. Jump out of the Gap!
Brian Hufford, CPA, CFP®, is CEO of Hufford Financial Advisors, LLC, an independent, fee-only planning firm that helps dentists achieve financial peace of mind. Contact Hufford at (888) 470-3064, or at [email protected].