4 Essential Steps to Financial Reality

To have an accurate picture of your finances, compare year-end 2009 and 2008 positions.

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Before getting too far into the new year, it's important to develop a realistic record of where you ended 2009 and how your financial situation changed during the year. You'd think everyone would already know where they stand, but such financial self-awareness is the exception. And obtaining it does take time and effort. But doing an annual report on your finances can provide an invaluable record that only you can assemble. Done properly, it should illuminate your future, paving the way to important financial decisions and helping you make smarter choices.

[See 6 Steps to a Better Retirement.]

Your annual report should include four sections: income, expenses, investments, and other assets. Much of this work can be a natural companion to the work you already do to file your income taxes. Even if someone else does your tax returns, you probably need to assemble the W-2s, 1099s, brokerage statements, and other documents that tell the story of what you earned and what you spent in 2009. If this is the first year you've done an annual report, you'll also need to pull the same documents for year-end 2008. But you should have all the major documents readily at hand from last year's tax returns. 

[Also see 10 Top Money Tips for 2010.] 

Income. This is not the taxable income number from your W-2 and other income statements that will be entered on your tax return. It should represent the annual value of your paychecks plus any other dollars that were actually provided to you as cash in hand. It would not include earnings on investments unless you cashed in the investments and converted them to cash. How much cash did your family unit (you, spouse, dependents, etc.) receive that was available to be spent or saved? How does this total in 2009 compare with 2008? 

Expenses. Tracking what you spent in 2009 is the single biggest component in building your annual report. It's also the most valuable. I've droned on in previous columns about doing a detailed monthly expense log. Here are my spending categories: groceries, domestic (household goods, clothing, grooming), car (gasoline, maintenance and repairs, payments), utilities, home mortgage, yard (we do a lot of gardening), entertainment (includes periodicals, sundries, cash withdrawals, and similar discretionary spending items), meals away from home, charity, healthcare, travel, insurance (you can include auto insurance here or under cars), educational spending, and taxes. I use my bank debit card and a single charge card as much as I can (and make sure I never pay late fees or carry a balance). Doing so produces a detailed electronic record that I can easily import into my expense spreadsheet. With cash, I find that I don't keep good records of what I spend. So while my expense log includes everything I spend, it fails to properly allocate my cash spending. Still, from year to year, I figure that any mistakes related to cash spending will be similar. Therefore, the amounts that are accurately tracked can be fairly compared from one year to the next. 

Investments. Include changes in all of your investment accounts as of the end of the year. This review also should be part of a broader assessment of your investments. And, yes, you should do this more often than once a year. Look at all your investments, including active retirement accounts. If you have an approach to diversifying your investments, review it and make sure this is still your approach. Then look at the changed values of your holdings and make sure you adjust your portfolio so your holdings meet your diversification objectives. Include CDs and any cash balances in bank and brokerage accounts as well. Add them all up and see how they fared at the end of 2009 compared with year-end 2008. I know that investment losses might make this a painful exercise, but you need to know. While you're at it, spend some time to determine how much money you paid other people to handle your investments and retirement plans—trading fees, management advisory fees, and account servicing fees. If you own mutual funds, you'll need to look at their prospectuses to find some of the fee information. If you have a 401(k) through work, your employer should be able to help you find out about fees as well. There are big variations in fees among mutual funds and investment firms. Because most retirement funds are invested for 30 or 40 years, paying 1 percent in annual fees versus 2 percent will save you thousands of dollars. 

Other Assets. What nonfinancial assets do you own that you could sell and convert to cash? This won't take long, and it needs to be done. If you own your own home, how much money would you clear if you had to sell it? You won't know this for certain unless you put your home up for sale. But you can get a good idea. If you live in a large city where real estate values are closely monitored, you should be able to get a good idea of how housing values have changed over time. Also, what's your home's appraised value for property taxes? Did it change last year because of weakness in housing values? What did homes like yours sell for during 2009? Such comparable sales figures are available from local multiple listing services and real estate agents. Many newspapers publish home sales prices and keep this information on their websites. What's the resale value of your car(s)? There are online tools to provide this information. Do you own other tangible assets that have cash values—a boat, jewelry, antiques, and the like? Total their cumulative cash resale value as of the end of 2009. If you can, compare it with the year-end 2008 values. If you can't, it's still good to know what your assets would bring on the market. And you can see next year how much their value has changed.