After viewing yesterday’s income and expense report for an imaginary person, Dan observed astutely:
… The one area that I don’t see is for a persons IRA, 401K, or ESPP. When is that money taken out or where/how is it assigned? It isn’t like you can say that you had a net income so you placed the net income in these funds because those IRA, 401K, or ESPP plans are taken out as if it was money flowing out.
Let’s call the imaginary person “Roger.” Here is a view of Roger’s income and expense report again.
After paying all non-discretionary (required) expenses, only $175 of the income remains. Roger could take this excess money and save it, invest ir, or spend it. Beneath the non-discretionary expenses, Roger also has discretionary expenses. This second category of expenses adds up to $350. Before Roger can think about saving and investing, Roger spends more than the $175 he has left.
Rather than having an extra $175 at the end of each month, Roger has a $175 deficit. In order to cover all his expenses, Roger has to come up with an additional $175. This will come from savings or a form of debt, like a credit card or a loan. Either way, Roger is cash flow negative and his financial health will get worse every month until expenses decrease or income increases.
If this month is typical for Roger, he will reduce his savings or increase his debt by $1,500 each year. And this is a conservative estimate, because he may need a new car someday or he may want move to a new house. Most likely, he will have large expenses not covered by his income. If Roger has savings to cover the monthly shortfall, eventually they will be depleted. He is not able to save or invest for retirement or any other future goals. Roger will be required to work to afford to survive until he can live no longer.
This should be a wake-up call. In this first part of this series, I wrote about financial enlightenment, the moment when you realize where you stand and your future outlook. I described how to take an inventory of your finances to determine your current position and how to use your income and expenses to predict your improvement or deterioration over time.
In many cases, people don’t reach a turning point in their financial lives until they hit “rock bottom.” That is something that people should avoid as much as possible. It’s not uncommon to just ignore a problem until it gets in the way of normal human functioning. You can live with a broken heater until winter, and you can continue to accumulate debt for a long time. Eventually, you’re going to want to be warm when the temperature drops and you’re going to want to keep your house when you start receiving foreclosure notices.
Now that he has reviewed his finances, Roger should have a good understanding of his condition. So far, I’ve written about self-evaluation, but now it is time for people whose situation is similar to Roger’s to take action. Starting with Part 2, I will share some ideas for moving in the right direction.
Image source: crowt59
Updated January 16, 2010 and originally published November 13, 2008.