Income allocation, or "where should my money go?"

Most traditional financial advisors spend the bulk of their time focusing on asset allocation, figuring out the best possible way to allocate your portfolio in order to meet your goals. And this is a worthy pursuit! But most traditional financial advisors focus on people whose portfolios dwarf their income; after all, they get paid in proportion to the size of your investments!

But when your portfolio is small and your income is six figures (as is the case for many people who work with Seaborn), even more important than asset allocation is income allocation. How do you allocate your dollars such that you are prepared for the future (e.g. job loss, children, and retirement) but also living fully in the present (e.g. travel, giving, and lattes)?

If only there were a framework for creating an income allocation plan!

A framework for creating an income allocation plan

At the high level, any income allocation framework should focus on the pillars of Adaptive Financial Planning: intentionality, short-term flexibility, and adaptive long-term planning, and in roughly that order of priority.

By prioritizing Intentionality, you ensure that your money is going where you want it to go. Yes, intentionality is strongly implied by the whole "plan" part of "income allocation plan", but it's worth stating explicitly: a fundamental part of living your best financial life is actively determining where your money goes, rather than passively letting it go where it wants to.

Short-Term Flexibility is often the red-headed stepchild of financial planning: because it doesn't have a clear ROI, it's often dismissed as irrelevant. The end-of-history illusion tempts us to assume that every month will be a "normal" month, that nothing will change, and thus flexibility has no value. Of course, the end-of-history illusion is, in fact, an illusion; there is no such thing as a normal month, life changes at the drop of a hat, and we need to be prepared for it by building flexibility into both our investments and monthly cash flow.

Finally, Adaptive Long-Term Planning encourages us to chart a financial course, setting us off in the right direction while knowing full well that we'll have to course-correct along the way. This is where maximizing ROI comes into play, while at the same time being cautious about any strategy that irretrievably locks up our resources.

That's the foundation. What does the structure actually look like?

First and foremost: set up a cash flow management system

As you've guessed, this is where Intentionality comes in. You can't really have an income allocation plan if you don't have a system for putting your money in the right place! It might be a full-on zero-based budgeting system like YNAB, or it might be a more high-level, "pay-yourself-first" system using automated deposits to targeted savings accounts. Whatever it is, your first priority should be to get it up and working.

By "working", I mean you don't find yourself regularly raiding savings or racking up credit card debt. No judgment on you if this is the case -- I've seen it happen for clients with multiple-six-figure incomes! -- but if your cash flow management system isn't working, getting it "fixed" should be your first priority. No, it's not as sexy as investing...but your finances are not where you should go for excitement! (I mean, personal finance is exciting for me, but that's my job!)

Build your income buffer

Once you've got a reliable idea of where your money is going, take a look at how much Short-Term Flexibility you've got in there. Specifically, determine how much of your income is going towards non-discretionary expenses like mortgage/rent, utilities, and minimum debt repayment. I recommend a goal of less than 50% of your post-tax income going towards such things; this will give you the flexibility to handle threats and opportunities with equanimity, turning mountains into molehills. That said, you're in charge of your finances; if you're OK with 60% or 70% in the short-term while you make progress towards your urgent goals, that's up to you.

Moreover, this discretionary buffer will allow you to make much more consistent progress towards your goals; rather than accumulating interest-laden, progress-crushing debt every time there's an unexpected expense, you're able to shift money around and maintain speed.

So how do you get there? The lowest-hanging fruit is often debt management: permanently knocking out and/or refinancing credit card and other non-long-term debts, and making sure the resulting cash flow goes towards savings and other discretionary targets. (Note: this is one of those cases where the "snowball method" shines, as paying down the lowest-balance debts first will get you the quickest cash flow wins!)

However, I want to reiterate: do not do any of this until you've nailed down your cash flow management system. Parkinson's Law states that "work expands to fill the time available"; Gregory's Corollary to Parkinson's Law states that "spending expands to fill the cash flow available"! If you regularly overspend and haven't got a cash flow management system in place, any freed-up cash flow will disappear so fast it'll make your head spin! Get your system in place first, then free up cash flow.

Set up your "minimum funding"

Once you've reached your target non-discretionary expense level, we get to the fun stuff. (Well, I think it's fun, anyway.) This is when we set up regular funding for all of your short-term and long-term goals.

Yes, all of them.

Emergency savings. Retirement. College. Down payment for your next car. Down payment on your first house. Any goals -- even might-be-maybes, like saving for a wedding -- should have a regular stream of money going towards them. (This is already done for your debts, in the form of minimum payments. No additional work required for this step!)

The key here is to start small, even if it's just 0.1%-0.5% of your post-tax income. If it's for retirement, you can put it in a retirement account of some kind (Roth IRA's are super flexible, and are accessible even if you're a high earner), and 529 plans are good for college savings (but mind the lack of flexibility there); otherwise, consider something with a decent rate of return that's highly liquid and stable, like a targeted online savings account. Once you're at a decent non-discretionary expense target, 0.1%-0.5% of your income for each of maybe half-a-dozen goals is eminently doable -- and if an all-hands-on-deck emergency comes up, you can press pause for a month and lean on your income buffer to take care of it. (Pretty cool how each step builds on the last one, eh?) Oh, and yes, this is where Long-Term Adaptive Planning starts coming in to play.

Set your focus

Of course, 0.5% of your income isn't going to get you to retirement. This is where your "focus" comes in: your most urgent goal, towards which every spare bit of savings goes until the goals is either (a) fully funded, or (b) at a satisfactory funding rate.

For example, in the beginning your focus might be an emergency fund of 3-6 months' basic expenses. (A worthy starting focus!) In this case, it would stay your focus until you had the full 3-6 months' basic expenses in the account, with your other goals staying at your minimum funding level until then.

Once you've got your emergency fund in place, though, maybe you want to make sure you've got money set aside for the down payment on your next car. Let's say you want to have $20,000 set aside for a car in 8 years; rather than keeping your car down payment as your focus until you've got the full $20K, you can change focus once you've got ~$200/month going towards the down payment, which should be enough to reach your goal in the time allotted.

Again, this practice builds on the prior step; by setting aside at least some of your income towards all of your goals, you can be confident that you're making steady progress towards your goals, and not unduly sacrificing them for your current one.

And if you're worried that you'll never get around to focusing on a particular goal, and that 0.5% won't be enough...fear not, and keep reading!

Revisit every 6-12 months

Once you've got this all set up, put a recurring "Revisit Income Allocation" date in your Google calendar for every 6 or 12 months, depending on how quickly your life changes. (In particular, consider setting the date for right after your annual raise. You'll see why in a moment.)

Goals change. Cash flow changes. Life changes. Those alone are worth revisiting your income allocation, going back through all the steps above and adjusting as necessary.

In particular, though, I highly recommend you raise the minimum funding for your goals each time you revisit. Do so as a percentage of your post-tax income, for example going from 0.1% to 0.2% or 0.5% to 1.0%. Consider doing this for your debts, as well, putting an additional 0.1%-0.5% of your income towards accelerating debt payoff. This combats Gregory's Corollary to Parkinson's Law, especially if it's done immediately after a raise; you won't really feel the pinch, since it's coming out of your raise anyway.

A few years of this, and you'll find yourself positively rocketing towards your financial goals -- and without feeling downward pressure on your lifestyle! You may even find yourself fully funding a goal or getting it to the targeted funding rate before it ever becomes your focus!

And there you have it: a framework for creating an income allocation plan. Establish a cash flow management system, create an income buffer, start minimum funding, set a focus, and revisit periodically.

So: get going!

Now, if you're thinking "that sounds simple, but the devil's in the details"...well, you're not wrong, and you're not alone, not by a long shot. That's why Seaborn exists, to help you through analysis paralysis and get you going in the right direction. Heck, even if you want someone to just take a quick audit and make sure your numbers aren't off, we're up for that, too! Either way, I'd love to chat, even if it's just to answer one-off questions you have.

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.