Where does your money go?

Many of us are disciplined about our necessary expenses, (the rent or mortgage, taxes, insurance, gas and electric) but quite haphazard about our discretionary or "unstructured" money.

One fascinating exercise is to analyze where you spend your money. Over the years of our practice, we find that after clients get past the necessary expenses and look at the discretionary expenses, they find that either they have no idea where the money goes, or that the money goes to places that are habitual but may not be satisfying.

We've heard all these phrases many times in my years of practice: "I go out to dinner so often, it isn't a treat anymore." "I have tags on so many of my clothes in my closet. I buy them and never wear them." "I am tight on money for two weeks, get my paycheck, and it's gone in a day. I couldn't even tell you where it goes." "My credit card bill was huge last month, I wasn't expecting that!"

Do we really want to be so loose about the money that we could use to create our dreams? Although it's too restrictive to watch every penny, is it foolish to treat every extra dollar as mad money?

We respond to structure. One of the keys to money happiness is to create a design for all of your money, both your necessary expenses of living and your quality of life money.

In our overall financial planning process, we will most likely recommend that you save money every month for your long-term goals. How do you do this? The only way to successfully and consistently save is to put aside savings the way you put aside money for other necessities such as your rent or mortgage. Pay yourself first! Good cash management gives you the confidence to know you can save.

Keys to successful cash management

Create and use a file for bills to be paid.

Put your bills in that file and pay them at least twice a month. If cash flow is tight, write the due date on every envelope and sort by due date. If you are really tight, sort by priority, then date. This way, you pay the pressing bills first.

Create a monthly cushion in your checking account

Aside from creating a separate cash reserve account, I recommend you keep a cushion in your checking account. This is especially important if you use an ATM card and/or have automatic withdrawals.

It's convenient and easy to set up your checking accounts at most banks for automatic deposits and withdrawals.

This set up has many advantages:

1. You're never late paying your bills.

2. You save time and stamp money because you are not writing out checks, licking envelopes and mailing bills.

3. If you use money management software, such as Quicken or Microsoft Money, you can automatically download these payments into your software.

By using automatic bill pay and an ATM card, you have an almost automatic check register. This insures you can easily reconcile your check book. You will also have a great leg up on preparing your budget and your taxes.

This works well when you know there will be money in the account when the bills are withdrawn.

We recommend that if you have automatic withdrawals from your account, you keep an extra month of those withdrawals in your checking account. For example, if you have $1,000 of automatic withdrawals, you always keep $1,000 in your account as a cushion. You have your monthly deposits and withdrawals, but you never go below $1,000 unless you are in an emergency. At some banks, your cushion amount may have the added bonus of helping you get free checking.

Create a separate cash reserve account.

Open or fund a savings or money market account designed to protect you from unexpected bumps in the road. This account replaces using a credit card for unexpected expenses. With a credit card you pay out interest to someone else when you use it. With a cash reserve account, you earn interest when you don't use it. In effect, you become your own credit card company!

This Cash Reserve account has rules for its use. Occasionally, we all have unexpected bills such as a car repair or replacing a broken appliance, or we suffer an illness where we can't earn money for a period of time.

How much you have in this account depends in part on your profession. If you are on salary in a stable job with good benefits, we recommend three months of expenses. (Expenses don't include income tax payments). If you are self-employed or working in any job where you are concerned about seasonality of income or being laid off, we recommend your cash reserve account equal six months of expenses.

With our clients, we use the analogy of a glass to explain this account. A glass is well-designed to hold only so much. If you try to put more in it, it overflows and is wasteful. Don't over-fund this account because this liquid money is earning minimal interest. The overflow is better used in other less-liquid, better paying investments.

If you need to use cash reserve money for something, refill the cash reserve account to the brim at your first opportunity. (Keep paying into your retirement plan and use any extra cash flow to refill your cash reserve account before making other investments or buying large discretionary items.)

You may not be able to build this account over-night, but once you have it, you will see a profound improvement in your money confidence.

Learn how to handle credit card debt

All this is fine and good, but many people have debt to handle before they can build this kind of cash reserve. We recommend that you create a plan to pay off the debt, and also start a cash-reserve account. Begin your new habit. Start using your cash reserve, no matter how small instead of your credit cards, and refill that reserve.

Barbara Bachelder, CFP® for Wealth by Design, LLC