A client can have brilliant investments and an airtight estate plan, and none of it matters if they cannot control the flow of money through their household. Cash flow is the oxygen of every financial plan.
HIGH-FREQUENCY: The three income types and their tax treatment cross multiple exam domains. Know which type gets payroll taxes, which gets preferential rates, and which has special loss rules.
- Earned income: salary, wages, bonuses, commissions, net self-employment income. Subject to income tax and payroll taxes (FICA). Most heavily taxed.
- Portfolio income: interest, dividends, capital gains. Subject to income tax but generally not payroll taxes. Long-term capital gains and qualified dividends get preferential rates.
- Passive income: business activities without material participation, plus rental income (with exceptions). Passive losses can generally only offset passive income.
On the expense side, fixed expenses (mortgage, insurance, loan payments, property taxes) have limited short-term flexibility. Variable expenses (groceries, entertainment, dining, travel) are where behavioral change has the fastest impact.
HIGH-FREQUENCY: Emergency fund sizing is one of the most frequently tested calculations in this domain. Know the benchmarks, the correct denominator, and the household-type adjustments.
Common mistakes
- Using gross income instead of essential expenses for the emergency fund ratio. A client earning $12,000/month with $7,000 in essential expenses needs $42,000 for six months, not $72,000 (six months of gross income). Trap: $72,000 is always among the choices.
- Treating avalanche and snowball as interchangeable. A client who is "overwhelmed and has abandoned previous repayment efforts" points toward snowball, not avalanche, even though avalanche saves more money. Trap: Defaulting to avalanche for every behavioral profile.
- Underestimating self-employed emergency fund needs. A self-employed client with four months of reserves is inadequate, even though four months would be acceptable for a stable dual-income household. Trap: "Adequate" as an answer choice for four months when the client is self-employed.
Bottom line
- Emergency fund: 3-6 months essential expenses (stable dual-income), 6-12 months (single, self-employed, or variable income)
- Denominator is essential expenses, not gross income, the #1 exam trap on this topic
- Priority hierarchy: employer match, emergency fund, high-interest debt, medium goals, then long-horizon goals
- Avalanche minimizes total interest (highest rate first); snowball maximizes motivation (smallest balance first)
Exam shortcut
The CFP Board tests emergency fund sizing by giving a detailed household profile and asking whether reserves are adequate. Always calculate using monthly essential expenses, not income or total spending. Self-employed or single-income households get the 6-12 month range. Avalanche = Alps = highest. Snowball = Small = smallest balance. Emergency fund denominator: "Expenses, not Earnings", both start with E, but the one that does NOT describe income is correct.
The full lesson (about 2,484 words, 17 min read) adds 2 worked examples, all 5 common mistakes, a self-check, free in the app.
Learning objectives
- B.9
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