Understanding basics of setting your financial goals…

The process of financial planning begins with identifying and articulating your financial goals. What exactly is a financial goal is hard to define. This is a question that will plague you when you sit down to plan your financial future. There are a few basic steps you need to follow while setting your financial goals so that the process of setting goals can actually be a lot more fruitful for you. Here are the 5 points to keep in mind…

Goals will be medium term and long term…

When we talk of goals in life, we are talking of both medium term and long term goals. Typically a medium term goal is one which has a time frame of 3 to 5 years. On the other hand, long term goals will typically have a time frame of 15-20 years. Medium term goals include things you intend to achieve in the near future like paying margin for your car, booking an apartment, planning a holiday with family etc. These involve relatively smaller outlays and are likely to arise in the near future. Long term goals include goals like planning retirement corpus, planning for your child’s education, saving for your child’s wedding etc. These goals may arise after 15-20 years but since they involve a substantial outlay, the earlier you start planning the better.

Goals are relevant if they can be reduced to a financial number…

A financial goal is relevant to your financial plan only if they are specific and can be defined in monetary terms. Unless you know the amount of money you need for a particular goal, you cannot start the process of planning. Goals have to be specific. Saying that your goal is to be happy in life is not exactly a quantifiable goal. When you cannot quantify a goal, how do you plan for the same? You need to define your goals in specific measurable terms and also put a monetary number to it. Only then it aids the process of financial planning. It will eventually boil down to how much money you need to achieve that particular goal.

Always consider inflation when you plan your long term goals…

We are not just referring to the inflation rate of 6% that India is currently experiencing. There is a different type of inflation that you will be subjected to. Take the case of education of your children. The cost of education has gone up multi-fold in the last 5 years. Applying a simple 6% inflation would have given you unrealistic results. When you are considering your retirement, you can safely assume that your cost of living will grow over the years at the rate of inflation. But when you consider specific investments like children’s marriage and child’s education, do not apply the inflation rate. Here there are qualitative and quantitative improvements that happen in the goal and that means the cost goes up exponentially. Factor that when you plan your financial goals.

When you estimate, be conservative on inflows and liberal on outflows

This is the basic rule of accounting to provide for all losses but to assume no profits. Many young professionals assume that their income will grow consistently at 15-20% over the next 20 years. Remember, that is unlikely to happen. You career will typically move in fits and jerks and there could be spasmodic changes in your income growth. Try to be as conservative as possible when it comes to estimating your income flows. When it comes to planning your outflows, you need to factor two things. Firstly, ensure that you inflate your liabilities in a realistic manner to reflect the fund requirement when the goal matures. Secondly, provide for uncertainties beyond your control. Provide for accidents, loss of job, your inability to earn, sickness etc. The more conservative you are the, more the likelihood of your plan succeeding.

Taxes are critical to your financial plan… 

A very important component of your financial plan is the way the return on these investments will be taxed. Today dividends on equities are tax-free (till a limit), but interest on debt and FDs are taxed at the peak rate. Equity and debt mutual funds are free of tax on dividends but then there is differential taxation on capital gains on equity and debt mutual funds. Thirdly, there is the idea of the government shifting from the EEE to the EET model of taxation. If you had a provident fund account, the contributions were tax-free, the interest was tax free and the redemption proceeds were also tax-free under the EEE model. If we shift to the EET model, then the redemption proceeds will be taxed in the year it is redeemed. This can substantially change your net fund availability and can either make or mar your long term financial plan.

Financial planning is a must for every individual and the process begins with setting your goals. These 5 basic rules can help you make your financial planning process more effective, less risky and more tax efficient.

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