Choosing the Right Business Entity Choosing the form of entity under which a business will operate is one of the first, and often the most important, decisions a business owner will make. Although the legal details underlying each entity type are inherently complex, exploring three major variables may help you determine which option is right for you: business control, owner liability, and tax implications.
The major business alternatives today include: - Sole Proprietorship - Partnership -C-Corporation -S-corporation -Limited Liability Company
Sole Proprietorship. As its name implies, a sole proprietorship has a single owner, and is perhaps the most simplistic of all entity types. The main benefits of the sole proprietorship include its ease of implementation and lack of regulatory requirements. In addition, the sole proprietorship allows complete business control to a single business owner (proprietor). Under a sole proprietorship, the business owner is required to file a Schedule C (profit or loss from a business or profession) with their personal income tax filing. The proprietor personally assumes all liability and business risk, which can often be "transferred" through the purchase of liability insurance.
Partnership. The main difference between the sole proprietorship and the partnership is the number of business owners. Although quite easy to establish, it is a good idea to begin a partnership with a formal arrangement known as the partnership agreement. The partnership agreement sets forth the intent of the business owners in the event of a wide variety of business events such as the sale of the entire business, the sale of a single individual's holdings or the disposition of ownership in the event of the death of a partner.
Like the sole proprietorship, the partnership represents a "flow-through entity" where both cash flows and tax liabilities flow through to the business owners. The partnership provides its owners minimal protection from business risk.
C-corporation. Though often costly and time-consuming to establish and maintain, the C-corporation provides the greatest amount of liability and business risk protection to the business owner(s). Strict governmental regulations outline company structure, reporting, and disclosure requirements.
Corporations have unlimited lives with ownership rights passing to designated heirs upon the death of an owner. The corporate entity also has a great deal of income tax flexibility and can offer the broadest array of tax deductible benefits, but may also trigger "double taxation" of some corporate profits as they are taxed at the corporate level as profits and again, potentially, at the individual level as taxable dividends are paid to shareholders.
S-Corporation. The "S Corp" functions as something of a hybrid, assuming many of the best features of several other entity types. The S Corporation is a legal entity that offers owners the benefits of greatly limited liability, while allowing company profits or losses to flow directly through to the business owners for income tax purposes, thus avoiding potential double taxation. The legal requirements and costs associated with starting an S Corporation are modest, as are the regulatory requirements. There are limitations on the number of owners within an S Corporation, and a C Corporation may not be an owner.
Limited Liability Company. Like the S Corporation, the Limited Liability Company (LLC) combines many of the benefits of other entity types. In contrast to the proprietorship and partnership, the LLC provides its owners (or members) with limited liability for the debt and business risk associated with ownership. The LLC also avoids the "double taxation" of the corporation by functioning as a "flow-through entity" for income tax purposes.
Selecting a business entity can be a complex decision with long-term effects on the ownership, owner liability and taxation of a business. Once you have prepared a business plan and evaluated your business ownership goals, consider seeking the advice of trusted financial professionals and advisors in finalizing your final selection of business entity.
Protecting Against the Loss of Key Employee The vast majority of small-business owners accept the wisdom of insuring the firm against the loss of its property values. We take care to insure the physical assets against fire, tornados and other disasters. Yet, protection from the loss a key executive may be far more important.
First, the probability of losing a key employee is far greater than a loss due to fire. It has been estimated that the chances of death of a key executive is 14 times greater at age 45, 17 times greater at age 50, and 23 times greater at age 55 than a loss caused by fire. Further, about one out of every three individuals dies in the working period of life with a consequent loss to his or her business.
Second, the loss due to a fire is temporary. Plants and factories can be rebuilt. Inventory can be replaced. The new building is likely to be more useful and valuable than the old one. On the other hand, a new hire may need several months or even years to become as productive as her or his predecessor. In fact, the deceased employee may prove impossible to replace.
Who Is Key? Every corporation has at least one key executive or an employee who makes a substantial contribution to the operation, profitability and success of the business. Any individual who has critical intellectual information, sales relationships, bank relationships, product knowledge, and/or industry contacts that may adversely affect profits in the event of their absence, may be considered key.
The Role of Key Person Life Insurance Although life insurance cannot ever fully replace the value of a key employee, it can indemnify the business for the financial setbacks that can occur. Life insurance can provide the business with needed funds to keep the business running, to assure creditors that their loans will be repaid, to assure customers that business will continue operations, to cover the special expenses of finding, hiring, and training a replacement.
How This Strategy Works There is no particular form of agreement or special contract needed by the business to obtain key employee insurance on an executive or owner. However, the board of directors should authorize the maintenance and payment of the policy.
The applicant is the company. The application is signed by an officer of the business other than the insured party. Generally, the premiums will be paid by the business on an after-tax basis and are not deductible as a business expense. The business will be designated as the beneficiary and the insurance proceeds received upon the death of a key executive are not subject to federal income tax.
Replacing a key person may be difficult, but the proceeds from the life insurance policy can help ensure a smooth transition following their passing. With key person life insurance, that's one more risk that small-business owners can worry a little less about.
Qualified Retirement Plans for Small Businesses For the small-business owner, attracting and retaining valuable employees can be a daunting challenge. One way to make working for your business more attractive to current and potential employees alike is to implement a qualified retirement plan for you and your employees. Besides greater appeal to your workers, qualified plans can also provide you with numerous tax advantages, including:
- Contributions for all participants are 100% tax-deductible to the business up to certain limits. - Annual contributions by the business are not considered taxable income to the plan participants. - Capital gains and interest earned are deferred from taxation during the accumulation years. - Income taxes are payable upon withdrawal. -At retirement, favorable tax treatments may apply such as spreading payments over the participant's lifetime and special averaging formulas.
Non-Tax Advantages In addition to the obvious tax and employee hiring/retention advantages, there are many other, equally important, reasons to implement a qualified plan. For example, plan assets are creditor-proof. The assets of the plan are not subject to malpractice lawsuits or bankruptcy rulings.
These and other advantages combine to help improve morale as the participants realize that their company provides the mechanism to help secure their retirement.
Types of Plans The two most common types of qualified retirement plans are pension and profit-sharing plans. A business can also sponsor an IRA or SEP (simplified employee pension plan).
Pension Plans. There are three major types of pension plans -- defined benefit, money purchase, and target benefit. - A defined benefit plan is one where the retirement benefit is determined by a plan formula - usually based on years of service. - A money purchase pension plan is one where the plan formula specifies the percentage of each participant's compensation that will be contributed each year. - A target benefit plan is a hybrid. It starts out as a defined benefit plan, which determines the benefit. Once the benefit is calculated, the plan converts to a defined contribution or money purchase plan.
Profit-Sharing Plans. The most popular type of profit-sharing plans is 401(k) plans. Elective deferrals to these plans are limited to $15,000 for the year 2006 ($20,000 for people 50 years of age and older, including catch-up provisions). Annual contributions to a profit-sharing plan are generally not required; instead, they can be discretionary each year.
Implementing a Cafeteria Plan in Your Business Internal Revenue Code 125 allows an employer to implement an employee benefit plan, which allows employees to select the benefit programs they prefer.
The plan offers two or more options and the employee chooses the option most appropriate for him or her from the "menu" of benefits available. It's sort of like ordering lunch from the local deli - which is why the plan is referred to as a "cafeteria plan"!
Cafeteria plans, along with 401(k)s, are among the most popular employee benefit plans of the past decade. The tax benefits to the employer and employees far exceed the minimal required government reporting.
Cafeteria Plan Benefit Options In general, the IRS allows the following benefits to be present in a Section 125 plan: - Group-term life insurance (up to $50,000; amounts above that level of death benefit may be subject to Social Security and Medicare taxation) - Accident and health plans - Long- and short-term disability benefits - Flexible spending accounts to save for health, medical, and childcare expenses - CODA [401(k) plans] - Dependent group life, accident, and health insurance coverages - Vacation
Employee Tax Aspects The plan essentially allows expenses that normally would be paid by the employee on an after-tax basis to be paid via salary reductions on a pretax basis. This allocated income will not be subjected to FICA or income taxes. The result is that taxable dollars have been converted to nontaxable dollars - thereby increasing the employee's take-home pay.
Employer Tax Aspects Generally, employer contributions to a plan are income tax deductible. In addition, contributions on behalf of the employees, if such contributions are not included in the employee's income, are not subject to FICA (Social Security) or FUTA (Federal Unemployment Tax Act). This can result in significant savings to the company's bottom line.
The employer must file an annual information return (IRS Form 5500) stating plan participation, cost and business type.
Use-It-or-Lose-It An important point for the employee to remember is that there can be no claim of any unused benefits or contributions from one plan year to the next. This is known as the "use it or lose it" rule.
Many employees steer clear of these plans because of this rule. You have to decide up front how much to put in the plan and if you don't spend it all within a year, you forfeit the leftover amount.
Sounds risky - at least until you consider that the tax breaks are so powerful that even if you wind up forfeiting 20% of what you put into a plan, you'll still come out ahead.
For example, let's say you set aside $5,000 for medical expenses in 2007 and wind up spending just $4,000. At face value, you've lost $1,000. But consider: If you're in the 25% federal tax bracket and face a 5% state income tax as well as the 7.65% Social Security and Medicare tax, the $5,000 you put in the plan will save you more than $1,800 in taxes, leaving you $800 ahead. Put another way, you'd have to earn almost $6,300 to have $4,000 left over to pay those bills. Even if you forfeit $1,000, you still come out ahead. That's why it's wise to be aggressive in using flexible spending accounts.
Deferred Compensation In addition to providing qualified plans to employees, many business owners implement nonqualified alternatives in order to supplement retirement benefits. These selective benefit plans are generally offered to key employees and owners. One popular nonqualified benefit is deferred compensation.
Basically, nonqualified deferred compensation refers to an arrangement between an employer and an employee in which compensation for current services is postponed until some future date or the occurrence of a future event. The effect is to postpone taxation for the employee until compensation is received - usually at retirement or disability.
Types of Deferred Compensation Deferred compensation plans can be categorized several different ways. Plans can be: - Funded or unfunded - Forfeitable or nonforfeitable - Defined benefit or money purchase - They can also provide one or a combination of death benefits, disability benefits and retirement benefits.
Funded plans generally involve a trust fund or escrow account where the employer transfers money at a later date for its "promise to pay" deferred compensation. These are not very popular as the participant may be deemed to have "constructive receipt" of such funds and therefore inherits a current tax liability when funded.
IRS Revenue Ruling 60-31, 1960-2 CB 174, states that an employee's right to receive deferred compensation, backed during the deferral period solely by an employer's "naked promise" to pay, produces no currently taxable income for the employee. A deferred compensation plan is not regarded as funded merely because the corporation purchased and owns a life insurance policy or annuity contract to make certain that funds will be available when needed.
Rabbi Trusts One of the problems with a typical unfunded deferred compensation plan is that the employee has no guarantee that future payments will be made. If the employer defaults in making promised payments, becomes insolvent, or files bankruptcy, the employee simply becomes a general creditor waiting in line with all the other creditors hoping to recoup some of their receivables.
The rabbi trust protects an executive from an employer's future unwillingness or inability to pay promised benefits while retaining the benefits of deferred income taxation. The IRS has stated in a series of private letter rulings that an irrevocable trust or an escrow account can be established to fund a deferred compensation agreement as long as the assets placed into the rabbi trust remain subject to the claims of general creditors. If this condition is met, the employee will not be deemed to have "constructive receipt" of the assets, and, therefore, will not have received a current economic benefit. Hence, the employee will not be required to pay taxes until the payments are made at a future date.
The rabbi trust gives the employee security in knowing that the employer is, in fact, setting aside money to fulfill its obligation under a deferred compensation agreement.
Choosing the Right Continuation Plan for Your Business The death of a major shareholder in a closely held corporation can seriously interrupt the continuity and profitability of the business. Surviving shareholders must struggle with how to continue the company as a profitable business with the loss of a key player. Heirs must concern themselves with how to replace the income that the shareholder had earned and how to extract their inherited portion of the company value.
To reduce potential areas of conflict and realize a smooth transition, company owners should enter into an agreement while the parties are still living. This is called a buy-sell agreement. Stock purchase plans are generally arrangements through which shareholders agree to sell their stock interests in the event of specific triggering events such as death, disability, or retirement.
Plan Types Stock purchase plans are generally classified into three categories: stock redemption plans, cross purchase plans, and hybrid plans.
Under a stock redemption plan, the corporation agrees to purchase all or part of the stock interest of a shareholder. There are three approaches to stock redemptions - full redemptions, partial redemptions, and Section 303 redemptions.
In a cross purchase agreement, the remaining shareholders buy the stock interest of a single shareholder. They can either distribute the shares proportionally to what they had before the triggering event occurred or non-proportionally according to what is outlined in the buy-sell agreement.
A hybrid plan, or wait-and-see approach, gives the corporation the first chance to buy. If the corporation does not buy in within a specified time frame (for example, 90 days), the other stockholders have the option to buy. If that option is not exercised, then the corporation must buy the shares.
Many factors need to be considered when determining the best type of stock purchase plan to implement, cost factors, psychological factors, ease of administration, tax implications, and transfer for value rules to name a few. You should seek the advice of financial and legal counsel to help implement your plan.
WHAT IS FINANCIAL ENGINEERING? We wanted to travel faster — automotive engineering made it happen. We wanted to travel across sea and mountains — nautical and aero-nautical engineering made it happen. We dreamt of going to the outer space— aerospace engineering turned that dream into reality. Engineering is an exact science of getting through challenges to achieve its goals. And so, when it comes to money,
FINANCIAL ENGINEERING is the absolute course to financial success.
THE TOTAL SOLUTION is a FULL SPECTRUM of financial programs that are suitable to meet your needs. YOU ARE NOT ALONE. Absolutely free, your Financial Engineer will guide you every step of the way to make sure that your decisions are on track with your financial goal. IT IS A SURE THING. Winning the lottery seems to be an exciting option. But the truth is, it's a dream. We can’t depend on dreams for peace of mind. It is tempting to hope but it is much wiser to count on sure & proven principles that have already worked for many. BEING IN CONTROL Set goals. Plan. Do what’s right for you. Decide about your money, about your habits, about every facet of your financial life. Only you can solve your financial challenges - not the government, not the institutions around you. Look in the mirror. Your greatest ally was there all along. LEARN HOW MONEY WORKS. To solve your financial problems, you need to learn how money works. Planning a vacation often gets more attention than planning for their future. It only takes very little time to learn FINANCIAL ENGINEERING, straight-forward solutions to most problems, used by financial experts. YOUR CHOICES: Do nothing or apply Financial Engineering. Statistics show that people who do nothing often end up broke, struggling for a lifetime. Choose your approach: Put up with the “pain of discipline” now, or suffer the “pain of regret” later.
FINANCIAL ENGINEERING will help you Protect Goals, Enhance Cashflow, & Build Net Worth.
3 ELEMENTS OF FINANCIAL ENGINEERING
PROTECT YOUR FINANCIAL GOALS. When you do your financial plan, the end result doesn't happen overnight. It takes time and patience and, maybe, a lot of hard work. No one knows what is going to happen to you while you are working to carry out your plan. And you need to achieve your financial goals no matter what — it is what you planned for yourself and your family. You can protect your goals. And the only way you can protect it is if you know exactly what your goals are. Once you have determined how much you need for an income, for paying off the bills, for education of your children, the mortgage, that vacation you wanted for your family, the long term care for you and your spouse, and most importantly, the estate of your family, then you are ready to secure the amount of protection you need. Knowing that your goals are protected from adversities, you will be able to function better, because you have the peace of mind.
INSURANCE products are aimed to secure something in spite of adversities. That is how we protect ourselves, our loved ones, our properties, our endeavors — our goals. There are so many different kinds of insurance. Life, health, disability income, auto, business, mortgage, debt payment, home warranty, property, professional, hazard, dental, vision are just some of it. Whatever kind of insurance it is, it’s the one that you will depend on when the unexpected happens. Your financial plan doesn’t have to be in vain when things go wrong. Make sure that you include the right insurance products in your financial plans. it is the best and the only financial protection people can afford to have.
BUYING INSURANCE must fit your needs and must be affordable. Find out what different companies charge for the kind of policy you want. You’ll find significant cost differences between companies. It makes good sense to ask your Financial Engineer to help you. He can be very useful in reviewing your insurance needs and in giving you information about the kinds of policies that are available. He will even review your existing policies to make sure that what you have suits your real needs. Don’t buy from the person just because he/she is your friend or relative. It is your lifetime expense, and the difference could affect your lifestyle today and in the future. Don’t look only at the initial premium, but take account of any later premium increases. Review your protection program with your Financial Engineer every few years to keep up with changes in the industry and your needs.
CASH FLOW ENHANCEMENT
CASH FLOW is money passing in and out of your control. Your net cash flow is your income minus your expenses. If this number is less than zero, you have a negative cash flow meaning you are spending more than you are earning. If you want to get ahead, and stay out of trouble, you must cut expenses now and/or make extra money. Positive cash flow is when there’s money left over to apply toward your goals. The Cash Flow equation or mathematical statement is INCOME - EXPENSES = NET CASH FLOW.
CASH FLOW ENHANCEMENT is the process of maximizing income while minimizing expense. Once your income is maximized and your expense is minimized, you have reached the state of maximum cash flow difference. The Enhanced Cash Flow equation or mathematical statement is: MAXIMIZED INCOME - MINIMIZED EXPENSE = ENHANCED CASH FLOW.
WANTS VERSUS NEEDS. Most people live paycheck to paycheck. They know the importance of savings but they want things today. The pull pressure on their money to different directions is so strong. It’s hard enough just getting through and saving for the future becomes impossibility. And so, even people who have made a lot of money are destroyed by unexpected emergencies or loss of income. It should not be that way. Applying some discipline can make everything better. You can’t have everything and you have to decide which to buy and not to buy. it is important to know the difference between “wants” and “needs”. Do you need that new car? Or do you just want it? do you need that new dress? Or do you just want it? It is tempting to make our “wants” to become necessities but it is important to separate the two. If you are working on the security you need, you may have to forget some of your wants for a while. It may be hard to do at the beginning but it is very much important to your financial health. You must have known someone who seemed to have everything, but when bad times hit, was bankrupt overnight. You see it everywhere. These are people who focus exclusively on their “wants,” spending all their money plus all their credit on luxury and enjoyment, but ignoring their need to build their net worth.
NET WORTH BUILDING
IT IS NOT WHAT YOU MAKE THAT COUNTS — IT IS WHAT YOU KEEP. Add up all the money you have made over your working life, how much of it have you saved? If you are like most people, you won’t believe how much money has come your way, and how little you have saved.
YOU CAN BE A MILLIONAIRE IN YOUR LIFETIME. Yes you can. Most people can’t imagine becoming a millionaire. Getting from one paycheck to the next seems like a major accomplishment. Nevertheless, most people worked between the age of 20 and 65 — that’s a total of 45 years. With an average $24,000 annual income over a lifetime would have earned $1,080,000 ($ 24,000/year X 45 years). For a working couple or an individual with $ 50,000 annual income, that would be $ 2,250,000! Aren't you close to becoming a millionaire?
NET WORTH means value of an entity or an individual. Not by what one makes but what one has. It’s also credit worthiness. Mathematically, TOTAL ASSETS - TOTAL LIABILITIES = NET WORTH.
NET WORTH BUILDING is accumulating assets while eliminating liabilities. If you owe more than the value of all your possessions, you have a negative Net Worth. You are not in a position to retire. You build your Net Worth to achieve financial security. Financial security is attained when your Net Worth is enough to generate the income needed to sustain the rest of your life.
ASSET CREATION is done in various ways. Opening bank accounts, annuity accounts, retirement accounts, buying real estate, permanent life insurance, stocks, mutual funds, and valuable properties are forms of asset creation.
ASSET ACCUMULATION is to make your assets grow more through interest, rental fees, gains, appreciation, equity, dividends, etc. Once you learn how money works, compounds, and multiply, you are not going to waste one bit of time and money to achieve your goal.
PROCRASTINATION AND INFLATION are the worst enemies when building your Net Worth. Procrastination wastes time, and time is the most important factor in compounding and multiplying your money. The most important step of your financial plan is getting started. Not tomorrow, but today, because nothing happens until you start taking that first step. You don't have to do everything at once. Just one step at a time. You’ll be amazed of the results once you begin moving. Every step you make moves you forward and ultimately you’ll get there, to the place of your dreams. Inflation eats your money. If you don’t know how to manage it, you’ll be surprised one day how little your money will be worth. That is why, you must have the tools needed to fight and beat inflation. Or, you will be sorry
BELIEVE. The best way to solve any problem is to believe that it is possible. People fail because they are somewhat pessimistic about success. Some people think that they don't have enough money to manage. Some think they don't have the time. Others think they don't have the knowledge. All this negativity will be neutralized by Financial Engineering.
FINANCIAL SUCCESS CAN HAPPEN TO YOU. With a little determination, you can make a tremendous difference in your future. Success doesn't happen overnight but it happens . Financial security isn’t built with $1000 bills. It is built of $1s of expenses carefully cut, or that $1s of additional income, saved on a systematic basis. It doesn't take much to become financially secured. Your best friend or your worst enemy for achieving your financial goals is yourself. If you start now, yourself is a friend. if you plan to do it later, then yourself is your own enemy. Decide. Which do you want yourself to be?
TAKE ONE STEP AT A TIME. Assess your current financial situation by setting up and maintaining your financial records. You’ll discover just how much power you have over your funds — a rewarding experience if you ever wonder “where all the money goes” — and see how good documentation can help you meet your financial goals. As with every portion of Financial Engineering, we’ll walk you through the process step-by-step. But it is not essential for you to work through all the details right away, you may just want to glance over this material now, then come back to it after meeting with your Financial Engineer. If you already maintain financial records, consider this a refresher — the chance to bolster your money’s performance even further.
ACCOUNTING IS KEY. Think of yourself as a small business entity. You have income and expenses, assets and liabilities, and back-up and protective measures, just as any company does. And, you have the same need to forecast what your financial position will be a few months and years from now. Only by carefully tracking its funds can a company, and you, know for certain when to jump at new opportunities and when to cut back expenses. Accounting systems are a crucial monitoring device and the starting point for paving a clear path to financial independence.
The price of higher education has seemed to defy gravity. According to The College Board, a not-for-profit membership association whose mission is to help students and parents prepare and pay for college, tuition and fees at both private and public institutions have nearly doubled in constant dollars over the last 20 years.1
But a college education is an investment that pays big dividends down the road. The College Board, citing U.S. Census Bureau statistics, estimates that individuals with a bachelor's degree earn over 70% more, on average, than those with only a high school diploma.2 Over a lifetime, that earnings gap translates into more than one million dollars - more than enough return to justify the investment, even if the rise in prices is outpacing inflation.3
Some parents, especially those of young children, put off planning on the assumption they can make up for lost time later. Even if your children are very young, however, it's not too soon to begin thinking about ways to prepare for helping them with the rising costs of a higher education. Given the proven power of compounding over time, starting early to save smaller sums of money each month can make a dramatic difference in the amount you can manage to put away over time.
1,2,3,5) "Trends in College Pricing 2005," The College Board 4) "Trends in Student Aid 2005," The College Board
Create a College Funding Strategy
With all the other expenses competing for your monthly income - mortgage, car payment, 401(k) plan contribution, and the like - carving out a small sum of money to save every month for college isn't easy. However, the earlier you start the more you're likely to accumulate.
Let's compare two hypothetical examples. The Smiths and Jones both want to send their children to a college whose four-year total cost is approximately $40,000. The Smiths start saving as soon as Junior is born, putting away $100 per month earning 8% per year. By the time Junior is ready for college, they will have saved $48,749 - more than enough to cover the entire cost plus account for inflation.
The Jones, however, wait until Precious is 10 years of age before starting to save. Even though they can put away $250 per month, when Precious is ready for college eight years later they have only saved $34,163 - meaning they'll have to make up any shortfalls out of pocket.
Of course, these hypothetical examples are for illustration purposes only and do not represent the return of any specific investment. Also, taxes, fees, and other costs are not considered. But the message is clear: The earlier you start, the less you'll need to save each month and the more you're likely to end up with by the time you send your child or children off to State U.
Fortunately, several savings and investment strategies exist to help you accumulate assets for college.
College Funding Ideas
Assess your needs. To determine how much to save, you need to estimate the future cost of tuition at public and private institutions. With education cost rising an average of over 8% a year for four-year institutions, you must save with inflation in mind.
Save early and often. The sooner you begin to set aside funds for college, the less you will have to save on a monthly basis. Allow your investments to grow along with your child.
Set up a systematic savings plan. Try to save monthly or quarterly, just as you would if you were paying off a car or a mortgage. (Please note, such a period savings or investment plan does not assure a profit and does not protect against loss in declining markets.)
Keep a separate college account. The most popular are custodial accounts. These accounts ease the tax burden by allowing parents to shift some of their assets to the child at the child's lower tax rate.Involve the family. Children are more aware of family finances and accept responsibility when they are involved. It also becomes easier for you if the child is able to contribute to the fund.
Create an incentive program with your child. Offer to match the money the child makes to his own account. Teach him or her to work and help contribute to their fund - they will value their education even more.
College funding takes discipline, effort, and planning. It's also becoming more complex every year. Rely on our financial planning expertise to help design a program that best fits your family's needs and situation.
Funding College - What Are Your Options?
With the price of an undergraduate education skyrocketing, it's little wonder that college tuition oftentops the list of families' financial concerns. Instead of letting the high cost of college intimidate you, however, it's far smarter to create a savings plan and then put it into action. Below are a few of the powerful programs that can help you fund future college costs.
Coverdell Education Savings Accounts One option is the Coverdell Education Savings Account (ESA), formerly known as the Federal education IRA. A Coverdell ESA allows families with adjusted gross income of less than $220,000 ($110,000 for single filers) to contribute up to $2,000 of after-tax income per student each year. As long as these funds are used for higher education, they are not taxable. (Benefits disappear for families earning more than $220,000 annually, or singles earning $110,000 per year.)
Contributions: Any individual who meets adjusted gross income (AGI) requirements can make a non-deductible contribution on behalf of a child under the age of 18. The AGI requirements are $95,000 for single taxpayers and $190,000 for married taxpayers. The $2,000 annual contribution limit is phased out for single taxpayers with AGI of $95,000 to $110,000 and for joint filers with AGI of $190,000 to $220,000. Although a child may be the beneficiary of any number of Coverdell ESAs, the total contributions for the child during any tax year cannot exceed $2,000. Contributions to a Coverdell ESA may be made until the due date of the contributor's federal income tax return, without extensions.
Withdrawals: Distributions are tax-free as long as they are used for qualified education expenses, such as tuition, books, fees, etc., at an eligible educational institution. This income exclusion is not available for any expenses for which the Hope Credit or the Lifetime Learning Credit is claimed for that student. If the distribution exceeds education expenses, a portion will be taxable to the beneficiary and will be subject to a 10% tax penalty. Exceptions to the penalty include the death or disability of the beneficiary or if the beneficiary receives a qualified scholarship.
If there is a balance in the Coverdell ESA at the time the beneficiary reaches 30 years old, it must be distributed within 30 days. A portion representing earnings on the account will be taxable and subject to a 10% penalty. The beneficiary may avoid this tax and penalty by rolling over the full balance to another Coverdell ESA for another family member.
Section 529: College Savings Plans Another attractive option is the Section 529 college savings plan. A 529 plan is a tax-advantaged investment plan designed to encourage saving for the future higher education expenses of a designated beneficiary (typically one's child or grandchild). The plans are named after Section 529 of the Internal Revenue Code and are administered by state agencies and organizations.
Each state that offers a 529 plan determines how its plan is structured and which investment options are offered. While most plans allow investors from out of state, there can be significant state tax advantages and other benefits, such as a state tax deduction, a matching grant, and scholarship opportunities, protection from creditors and exemption from state financial aid calculations, for investors who invest in 529 plans offered by their state of residence.
There are two types of 529 plans: prepaid and savings.
Prepaid plans (sometimes called guaranteed savings plans) are offered in 18 states and allow for the pre-purchase of tuition based on today's rates and then paid out at the future cost when the beneficiary is in college. Performance is often based upon tuition inflation. Prepaid plans may be administered by states or higher education institutions.
Savings plans are different in that your account earnings are based upon the market performance of the underlying investments, which typically consist of mutual funds. Savings plans may only be administered by states. 48 states and Washington, D.C. offer a savings plan. Most 529 savings plans offer a variety of age-based investment options where the underlying investments become more conservative as the beneficiary gets closer to college-age. They also offer risk-based investment options where the underlying investments remain in the same fund or combination of funds regardless of the age of the beneficiary. In addition, many savings plans offer a stable value or guaranteed option designed to protect an investor's principal while providing for some investment growth, while others offer investments in certificates of deposit.
With the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), 529 plans gained their current popularity and tax advantages. Prior to EGTRAA, 529 plans grew tax-deferred and distributions from 529 plans for qualified higher education expenses were taxed at the beneficiary's federal income tax rate. After EGTRAA, 529 plans still grow tax-deferred but distributions from 529 plans for qualified higher education expenses are exempt from federal income tax. The 529 plan provisions of EGTRAA, originally set to expire after 2010 due to a sunset provision, were made permanent by the Pension Protection Act of 2006. This permanency means you can save in a 529 plan knowing that your withdrawals for qualified education expenses will remain free from federal income tax! Many states mirror the federal tax advantages for 529 plans by offering state tax-deferred growth and tax-free withdrawals for qualified higher education expenses.
Investment Options for Funding College
College should be considered a lifetime investment rather than just a four-year expense. It requires financial planning and personal sacrifice. The earlier you start saving and investing, the less money you will have to save and invest later and, most likely, the more assets you'll end up accumulating.
What's more, the earlier you start saving, the less risk you'll probably have to take in your investment choices. That's because long-term investing generally carries less risk as you allow more time for your assets to ride out economic and bull/bear market cycles.
Many investment alternatives are suitable for college savings. Here are just a few:
U.S. Savings Bonds (conservative): Interest on EE bonds is tied to yield on 5-year Treasury bonds and is adjusted every six months; bonds are available for $24 and up; there are no fees or commissions on purchase or redemption; and income is exempt from all state and local taxes. Federal income tax can be deferred until bonds are redeemed.
Certificates of deposit (conservative): Guaranteed rate of return; there are penalties for early withdrawal; and income earned from CDs purchased in your name is taxed as ordinary income. FDIC insured up to $100,000 per account per institution.
Corporate and municipal bonds (conservative/moderate): Fixed-income investments pay a predetermined interest periodically; your principal is returned at maturity; bond prices are influenced by market conditions.
Zero coupon bonds (conservative to aggressive): Purchased at a discount from face value; does not pay periodic interest; yield is compounded for payout at maturity; bondholders are taxed annually as if interest were received.
Stripped municipal securities (moderate/aggressive): Municipal bonds are sold in two parts: the interest portion is for investors seeking current income and principal portion for those seeking lump-sum and potential for capital gains at maturity; gains are usually tax-exempt.
Mutual funds (conservative to aggressive): Broad spectrum of choices ranging from money market funds (conservative) to balanced funds (moderate) to growth stock funds (aggressive); mutual fund owners enjoy professional management of their money and liquidity; capital gains taxes may apply every year; some funds may distribute taxable dividends.
Common stock (moderate/aggressive): Potential for capital appreciation and dividend yield; sales commission charged for purchase.
The longer you have until funds will be needed, the more aggressive you may invest. As college draws closer, your portfolio should reflect less risk and volatility. To review all these options and decide which are best for your situation, please feel free to contact me.
Additional Sources of Financial Aid for College
Even if you haven't been able to save all the money you need for college, several alternatives exist to help you make up the difference.
Financial assistance comes in many shapes and sizes - from scholarships and grants, which do not need to be repaid, to federal loans, which carry very favorable interest rates and terms, but must be repaid eventually. The following are a few of the most popular sources of financial assistance:
Calculating Financial Aid Usually due before January 1, the standard federal Free Application for Federal Student Aid (FAFSA) determines how much, if any, financial assistance the government will award to your child. Both private and public schools use this standard form to dole out their own scholarship monies as well. Additionally, some schools now require the Financial Aid Profile for assessing the need for non-government dollars.
Working with a number of factors, a school will determine each family's need for financial aid. From there, financial aid officers will attempt to craft a package, often combining both grants, which don't have to be paid back, and loans, which must be repaid later, usually with accrued interest. Clearly, the better deal is the free money. Often the earlier one applies, the more of their funds will come from the "grant" side of the ledger.
Government Loans: Stafford: With a Stafford loan, the US Government either provides the funds for the loan, or guarantees the funds loaned by other institutions. The loans are available regardless of family income, but for families with incomes under $70,000, no interest accrues and no payments are required until the student leaves school.
Government Loans: PLUS: The Parent Loan for Undergraduate Students (PLUS) loans are federally funded and guaranteed loans issued through local banks, credit unions and savings & loan institutions. The maximum loan amount is defined as the total cost of college, minus the amount of financial aid received. Repayment of principal and interest begins immediately with interest capped at 9%. Loan insurance is required to qualify for a PLUS loan.
Work/Study Grants: Many colleges and universities offer work/study grants. Sometimes their earnings are deducted from tuition and other times the student earns a salary.
Americorps: This network of national service programs engages more than 50,000 Americans each year in intensive service to meet critical needs in education, public safety, health, and the environment. It is open to U.S. citizens, nationals, or lawful permanent residents aged 17 or older. Members serve full or part time over a 10- to 12-month period.
After successfully completing a term of service, AmeriCorps members who are enrolled in the National Service Trust are eligible to receive an education award. The education award can be used to pay education costs at qualified institutions of higher education or training, or to repay qualified student loans. The award currently is $4,725 for a year of full-time service, with correspondingly lesser awards for part-time and reduced part-time service. A member has up to seven years after his or her term of service has ended to claim the award.
The GI Bill: Veterans, active duty personnel, and their families are eligible for a wide variety of benefits and loan repayment programs under the GI Bill, U.S. Army college fund, and VA educational services.
These are just some of the many ways to defray the rising costs of college. Contact us for more information on how to make higher education a reality for your children or grandchildren - or perhaps even yourself!
Finding Scholarship Opportunities
The vast majority of the nation's institutions of higher learning offer various types of scholarship, granting money to college students based on a host of criteria such as academic merit, financial need, and in some cases, racial or ethnic background.
Although the application process can be complicated and redundant between scholarships, a great deal of money is available for those who are willing to jump through the right hoops and prove their merit and/or need.
Finding Out About Available Scholarships Your child's high school guidance counselor should have a great deal of information on local scholarships. From there, you can consult the college's financial aid office. Many corporations offer college tuition aid or reimbursement to their employees and some offer scholarships to their employees' children. In addition, many religious organizations offer scholarships.
Review college financial aid books at your library. Some of them have extensive listings of sources that you can't find elsewhere. Contact both the U.S. Department of Education and your state department of education.
Many books have been written on the application and qualification process, which can help guide you through the process, which you can also access at your local library or bookstore. Finally, search the Internet for the numerous websites offering college savings calculators and information on financial aid. Start with the website of the college or university you want to attend, as well as local and national banks offering loan programs. The College Board (www.collegeboard.com) is another valuable source of comprehensive information.
Helpful Tips You can significantly reduce the cost of your college experience using some of these helpful tips:
Plan to spend your first two years at a community college.
Live at home and commute, if possible.
Work part-time, particularly in your desired field of future employment.
Join AmeriCorps and earn education awards in return for national service.
Join the Reserve Officers Training Forces (ROTC); it will pay for tuition, fees, and books and also provides a monthly allowance. You'll have to serve four years as an officer in the military after graduation.
Work full-time at a company that offers tuition reimbursement.
Take advanced placement courses in high school; convert them into college course credits by scoring sufficiently well on advanced placement exams.
Funding college isn't easy, but the rewards are clear. Let us help you design a plan to fund the rising costs of higher education.
529 Plans and Financial Aid Eligibility
If you're thinking about joining a 529 plan, or if you've already opened an account, you might be concerned about how 529 funds will affect your child's chances of receiving financial aid. Of all the areas related to 529 plans, financial aid is perhaps the most uncertain, and the one most likely to change in the future. But here's where things stand now.
First, why should you be concerned? The financial aid process is all about assessing what a family can afford to pay for college and trying to fill the gap. To do this, the institutions that offer financial aid examine a family's income and assets to determine how much a family should be expected to contribute before receiving financial aid. Financial aid formulas weigh assets differently, depending on whether they are owned by the parent or the child. So, it's important to know how your college savings plan account or your prepaid tuition plan account will be classified, because this will affect the amount of your child's financial aid award.
A general word about financial aid: Financial aid is money given to a student to help that student pay for college or graduate school. This money can consist of one or more of the following:
·A loan (which must be repaid in the future) ·A grant (which doesn't need to be repaid) ·A scholarship ·A work-study job (where the student gets a part-time job either on campus or in the community and earns money for tuition)
The typical financial aid package contains all of these types of aid. Obviously, grants are more favorable than loans because they don't need to be repaid. However, over the past few decades, the percentage of loans in the average aid package has been steadily increasing, while the percentage of grants has been steadily decreasing. This trend puts into perspective what qualifying for more financial aid can mean. There are no guarantees that a larger financial aid award will consist of favorable grants and scholarships--your child may simply get (and have to pay back) more loans.
The two main sources of financial aid are the federal government and colleges. In determining a student's financial need, the federal government uses a formula known as the federal methodology, while colleges use a formula known as the institutional methodology. The treatment of your 529 plan may differ, depending on the formula used.
How is your child's financial need determined? Though the federal government and colleges use different formulas to assess financial need, the basic process is the same. You and your child fill out a financial aid application by listing your current assets and income (exactly what assets must be listed will depend on the formula used). The federal application is known as the FAFSA (Free Application for Federal Student Aid); colleges generally use an application known as the PROFILE.
Your family's asset and income information is run through a specific formula to determine your expected family contribution (EFC). The EFC represents the amount of money that your family is considered to have available to put toward college costs for that year. The federal government uses its EFC figure in distributing federal aid; a college uses its EFC figure in distributing its own private aid. The difference between your EFC and the cost of attendance (COA) at your child's college equals your child's financial need. The COA generally includes tuition, fees, room and board, books, supplies, transportation, and personal expenses. It's important to remember that the amount of your child's financial need will vary, depending on the cost of a particular school.
The results of your FAFSA are sent to every college that your child applies to. Every college that accepts a student will then attempt to craft a financial aid package to meet that student's financial need. In addition to the federal EFC figure, the college has its own EFC figure to work with. Eventually, the financial aid administrator will create an aid package made up of loans, grants, scholarships, and work-study jobs. Some of the aid will be from federal programs (e.g., Stafford Loan, Perkins Loan, Pell Grant), and the rest will be from the college's own endowment funds. Keep in mind that colleges aren't obligated to meet all of your child's financial need. If they don't, you're responsible for the shortfall.
The federal methodology and 529 plans Now let's see how a 529 account will affect federal financial aid. Under the federal methodology, 529 plans--both college savings plans and prepaid tuition plans--are considered an asset of the parent, if the parent is the account owner.
So, if you're the parent and the account owner of a 529 plan, you must list the value of the account as an asset on the FAFSA. Under the federal formula, a parent's assets are assessed (or counted) at a rate of no more than 5.6 percent. This means that every year, the federal government treats 5.6 percent of a parent's assets as available to help pay college costs. By contrast, student assets are currently assessed at a rate of 20 percent.
There are a few points to keep in mind regarding the classification of 529 plans as a parental asset:
·A parent is required to list a 529 plan as an asset only if he or she is the account owner of the plan. If a grandparent, other relative, or friend is the account owner, then the 529 plan doesn't need to be listed on the FAFSA. ·However, any student-owned or UTMA/UGMA-owned 529 account is reported as a parental asset if the student files the FAFSA as a dependent student. A 529 account is considered an UTMA/UGMA-owned account when UTMA/UGMA assets are transferred to a 529 account. ·If your adjusted gross income is less than $50,000 and you meet a few other requirements, the federal government doesn't count any of your assets in determining your EFC. So, your 529 plan wouldn't affect financial aid eligibility at all.
Distributions (withdrawals) from a 529 plan that are used to pay the beneficiary's qualified education expenses aren't classified as either parent or student income on the FAFSA.
The federal methodology and other college savings options How do other college savings options fare under the federal system? Coverdell education savings accounts, mutual funds, and U.S. savings bonds (e.g., Series EE and Series I) owned by a parent are considered parental assets and counted at a rate of 5.6 percent. However, UTMA/UGMA custodial accounts and trusts are considered student assets. Under the federal methodology, student assets are assessed at a rate of 20 percent in calculating the EFC.
Also, distributions (withdrawals) from a Coverdell ESA that are used to pay qualified education expenses are treated the same as distributions from a 529 plan--they aren't counted as either parent or student income on the FAFSA, so they don't reduce financial aid eligibility.
One final point to note is that the federal government excludes some assets entirely from consideration in the financial aid process. These assets include all retirement accounts (e.g., traditional IRAs, Roth IRAs, employer-sponsored retirement plans), cash value life insurance, home equity, and annuities.
The institutional methodology and 529 plans When distributing aid from their own endowment funds, colleges aren't required to use the federal methodology. As noted, most colleges use the PROFILE application (a few colleges use their own individual application). Generally speaking, the PROFILE digs a bit deeper into your family finances than the FAFSA.
Regarding 529 plans, the PROFILE treats both college savings plans and prepaid tuition plans as a parental asset. And once funds are withdrawn, colleges generally treat the entire amount (contributions plus earnings) from either type of plan as student income.
Note:Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about specific 529 plans is available in the issuer's official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.
529 Plans vs. Other College Savings Options
Section 529 plans can be a great way to save for college--in many cases, the best way--but they're not the only way. When you're investing for a major goal like education, it makes sense to be familiar with all of your options.
U.S. savings bonds U.S. savings bonds are backed by the full faith and credit of the federal government. They're very easy to purchase, and available in face values as low as $50 ($25 if purchased electronically). Two types of savings bonds, Series EE (which may also be called Patriot bonds) and Series I bonds, are popular college savings vehicles. Not only is the interest earned on them exempt from state and local tax at the time you redeem (cash in) the bonds, but you may be able to exclude at least some of the interest from federal income tax if you meet the following conditions:
·Your modified adjusted gross income (MAGI) must be below $86,100 if you're filing single and $136,650 if you're married filing jointly in 2011 ·The bond proceeds must be used to pay for qualified education expenses ·The bonds must have been issued in 1990 or later ·The bonds must be in the name of one or both parents, not in the child's name ·Married taxpayers must file a joint return ·The bonds must have been purchased by someone at least 24 years old ·The bonds must be redeemed in the same year that qualified education expenses are being paid
But a 529 plan, which includes both college savings plans and prepaid tuition plans, may be a more attractive way to save for college. A college savings plan invests primarily in stocks through one or more pre-established investment portfolios that you generally choose upon joining the plan. So, a college savings plan has a greater return potential than U.S. savings bonds, because stocks have historically averaged greater returns than bonds (though past performance is no guarantee of future results). However, there is a greater risk of loss of principal with a college savings plan. Your rate of return is not guaranteed--you could even lose some of your original contributions. By contrast, a prepaid tuition plan generally guarantees you an annual rate of return in the same range as U.S. savings bonds (or maybe higher, depending on the rate of college inflation).
Perhaps the best advantage of 529 plans is the federal income tax treatment of withdrawals used to pay qualified education expenses. These withdrawals are completely free from federal income tax no matter what your income, and some states also provide state income tax benefits. The income tax exclusion for Series EE and Series I savings bonds is gradually phased out for couples who file a joint return and have a MAGI between $106,650 and $136,650. The same happens for single taxpayers with a MAGI between $71,100 and $86,100. These income limits are for 2011 and are indexed for inflation.
However, keep in mind that if you don't use the money in your 529 account for qualified education expenses, you will owe a 10 percent federal penalty tax on the earnings portion of the funds you've withdrawn. And as the account owner, you may owe federal (and in some cases state) income taxes on the earnings portion of your withdrawal, as well. Plus, there are typically fees and expenses associated with 529 plans. College savings plans may charge an annual maintenance fee, an administrative fee, and an investment fee based on a percentage of total account assets, while prepaid tuition plans typically charge an enrollment fee and various administrative fees.
Mutual funds At one time, mutual funds were more widely used for college savings than 529 plans. Mutual funds do not impose any restrictions or penalties if you need to sell your shares before your child is ready for college. However, if you withdraw assets from a 529 plan and use the money for noneducational expenses, the earnings part of the withdrawal will be taxed and penalized. Also, mutual funds let you keep much more control over your investment decisions because you can choose from a wide range of funds, and you're typically free to move money among a company's funds, or from one family of funds to another, as you see fit.
By contrast, you can't choose your investments with a prepaid tuition plan, though you are generally guaranteed a certain rate of return or that a certain amount of tuition expenses will be covered in the future. And with a college savings plan, you may be able to choose your investment portfolio at the time you join the plan, but your ability to make subsequent investment changes is limited. Some plans may let you direct future contributions to a new investment portfolio, but it may be more difficult to redirect your existing contributions. However, states have the discretion to allow you to change the investment option for your existing contributions once per calendar year or when you change the beneficiary. Check the rules of your plan for more details.
In the area of taxes, 529 plans trump mutual funds. The federal income tax treatment of 529 plans is a real benefit. You don't pay federal income taxes each year on the earnings within the 529 plan. And any withdrawals that you use to pay qualified higher education expenses will not be taxed on your federal income tax return. (But if you withdraw money for noneducational expenses, you'll owe income taxes on the earnings portion of the withdrawal, as well as a 10 percent federal penalty)
Tax-sheltered growth and tax-free withdrawals can be compelling reasons to invest in a 529 plan. In many cases, these tax features will outweigh the benefits of mutual funds. This is especially true when you consider how far taxes can cut into your mutual fund returns. You'll pay income tax every year on the income earned by your fund, even if that income is reinvested. And when you sell your shares, you'll pay capital gains tax on any gain in the value of your fund.
Custodial accounts A custodial account holds assets in your child's name. A custodian (this can be you or someone else) manages the account and invests the money for your child until he or she is no longer a minor (18 or 21 in most states). At that point, the account terminates and your child has complete control over the funds. Many college-age children can handle this responsibility, but there's still a risk that your child might not use the money for college. But you don't have to worry about this with a 529 plan because you, as the account owner, decide when to withdraw the funds and for what purpose.
A custodial account is not a tax-deferred plan. The investment earnings on the account will be taxed to your child each year. Under special rules commonly referred to as the "kiddie tax" rules, children are generally taxed at their parent's (presumably higher) tax rate on any unearned income over a certain amount. For 2011, this amount is $1,900 (the first $950 is tax free and the next $950 is taxed at the child's rate). The kiddie tax rules apply to: (1) those under age 18, (2) those age 18 whose earned income doesn't exceed one-half of their support, and (3) those ages 19 to 23 who are full-time students and whose earned income doesn't exceed one-half of their support. The kiddie tax rules significantly reduce the tax savings potential of custodial accounts as a college savings strategy. Remember that earnings from a 529 plan will escape federal income tax altogether if used for qualified higher education expenses; the state where you live may also exempt the earnings from state tax.
But a custodial account might appeal to you for some of the same reasons as regular mutual funds. Though the funds must be used for your child's benefit, custodial accounts don't impose penalties or restrictions on using the funds for noneducational expenses. Also, your investment choices are virtually unlimited (e.g., stocks, mutual funds, real estate), allowing you to be as aggressive or conservative as you wish. As discussed, 529 plans don't offer this degree of flexibility.
Note: Custodial accounts are established under either the Uniform Transfers to Minors Act (UTMA) or the Uniform Gifts to Minors Act (UGMA). The two are similar in most ways, though an UTMA account can stay open longer and can hold certain assets that an UGMA account can't.
Finally, there is the issue of fees and expenses. Depending on the financial institution, you may not have to pay a fee to open or maintain a custodial account. But generally you can count on incurring at least some type of fee with a 529 plan. College savings plans may charge an annual maintenance fee, an administrative fee, and an investment fee based on a percentage of total account assets, while prepaid tuition plans typically charge an enrollment fee and various administrative fees.
Trusts Though trusts can be relatively expensive to establish, there are two types you may want to investigate further:
Irrevocable trusts: You can set up an irrevocable trust to hold assets for your child's future education. This type of trust lets you exercise control over the assets through the trust agreement. However, trusts can be costly and complicated to set up, and any income retained in the trust is taxed to the trust itself at a potentially high rate. Also, transferring assets to the trust may have negative gift tax consequences. A 529 plan avoids these drawbacks but still gives you some control.
2503 trusts: There are two types of trusts that can be established under Section 2503 of the Tax Code: the 2503c "minor's trust" and the 2503b "income trust." The specific features and tax consequences vary depending on the type of trust that is used, and the details are beyond the scope of this discussion. Suffice it to say that either type of trust is much more costly and complicated to establish and maintain than a 529 plan. In most cases, a 529 plan is a better way to save for college.
Borrowing Smart: The Basics
Many people instinctively believe that borrowing is inherently a bad thing. Used to excess, they're right. But how many of us have the money to buy a house - or even a new car - outright? Used judiciously, however, borrowing can provide powerful leverage that can improve your financial standing.
Take a $200,000 house. Assuming a downpayment of 20%, or $40,000, a $50,000 rise in the price of that home would mean the owner more than doubled his or her money! If the homeowner had paid with cash, the $50,000 increase would represent a return of just 25%, minus the opportunity cost missed by not investing the remaining $150,000. That's the power of leverage.
To help you "borrow smart," this article explains some of the basic terms and concepts behind lending.
Structuring the Terms of Your Loan Borrowing can be a smart investment in your financial future, especially if used for a house that will likely appreciate over time, improvements that raise the value of your home, or college costs that will eventually pay off in higher earnings potential. And sometimes borrowing is unavoidable, especially in cases of emergency.
Fortunately, today's financial institutions make a wide variety of loans readily available and relatively easy to obtain. However, loans are generally complex financial transactions. The more you know before going signing the loan contract, the better prepared you will be to choose the type of loan that best meets your needs.
How your loan is structured helps the lending institution determine how much risk they are assuming, and, in turn, what interest rate they will charge. There are three basic loan features that define your loan: whether the loan is paid back in installment payments or as a lump sum, whether the loan is secured or unsecured, and whether the interest rate on the debt is variable or fixed.
Installment Loans vs. Lump Sum Payment When you take out a loan, you promise to repay the loan, plus interest, based on a contractual agreement. When you choose an installment loan, you borrow a lump sum of money, and then pay back a fraction of what you borrowed at regular intervals over an extended period of time. This way, you pay back both the loan principal and interest gradually. If you prefer, you may choose to borrow a lump sum of money, then pay back the entire loan principal and all accrued interest in a single payment at some future date in a single, lump-sum payment.
Secured vs. Unsecured Loans When a lender analyzes the risk they associate with a debt, an important consideration is whether the loan is secured or unsecured. A secured loan is based on your ability to provide collateral of similar or greater value than the amount being loaned. Should you default, the bank can reclaim and sell the collateral to recoup most, if not all, of the amount loaned. A home loan is an excellent example of a secured loan - the bank will lend most of a home's purchase price, but retains a lien against the home for as long as the loan is outstanding.
In contrast, an unsecured loan is based solely on a promise of repayment. Because the lender holds no collateral, unsecured loans carry significantly more risk for the lender which, as a result, charges a higher interest rate on the borrowed funds.
Fixed vs. Variable Interest Rate The interest rate you pay on a loan is based on many factors, including your credit rating, your payment history, and whether your loan is based on a fixed or a variable interest rate. Fixed interest rate loans are just as the name implies - the interest rate does not change during the term of the loan. Because the lender cannot change the rate as market conditions change, a fixed-rate loan usually has a higher initial interest rate than a variable interest rate loan.
The rate on a variable interest rate loan, in contrast, generally starts slightly lower than the fixed rate, but it is "adjusted" from time to time to reflect current economic factors. If rates drop, the variable loan rate will typically drop. If rates rise, the variable loan rate will normally rise. Because of the initially lower interest rate, the monthly payment on a variable rate loan is lower than its fixed counterpart. This lower payment often allows you to qualify for a higher loan balance.
Required Lender Disclosures Lenders are required to tell you exactly what a loan will actually cost per year, expressed as an annual percentage rate (APR). Some lenders charge lower interest but add high fees; others do the reverse. The APR allows you to compare apples to apples by combining the fees with one year of interest charges to give you the true annual interest rate. If the lender quotes you a periodic interest rate, this won't be the true interest rate because it does not include the fees he may charge you.
Every lender is required to provide a total cost disclosure before a loan is made. It will tell you exactly what the loan will actually cost you in dollars and cents if you make all payments to the lender as you've agreed.
Smart borrowing can work in your favor - but only if you understanding how lending really works. Contact us for more information if you're considering a new loan or deciding how to proceed with an existing one.
Don't Get Caught in the "Credit Trap" - Use Credit Cards Wisely
First introduced to the public in 1959, and used sparingly for their first few decades, credit cards have become a fixture in our daily lives. From the convenience of not having to carry hard currency to the luxury of buying what we want, when we want it, credit cards promised a whole new world of freedom. The concept of credit wasn't new, but credit cards have made the process of getting - and using - credit to finance purchases simpler and easier for millions of everyday people.
Unfortunately, such freedom comes at a price. Americans now carry more than 225 million signature-based debit cards and have a whopping $800 billion in outstanding credit-card balances!1 If you're like most people, you probably have at least one credit card, if not a half dozen. And you probably carry a balance on at least one account, paying monthly interest as you go. If so, you may be shortchanging your financial future in exchange for a few consumer goods in the present.
How Revolving Debt Works If paid off monthly, credit cards are simply a convenient way to consolidate purchases into one billing entity, the company issuing the credit card, and making a single monthly payment. Although the company might charge a small annual fee, such use sidesteps any interest charges or card usage fees.
When credit cards are not paid off monthly, however, they become similar to loans from the bank in that they carry interest charges, minimum monthly payments, and a term for paying off the balance completely. Credit card companies frequently charge double-digit interest rates on outstanding balances. That's a steep price to pay for convenience and the ability to make impulse purchases!
Think ALL the Costs of Credit In selecting, or keeping, a credit card, make sure you know and understand all the costs, rates, and fees involved.
Annual fees - many credit cards charge an annual, fixed fee just for the privilege of having credit extended to you from the company sponsoring the card. Annual fees can often be avoided entirely by shopping for a credit card that guarantees no annual fee.
Finance charges - finance charges vary widely. If you plan to maintain an outstanding balance on your credit card, make sure to find the best interest rate on a card that meets your needs. Many cards offer you a low "teaser rate" for a specified period, then dramatically increase the rate you pay on outstanding balances. Some base your minimum monthly payment on a loan term that if the minimum payment is made consistently, could keep you in debt for 40 years or more.
Tax treatment of interest - unlike the interest paid on most home mortgages, second mortgages, and some home equity lines of credit, the interest paid on credit cards is not deductible from your taxable income.
Fortunately, there is a great deal of regulation of credit cards requiring full disclosure of all relevant credit terms being extended by the card issuer. Be careful to review all credit documentation thoroughly before selecting a credit card for regular use.
Another Alternative: Debit Cards One fast-growing alternative to credit cards is a "debit card." This type of card is not a credit card at all; instead, it simply gives you card-based access to your bank savings or checking account. A debit card gives you the convenience of not needing to carry cash, or even checks, but you must be mindful that when used your purchases are being deducted directly from your existing account - once the account is empty, the card has no purchasing power until you make another deposit!
How you use credit says a great deal about your style of money management. If you would like to learn ways to reduce your dependence on credit, pay down current debts, and save or invest that money instead, we'd be happy to show you how.
The Mysteries of Mortgages Unraveled
With home ownership in the United States now approaching 70% of all households, the chances are good that you've either taken out a mortgage in the past or have one now. However, many homebuyers don't take research and take out a mortgage as carefully as one might imagine given the amount of money borrowed and the huge difference even a few basis points (one one-hundredth of a percentage point) can make over lengthy loan.
Instead, homebuyers often search for the home they want, then apply for a mortgage and hope for the best. A far better approach is to find out how much mortgage you can qualify for, then look at homes you know are in your price range. Known as "prequalification," having this piece of paper in your hand can also set you apart as a serious, committed buyer in hot real estate markets where properties are fetching multiple offers.
You may be able to lock in a mortgage rate when you pre-qualify, so you know exactly how much you'll spend each month. If possible, ask the lender to agree, in writing, to lower your rate if rates go down before actual purchase of the home.
Finding Objective Mortgage Data and Information Numerous businesses and institutions provide impartial mortgage research to the public, usually at no charge.
HSH Associates tracks mortgage rates nationwide and will sell you a printout of lenders and rates in your area. You can call 800-873-2837 for more information, or visit their website at www.hsh.com.
Consumer Reports Home Price Service will give you information on property prices and sales figures in your area. Their telephone number is 800-775-1212.
Bank Rate provides information on the prevailing rates of different types of mortgages as well as a list of local lenders and their current rates. Their website is www.bankrate.com.
Alternative Sources of Mortgage Loans There are also several programs that offer help for those home-buyers whose income level is less than what is usually required to qualify for a mortgage. They include the following:
FNMA and Farmer's Home Administration. Their telephone number is 800-732-6643
U.S. Department of Housing and Urban Development (HUD).
Many states provide low interest and low down payment mortgages for first-time buyers if they meet state guidelines. Check the state government section of your telephone book for their number.
VA (Veteran's Administration) enables qualifying veterans to borrow with little or no down payment. Call the VA local number listed in your phone book for details.
FHA (Federal Housing Administration) mortgages let you borrow up to 95% of the price of a house if the price and closing costs are within their guidelines. Check with your lender or directly with FHA for more information.
Who Offers Mortgages? Practically all financial service companies, including many brokerage firms, have entered the mortgage market. This would include banks and credit unions, developers, mortgage brokers, and mortgage companies or mortgage bankers. Shop around and you'll likely be pleasantly surprised at the wide range of loan types and terms you'll be offered.
Understanding the Underwriting Process
Even though it's probably the largest purchase they'll ever make, few consumers take the time to really go "behind the scenes" to more fully understand the complex world of mortgage lending.
Qualifying For a Mortgage Whether you're looking for a first mortgage on a new home, refinancing an existing mortgage, or take out a second mortgage, the interest rate you'll be offered depends on the same factors:
Your total monthly household income compared to both the mortgage payment alone (known as the "front-end ratio") as well as all of your monthly obligations including the mortgage (total debt-to-income ratio);
The value of your property compared to the liabilities placed on it (otherwise known as the "loan to value," or LTV); and
Your credit report from the various credit reporting agencies such as Equifax and Fair Isaac (which compiles the well-known and commonly used "Fico score").
The "processing" of your loan is the preparation of all relative documents to verify, prove, and package together all information pertinent to these factors.
"A" vs. Sub-Prime First Mortgages There are strict requirements to qualify for so-called "Conforming A" loans, which generally offer the lowest rates and terms available. Those who do not meet these requirements have a great many options available to them in qualifying for "Non-Conforming A" mortgages or Sub-Prime mortgages, at rates somewhat higher than Conforming rates.
The best rates are usually available to low-risk borrowers - those who meet Conforming A loan standards. Generally speaking, requirements for Conforming A loans include credit scores in excess of 620 points, income ratios between 28% and 40%, and loan to value ratios below 95% on new home purchases and no-cash-out refinances and below 80% on cash-out refinances. A Conforming A loan must also be at or below a maximum amount specified by the two federally chartered repurchasers of home loans, Freddie Mac and Fannie Mae. For 2006, this limit is $417,000; loans above this amount are called "jumbo" mortgages and generally carry a slightly higher interest rate.
In the next tier are Non-Conforming A loans. These are borrowers with good credit and loan-to-value ratios, but whose income is either insufficient to accommodate a Conforming loan or is not easily verified. These loans are ideal for self-employed individuals or small-business owners whose income is variable or difficult to verify.
For those who have credit difficulties there are dozens of levels of credit rated from A- down to C-, known as Sub-Prime mortgages. Rates on Sub-Prime mortgages vary widely based on the borrower's individual credit scores, number of late payments in the last two years, loan to value ratio, and other key factors.
When Does A Second Mortgage Make Sense? A second mortgage is a loan made to you in exchange for a lien against your property. This lien is subordinate to the holder of your first mortgage - in the event of a default, the first lienholder must be repaid in full before subsequent lienholders are repaid. This makes the second mortgage a more risky investment for the lending institution, and this risk is typically reflected in a higher interest rate.
Second mortgages are not associated with the purchase of a new home, but rather are often taken out simultaneously with a refinanced first mortgage or independently of any other mortgages. The main reason for taking out a second mortgage is to take equity from your home and turn it into cash in pocket. This cash is often used to consolidate higher interest rate loans, pay late bills, pay taxes, purchase vehicles or rental property, fund college expenses, and other uses.
It usually does not make good financial sense to take out a second mortgage if you are having trouble servicing all of your current debts, or if the second mortgage pushes you above the 80% loan-to-value mark. Since interest on a second mortgage is generally tax deductible, a home equity loan or line of credit can be a cost-effective way to fund big-ticket items that would have to be purchased instead
Ins and Outs of Mortgage Insurance Mortgage insurance (MI) is a monthly payment added to your mortgage used to establish a pool of funds to indemnify lenders against default on first mortgages with "high" loan-to-value ratios. Generally speaking, any first mortgage with a loan-to-value ratio in excess of 80% requires mortgage insurance.
When refinancing a first mortgage the same 80% ratio applies, unless cash is being taken out as well - in such cases mortgage insurance is required for first mortgages with loan-to-value ratios in excess of 75%. The cost of mortgage insurance increases as loan-to-value increases, and the less equity you own in your home, the greater the mortgage insurance payment.
Before you make any decisions regarding your current mortgage, it's wise to review your current financial situation, goals, and time horizon. Understanding more about how mortgages work will help you make the best decision for your situation. As always, feel free to contact me if you would like assistance.
Life Without Debt - But How?
Many American families are finding themselves deeper and deeper in debt. Complicating matters even more, new legislation passed by Congress in 2005 will make it harder to declare bankruptcy, and saddle filers with a greater percentage of their debts to repay.
If you, too, find yourself in trouble financially, there are usually no easy answers - but there are some ways out for those willing to commit to changing their spending habits.
Your ability to pay your bills can be affected by situations beyond your control such as serious illness, divorce, or unemployment. Poor financial management can also threaten your economic security. You may be able to juggle your creditors for a time, but eventually you may come to realize you need help in resolving your financial problems.
Consumer Debt. The first step in regaining financial control is to limit, if not eliminate, the use of consumer debt. One popular radio talk show host suggested you cut up all your credit cards, or put them in a baggie, fill it with water, and freeze them. Continuing to charge will delay your eventual day of reckoning, but only exacerbates your overall financial hardships.
Whenever possible, it's best to pay your living expenses in cash, using credit as a convenience that you pay off in full at the end of each month. If you cannot pay your bills in cash, you need to seriously consider your standard of living and how you might be able to get by on less. Sit down and make a plan that's livable for you.
Credit Counseling Resources. The National Foundation for Consumer Credit (NFCC) is a non-profit organization with offices in all 50 states. The NFCC can help you arrange repayment plans that fit your income level and ability. They will study your debts, analyze your income and help you work out ways to overcome your financial problems. You can call 800-388-2227 for information about the closest member agency.
Consider a Consolidation Loan. If you have equity in your home, consider a home equity loan. This type of loan can consolidate all your consumer debt into a single payment, usually with a lower interest rate and often with income tax deductible interest. Be careful not to tap into your equity, only to run up consumer debt again, however.
Paying Down Debt Takes Time. If you create a strict plan for eliminating your consumer debts and stick with it, it could take as few as two and as many as five years to implement your plan. The first step in any debt reduction plan is a sincere commitment by the entire family to control spending and eliminate financial waste.
Bankruptcy - The Last Resort.Bankruptcy should be considered only as a solution of last resort. Bankruptcy carries numerous negative implications and should not be entered into lightly. It's always smart to consult an attorney before filing; in some cases it's required. You can usually retain your home, personal belongings and an automobile necessary for you to work. However, remember that bankruptcy does not change the habits that created the financial difficulties in the first place.
There is life after debt - but it takes constant financial discipline and a commitment to living within one's means to stay that way. For assistance in developing a financial plan that can leave you debt free and on the path to a more secure financial future, please contact us.
Is It Time to Review Your Estate Plan?
Estate planning is an ongoing process. You must not only develop and implement a plan that reflects your current financial and family situation; you must also constantly review your current plan to ensure it fits any changes in your circumstances.
Of course, with the extensive changes under The Economic Growth and Tax Relief Reconciliation Act of 2001 and the probability that more changes will occur in this decade, reviewing your estate plan regularly is now more critical than ever. You'll especially want to update it after any of the events listed in the Planning Tip.
Where Do You Go From Here? Remember, estate planning is about much more than reducing your estate taxes; it's about ensuring your family is provided for, your business can continue, and your charitable goals are achieved. So even if the estate tax is permanently repealed, you will want to have an up-to-date plan in place.
To this end, use the accompanying estate planning checklist to identify areas where you need more information or assistance. Or jot down a few notes about things you want to look at more closely and discuss with a professional advisor. It may be easy for you to put off developing a detailed estate plan - or updating it in light of changes in tax law or your situation. But if you delay, much of your estate could go to Uncle Sam - and this could be difficult for your family.
So please call me with any questions you may have about the strategies presented here or how they can help you minimize your estate tax liability. We welcome the opportunity to discuss your situation and show how we can help you create and help implement an estate plan that preserves for your heirs what it took you a lifetime to build.
Fundamental Questions about Estate Planning
Many people assume estate planning is all about reducing taxes. But it's also about making sure your assets are distributed according to your wishes both now and after you're gone. Here are three questions to consider before you begin your estate planning.
Who Should Inherit Your Assets? If you are married, you must consider marital rights before deciding who should inherit your assets. States have different laws designed to protect surviving spouses. If you die without a will or living trust, state law dictates how much passes to your spouse. Even with a will or living trust, if you provide less for your spouse than state law deems appropriate, the law will allow the survivor to receive the greater amount.
Once you've considered your spouse's rights, ask yourself these questions:
Should your children share equally in your estate?
Do you wish to include grandchildren or others as beneficiaries?
Would you like to leave any assets to charity?
Which Assets Should Your Survivors Inherit? You may want to consider special questions when transferring certain types of assets. For example:
If you own a business, should the stock pass only to your children who are active in the business?
Should you compensate the others with assets of comparable value?
If you own rental properties, should all beneficiaries inherit them?
Do they all have the ability to manage property?
What are each beneficiary's cash needs?
When and How Should They Inherit the Assets? To determine when and how your beneficiaries should inherit your assets, you need to focus on three factors:
The potential age and maturity of the beneficiaries,
The size of your estate versus your and your spouse's need for income during your lifetimes, and
The tax implications of your estate plan.
Outright bequests offer simplicity, flexibility and some tax advantages, but you have no control over what the recipient does with the assets once they are transferred. Trusts can be useful when the beneficiaries are young or immature, when your estate is large, and for tax planning reasons. They also can provide the professional asset management capabilities an individual beneficiary lacks.
Strategies for Special Situations
Standard estate planning strategies don't fit every situation. Single people, unmarried couples, noncitizen spouses, individuals planning a second marriage, and grandparents are among those who might benefit from less common techniques. In this section, we look at several special situations and estate planning ideas that may apply to them.
Singles - the potential repeal of the estate tax is especially helpful to this group because it eliminates the disadvantage of not having the unlimited marital deduction, which allows a spouse to leave assets to a surviving spouse's estate tax free. But a will or a living trust can ensure that your loved ones receive your legacy in the manner you desire. In addition, with the use of trusts, you can provide financial management assistance to your heirs who are not prepared for this responsibility.
Second Marriages - estate planning for the second marriage can be complicated, especially when children from a prior marriage are involved. Finding the right planning technique for your situation can not only ease family tensions but also help you pass more assets to the children at a lower tax cost.
A Qualified Terminal Interest Property (QTIP) marital trust can maximize estate tax deferral while benefiting the surviving spouse for his or her lifetime and the children after the spouse's death. Combining a QTIP with life insurance benefiting the children or creatively using joint gifts or GST tax exemptions can further leverage your gifting ability.
A prenuptial agreement can also help you achieve your estate planning goals. But any of these strategies must be tailored to your particular situation, and the help of qualified financial, tax and legal advisors is essential.
Unmarried Couples - because unmarried couples are not automatically granted rights by law, they need to create a legal relationship with a domestic partnership agreement. Such a contract can solidify the couple's handling of estate planning issues. In addition, without the benefit of the marital deduction, unmarried couples face a potentially overwhelming estate tax burden as long as the estate tax is in effect.
There are solutions, however. One partner can reduce his or her estate and ultimate tax burden through a traditional annual gifting program or by creating an irrevocable life insurance trust or a charitable remainder trust benefiting the other partner. Again, these strategies are complex and require the advice of financial, tax and legal professionals.
Noncitizen Spouses - the marital deduction differs for a surviving spouse who is a non-U.S. citizen. The government is concerned that on your death, your spouse could take the marital bequest tax-free and then leave U.S. jurisdiction without the property ever being taxed.
Thus, the marital deduction is allowed only if the assets are transferred to a qualified domestic trust (QDOT) that meets special requirements. The impact of the marital deduction is dramatically different because any principal distributions from a QDOT to the noncitizen spouse and assets remaining in the QDOT at his or her death will be taxed as if they were in the citizen spouse's estate. Also note that the gift tax marital deduction is limited to a set amount annually.
Estate Settlement Issues
You also should be aware of the other procedures involved in estate settlement. Here is a quick review of some of them. Your attorney, as well as the organizations mentioned, can provide more details.
Transferring Property When thinking about transferring your property, what probably first comes to mind are large assets, such as stock, real estate and business interests. But you also need to consider more basic assets, including:
Safe deposit box contents. In most states, the bank seals the box as soon as it learns of the death and opens it only in the presence of the estate's personal representative.
Savings bonds. The surviving spouse can immediately cash in jointly owned E bonds. To cash in H and E bonds registered in the deceased's name but payable on death to the surviving spouse, they must be sent to the Federal Reserve.
Receiving Benefits The surviving spouse or other beneficiaries may be eligible for any of the following:
Social Security benefits. For the surviving spouse to qualify, the deceased must have been age 60 or older or their children must be under age 16. Disabled spouses can usually collect at an earlier age. Surviving children can also get benefits.
Employee benefits. The deceased may have insurance, back pay, unused vacation pay, and pension funds to which the surviving spouse or beneficiaries are entitled. The employer will have the specifics.
Insurance they may not know about. Many organizations provide life insurance as part of the membership fee. They should be able to provide information.
Keep It All in the Family with FLPs
The Family Limited Partnership, or FLP - pronounced "flip" - is designed to reduce the value of your estate for estate tax purposes while allowing you to maintain full control of the investments and assets inside the partnership.
FLPs are established much like traditional limited partnerships. There are two parties involved: the general partners, who control the trust, and limited partners who have a share in the profits (but no control). The general partners (often, you and/or a spouse) design the partnership to give limited partnership shares to family members. General partners control the operations of the FLP and make day-to-day investment decisions. They can also receive a percentage of the FLP's income in the form of a management fee.
Limited partners (your heirs) have an ownership interest in the FLP, but they have very limited control. They share in the income generated by the FLP, depending on how many shares they own. When the FLP is dissolved, a proportionate amount of FLP property will pass to each limited partner.
Setting Up a FLP FLPs have come under increased IRS scrutiny in recent years, so you should work with a reputable estate planning attorney. With the attorney's assistance, you can place your assets within the FLP using your estate tax credit. For instance, a husband and wife can each transfer up to $2,000,000 ($4 million total) into the FLP and allocate those assets to the limited partnership side. They can then place a smaller amount (e.g. $12,000) in the FLP for the general partnership side. There are usually no taxes incurred when funding a FLP with your assets.
In the beginning, you and your spouse own both General Partner and Limited Partner shares. Over time, you gift to your heirs Limited Partner shares using your annual $12,000 gift exclusion. Don't worry about giving away too much of the shares. Based on current tax law, the General Partners may own as little as 1% of the FLP's assets and still retain control. That means you can still buy and sell assets, dispose of property, and declare any distributions of FLP shares.
Leverage Your Estate Tax Credit FLPs allow you to pass on more than the maximum $2 million (in 2006; $4 million per couple) Unified Estate Tax Credit. A gift of $2 million in limited partnership assets often may appraised at a substantially lower dollar amount. That's because there is no "market" for LP shares - they lack control and cannot be sold to others. This lower appraisal is called "discounting" the value of LP shares. Avoid discounting the shares too aggressively, however - the IRS could take exception and invalidate your FLP.
Protection Against Creditors Because of their lack of control, LP shares are most undesirable to creditors. Creditors will find it difficult to seize limited partner shares, since they are not publicly traded.
Creditors also don't want to pay tax on income they don't receive. If the partnership has earned income, but the general partner does not declare a distribution, each general and limited partner is required to report a proportionate share of the earned income on his or her personal tax return, without actually receiving any dollars with which to pay the tax.
Two More Advantages of FLPs FLPs are considered an "intangible asset" - most likely, only the state of your domicile will be able to impose any inheritance tax on Partnership units. This is ideal for real estate investors owners who own property in several states.
FLPs can provide additional retirement income - as mentioned previously, FLPs can provide general partners with management fees. This fee reflects the work you do as the general partner to maintain the FLP as a working business, and is considered earned income.
Family Limited Partnerships involve significant costs and risks involved, and are not ideal for highly appreciated assets. FLPs must also be drafted by an experienced estate planning attorney, and have a tangible business intent. For this reason, we strongly urge you to consult with a professional with specific expertise in this area.
Without a Will, There's No Way
A will is a legal document that transfers what you own to your beneficiaries upon your death. It also names an executor to carry out the terms of your will and a guardian for your minor children, if you have any.
Your signature and those of two witnesses make your will authentic. Witnesses don't have to know what the will says, but they must watch you sign it and you must watch them witness it.
Hand-written wills -- called holographs -- are legal in about half the states, but most wills are typed and follow a standard format.
Who Needs a Will? The short answer is everyone! However, it's imperative to make a will as soon as you have any real assets, or get married, and certainly by the time you have children.
What If You Don't Have a Will? Without a will, you die intestate. The law of your state then determines what happens to your estate and your minor children. This process, called administration, is governed by the probate court and is notoriously slow, often expensive, and subject to some surprising state laws. It's estimated than more than two-thirds of Americans die intestate. Do you really want a court deciding vital family matters such as how to divide your estate and custody of your children?
What Should Your Will Include? Your will should contain several key points in order to be valid. The following list is a start; check with a local estate attorney for a more comprehensive list:
Your name and address.
A statement that you intend the document to serve as your will.
The names of the people and organizations -- your beneficiaries -- who will share in your estate.
The amounts of your estate to go to each beneficiary (usually in percentages rather than dollar amounts.)
An executor to oversee the disposition of your estate and trustee(s) to manage any trust(s) you establish.
Alternates to provide both executor responsibilities and trustee(s).
A guardian to take responsibility for your minor children and possibly a trustee to manage the children's assets in cooperation with the guardian.
Which assets should be used to pay estate taxes, probate fees and final expenses.
What Is A Living Will? A living will expresses your wishes about being kept alive if you're terminally ill or seriously injured.
What Is A Living Will?
In the aftermath of the tragic case involving Terri Schiavo, interest in living wills has increased markedly. A living will expresses your wishes about being kept alive if you're terminally ill or seriously injured.
Other famous Americans have used living wills to retain control over their final medical care through use of a living will and a health care power of attorney. During the final weeks of his life, former President Richard Nixon refused "heroic measures" and received only palliative (comfort-easing) care at his home. Similarly, former First Lady Jacqueline Kennedy Onassis refused life-prolonging medical intervention before her passing.
Perhaps you've reflected on your own wishes if you were to face a similar situation. Although no one likes to imagine the possibility of being in such a helpless state, the statistical possibility of such an event remains significant. This is why it's wise to ensure that your wishes will be respected if you become incapacitated.
Just as a will becomes the governing entity for your estate after you die, a living will can make your wishes clear and legally binding in the event of a devastating illness or injury. A living will is often referred to as a health care power of attorney. In it you state how you should be treated in the event of a terminal disease, severe illness, or tragic accident. By giving such directions when you are healthy, your relatives won't have to make difficult decisions on your behalf, and you'll receive the type of care you desire.
Issues you might want to consider addressing include:
Religious and faith issues
Hospital, nursing home, and hospice arrangements
To carry out your living will, you'll need a health care directive, a written statement that expresses how you wish to be treated in advance of any incapacity. Make sure you give precise, comprehensive directions.
You'll also need a health care proxy, designating a representative to make your health care decisions based on the guidelines you provide in the directive if you are incapacitated or unable to communicate your desires.
Wills: The Cornerstone of Your Estate Plan
If you care about what happens to your money, home, and other property after you die, you need to do some estate planning. There are many tools you can use to achieve your estate planning goals, but a will is probably the most vital. Even if you're young or your estate is modest, you should always have a legally valid and up-to-date will. This is especially important if you have minor children because, in many states, your will is the only legal way you can name a guardian for them. Although a will doesn't have to be drafted by an attorney to be valid, seeking an attorney's help can ensure that your will accomplishes what you intend.
Wills avoid intestacy Probably the greatest advantage of a will is that it allows you to avoid intestacy. That is, with a will you get to choose who will get your property, rather than leave it up to state law. State intestate succession laws, in effect, provide a will for you if you die without one. This "intestate's will" distributes your property, in general terms, to your closest blood relatives in proportions dictated by law. However, the state's distribution may not be what you would have wanted. Intestacy also has other disadvantages, which include the possibility that your estate will owe more taxes than it would if you had created a valid will.
Wills distribute property according to your wishes Wills allow you to leave bequests (gifts) to anyone you want. You can leave your property to a surviving spouse, a child, other relatives, friends, a trust, a charity, or anyone you choose. There are some limits, however, on how you can distribute property using a will. For instance, your spouse may have certain rights with respect to your property, regardless of the provisions of your will.
Gifts through your will take the form of specific bequests (e.g., an heirloom, jewelry, furniture, or cash), general bequests (e.g., a percentage of your property), or a residuary bequest of what's left after your other gifts.
Wills allow you to nominate a guardian for your minor children In many states, a will is your only means of stating who you want to act as legal guardian for your minor children if you die. You can name a personal guardian, who takes personal custody of the children, and a property guardian, who manages the children's assets. This can be the same person or different people. The probate court has final approval, but courts will usually approve your choice of guardian unless there are compelling reasons not to.
Wills allow you to nominate an executor A will allows you to designate a person as your executor to act as your legal representative after your death. An executor carries out many estate settlement tasks, including locating your will, collecting your assets, paying legitimate creditor claims, paying any taxes owed by your estate, and distributing any remaining assets to your beneficiaries. Like naming a guardian, the probate court has final approval but will usually approve whomever you nominate.
Wills specify how to pay estate taxes and other expenses The way in which estate taxes and other expenses are divided among your heirs is generally determined by state law unless you direct otherwise in your will. To ensure that the specific bequests you make to your beneficiaries are not reduced by taxes and other expenses, you can provide in your will that these costs be paid from your residuary estate. Or, you can specify which assets should be used or sold to pay these costs.
Wills can create a testamentary trust You can create a trust in your will, known as a testamentary trust, that comes into being when your will is probated. Your will sets out the terms of the trust, such as who the trustee is, who the beneficiaries are, how the trust is funded, how the distributions should be made, and when the trust terminates. This can be especially important if you have a spouse or minor children who are unable to manage assets or property themselves.
Wills can fund a living trust A living trust is a trust that you create during your lifetime. If you have a living trust, your will can transfer any assets that were not transferred to the trust while you were alive. This is known as a pourover will because the will "pours over" your estate to your living trust.
Wills can help minimize taxes Your will gives you the chance to minimize taxes and other costs. For instance, if you draft a will that leaves your entire estate to your U.S. citizen spouse, none of your property will be taxable when you die (if your spouse survives you) because it is fully deductible under the unlimited marital deduction. However, if your estate is distributed according to intestacy rules, a portion of the property may be subject to estate taxes if it is distributed to heirs other than your U.S. citizen spouse.
Assets disposed of through a will are subject to probate Probate is the court-supervised process of administering and proving a will. Probate can be expensive and time consuming, and probate records are available to the public. Several factors can affect the length of probate, including the size and complexity of the estate, challenges to the will or its provisions, creditor claims against the estate, state probate laws, the state court system, and tax issues. Owning property in more than one state can result in multiple probate proceedings. This is known as ancillary probate. Generally, real estate is probated in the state in which it is located, and personal property is probated in the state in which you are domiciled (i.e., reside) at the time of your death.
Will provisions can be challenged in court Although it doesn't happen often, the validity of your will can be challenged, usually by an unhappy beneficiary or a disinherited heir. Some common claims include:
·You lacked testamentary capacity when you signed the will ·You were unduly influenced by another individual when you drew up the will ·The will was forged or was otherwise improperly executed ·The will was revoked
Living Trusts: A Tool for the Living
One of the most popular estate planning instruments today is the revocable living trust.
Trusts are used to maintain control and disposition of assets after death, and some can be used to minimize the estate tax impact of property transfers.
The difference between a revocable and irrevocable trust is whether the trust creator can change or terminate the trust. In the revocable trust, the creator can change the terms and conditions of the trust, or even eliminate the trust altogether. An irrevocable trust, on the other hand, cannot be altered once established.
When used and implemented correctly, an irrevocable living trust offers many benefits.
Using a Living Trust for Financial Protection A revocable living trust provides financial protection in the event you are no longer able to manage your financial affairs yourself. You can be trustee while you are healthy, but if you have a stroke or become otherwise incapacitated, your successor trustee would manage your assets in the trust.
Using a Living Trust for Privacy Another benefit of revocable living trusts is continued privacy because the instrument will bypass probate. The trust can function like a will, dictating at what age children are to receive trust assets and the percentage shares of the distribution. The trust can be linked to a pour-over will, a short document that names the executor and that determines how taxes, creditors, and final expenses will be paid. The pour-over will directs the executor to gather all assets not included in the trust and pour them over into the trust. Once that happens, the trustee will follow the directions included in the trust. The pour-over will must be filed with the probate court, but because it doesn't say much, it doesn't reveal much.
Using a Living Trust to Reduce Probate Regarding probate, living trusts offer another useful feature -- if you own property in a state other than your state of residence, when you die, that property must go through what's known as an ancillary probate. Many people think it's worth setting up the trust just to avoid the out-of-state probate hassle, which necessitates hiring a lawyer in that other state.
Using a Living Trust as a Management Tool The living trust can be used as a tool to manage your property, and can be especially helpful if you become incapacitated because the successor trustee can manage your property, rather than a court-appointed trustee, which takes time. The benefit of having an immediate successor can be especially important if you own a business or other assets that need to be managed seamlessly.
Other Benefits of a Living Trust Finally, you can include provisions in the trust that preserve the use of your estate and use the gift tax exclusion to set up other trusts that will help reduce estate taxes.
Disadvantages of a Living Trust There are disadvantages to using a revocable living trust as well. You must re-title assets into the trust name, which entails a lot of paperwork. And although creditors only have a limited time after your death to make claims against your estate while it's being probated, there is no time limit within which creditors may go after assets in a living trust.
Conclusions If your goal in using a revocable living trust is only to avoid probate, there are easier ways to accomplish this task. However, the revocable living trust can provide a wide variety of estate planning benefits that are difficult to achieve with any other estate-planning tool.
Trusts can be extremely complex and generally require the aid of an experienced estate-planning attorney. Please contact us for more information on charitable trusts.
Selecting an Executor or Trustee
Whether you choose a will or a living trust, you also need to select someone to administer the disposition of your estate - an executor or personal representative and, if you have a living trust, a trustee. An individual (such as a family member, a friend or a professional advisor) or an institution (such as a bank or trust company) can serve in these capacities. Many people name an individual and an institution to leverage their collective expertise.
What does the executor or personal representative do? He or she serves after your death and has several major responsibilities, including:
Administering your estate and distributing the assets to your beneficiaries.
Making certain tax decisions.
Paying any estate debts or expenses.
Ensuring all life insurance and retirement plan benefits are received.
Filing the necessary tax returns and paying the appropriate federal and state taxes.
Whatever your choice, make sure the executor, personal representative or trustee is willing to serve, and consider paying a reasonable fee for the services. The job isn't easy, and not everyone will want or accept the responsibility. Designate an alternate in case your first choice is unable or unwilling to perform. Naming a spouse, child, or other relative to act as executor is common, and he or she certainly can hire any professional assistance that might be needed.
Finally, make sure the executor, personal representative, or trustee doesn't have a conflict of interest. For example, think twice about choosing an individual who owns part of your business, a second spouse or children from a prior marriage. A co-owner's personal goals regarding the business may differ from those of your family, and the desires of a stepparent and stepchildren may conflict.
Selecting a Guardian for Your Children If you have minor children, perhaps the most important element of your estate plan doesn't involve your assets. Rather, it involves your children's guardianship. Of course, the well being of your children is your priority, but there are some financial issues to consider:
Will the guardian be capable of managing your children's assets?
Will the guardian be financially strong? If not, consider compensation.
Will the guardian's home accommodate your children?
How will the guardian determine your children's living costs?
If you prefer, you can name separate guardians for your child and his or her assets. Taking the time to name a guardian or guardians now ensures your children will be cared for as you wish if you die while they are still minors.
The Role of Life Insurance in an Estate Plan
Life insurance can play an important role in your estate plan. It is often necessary to support your family after your death or to provide liquidity. Not only do you need to determine the type and amount of coverage you need, but also who should own insurance on your life to best meet your estate planning goals.
Avoid Liquidity Problems Estates are often cash poor, and your estate may be composed primarily of illiquid assets such as closely held business interests, real estate or collectibles. If your heirs need cash to pay estate taxes or to support themselves, these assets can be hard to sell. For that matter, you may not want these assets sold. Insurance can be the best solution for liquidity problems.
Even if your estate is of substantial value, you may want to purchase insurance simply to avoid the unnecessary sale of assets to pay expenses or taxes. Sometimes second-to-die insurance makes the most sense. Of course, your situation is unique, so please get professional advice before purchasing life insurance.
Choose the Best Owner If you own life insurance policies at your death and you die while the estate tax is in effect, the proceeds will be included in your taxable estate. Ownership is usually determined by several factors, including who has the right to name the beneficiaries of the proceeds. The way around this problem? Don't own the policies when you die. But don't automatically rule out your ownership either.
Determining who should own insurance on your life is a complex task because there are many possible owners: you or your spouse, your children, your business, an irrevocable life insurance trust (ILIT), a family limited partnership (FLP) or limited liability company (LLC). Generally, to reap maximum tax benefits, you must sacrifice some control and flexibility as well as some ease and cost of administration.
To choose the best owner, you must consider why you want the insurance: to replace income, to provide liquidity, or to transfer wealth to your heirs. You must also determine the importance to you of tax implications, control, flexibility, and ease and cost of administration. Let's take a closer look at each type of owner:
You or your spouse. Ownership by you or your spouse generally works best when your combined assets, including insurance, do not place either of your estates into a taxable situation. There are several non-tax benefits to your ownership, primarily relating to flexibility and control. The biggest drawback to ownership by you or your spouse is that on the death of the surviving spouse (assuming the proceeds were initially paid to the spouse), the insurance proceeds could be subject to federal estate taxes, depending on when the surviving spouse dies.
Your children. Ownership by your children works best when your primary goal is to pass wealth to them. On the plus side, proceeds are not subject to estate tax on your or your spouse's death, and your children receive all of the proceeds tax free. There also are disadvantages. The policy proceeds are paid to your children outright. This may not be in accordance with your general estate plan objectives and may be especially problematic if a child is not financially responsible or has creditor problems.
Your business. Company ownership or sponsorship of insurance on your life can work well when you have cash flow concerns related to paying premiums. Company sponsorship can allow premiums to be paid in part or in whole by the company under a split-dollar arrangement. But if you are the controlling shareholder of the company and the proceeds are payable to a beneficiary other than the company, the proceeds could be included in your estate for estate tax purposes.
An ILIT. A properly structured ILIT could save you estate taxes on any insurance proceeds. Thus, a $2 million life insurance policy owned by an ILIT could reduce your estate taxes by hundreds of thousands of dollars in 2006. How does this work? The trust owns the policies and pays the premiums. When you die, the proceeds pass into the trust and are not included in your estate. The trust can be structured to provide benefits to your surviving spouse and/or other beneficiaries. ILITs have some inherent disadvantages as well, foremost among them that you lose control over the insurance policy after the ILIT has been set up.
Planning Tip: CONSIDER SECOND-TO-DIE LIFE INSURANCE Second-to-die life insurance can be a useful tool for providing liquidity to pay estate taxes. This type of policy pays off when the surviving spouse dies. Because a properly structured estate plan can defer all estate taxes on the first spouse's death, some families find they don't need any life insurance then. But significant estate taxes may be due on the second spouse's death, and a second-to-die policy can be the perfect vehicle for offsetting the taxes. It also has other advantages over insurance on a single life. First, premiums and estate administrative costs are lower. Second, uninsurable parties can be covered. But a second-to-die policy might not fit in your current irrevocable life insurance trust (ILIT), which is probably designed for a single life policy. Make sure the proceeds are not taxed in either your estate or your spouse's by setting up a new ILIT as policy owner and beneficiary.
Asset Protection in Estate Planning
You're beginning to accumulate substantial wealth, but you worry about protecting it from future potential creditors. Whether your concern is for your personal assets or your business, various tools exist to keep your property safe from tax collectors, accident victims, health-care providers, credit card issuers, business creditors, and creditors of others.
To insulate your property from such claims, you'll have to evaluate each tool in terms of your own situation. You may decide that insurance and a Declaration of Homestead may be sufficient protection for your home because your exposure to a claim is low. For high exposure, you may want to create a business entity or an offshore trust to shield your assets. Remember, no asset protection tool is guaranteed to work, and you may have to adjust your asset protection strategies as your situation or the laws change.
Liability insurance is your first and best line of defense Liability insurance is at the top of any plan for asset protection. You should consider purchasing or increasing umbrella coverage on your homeowners policy. For business-related liability, purchase or increase your liability coverage under your business insurance policy. Generally, the cost of the premiums for this type of coverage is minimal compared to what you might be required to pay under a court judgment should you ever be sued.
A Declaration of Homestead protects the family residence Your primary residence may be your most significant asset. State law determines the creditor and judgment protection afforded a residence by way of a Declaration of Homestead, which varies greatly from state to state. For example, a state may provide a complete exemption for a residence (i.e., its entire value), a limited exemption (e.g., up to $100,000), or an exemption under certain circumstances (e.g., a judgment for medical bills). A Declaration of Homestead is easy to file. You pay a small fee, fill out a simple form, and file it at the registry where your deed is recorded.
Dividing assets between spouses can limit exposure to potential liability Perhaps you work in an occupation or business that exposes you to greater potential liability than your spouse's job does. If so, it may be a good idea to divide assets between you so that you keep only the income and assets from your job, while your spouse takes sole ownership of your investments and other valuable assets. Generally, your creditors can reach only those assets that are in your name.
Business entities can provide two types of protection--shielding your personal assets from your business creditors and shielding business assets from your personal creditors
Consider using a corporation, limited partnership, or limited liability company (LLC) to operate the business. Such business entities shield the personal assets of the shareholders, limited partners, or LLC members from liabilities that arise from the business. The liability of these owners will be limited to the assets of the business.
Conversely, corporations, limited partnerships, and LLCs provide some protection from the personal creditors of a shareholder, limited partner, or member. In a corporation, a creditor of an individual owner is able to place a lien on, and eventually acquire, the shares of the debtor/shareholder, but would not have any rights greater than the rights conferred by the shares. In limited partnerships or LLCs, under most state laws, a creditor of a partner or member is entitled to obtain only a charging order with respect to the partner or member's interest. The charging order gives the creditor the right to receive any distributions with respect to the interest. In all respects, the creditor is treated as a mere assignee and is not entitled to exercise any voting rights or other rights that the partner or member possessed.
Certain trusts can preserve trust assets from claims People have used trusts to protect their assets for generations. The key to using a trust as an asset protection tool is that the trust must be irrevocable and become the owner of your property. Once given away, these assets are no longer yours and are not available to satisfy claims against you. To properly establish an asset protection trust, you must not keep any interest in the trust assets or control over the trust.
Trusts can also protect trust assets from potential creditors of the beneficiaries of the trust. The extent to which a beneficiary's creditors can reach trust property depends on how much access the beneficiary has to the trust property. The more access the beneficiary has to the trust property, the more access the beneficiary's creditors will have. Thus, the terms of the trust are critical.
There are many types of asset protection trusts, each having its own benefits and drawbacks. These trusts include:
Since certain claims can pierce domestic protective trusts (e.g., claims by a spouse or child for support and state or federal claims), you can bolster your protection by placing the trust in a foreign jurisdiction. Offshore or foreign trusts are established under, or made subject to, the laws of another country (e.g., the Bahamas, the Cayman Islands, Bermuda, Belize, Jersey, Liechtenstein, and the Cook Islands) that does not generally honor judgments made in the United States.
A word about fraudulent transfers: The court will ignore transfers to an asset protection trust if:
·A creditor's claim arose before you made the transfer ·You made the transfer with the intent to defraud a creditor ·You incurred debts without a reasonable expectation of paying them
Determining the Tax
The next step is to understand some estate tax basics. First, you need to get an idea of what your estate is worth and whether you need to worry about estate taxes, both under today's rates and as exemptions increase under the Economic Growth and Tax Relief Reconciliation Act of 2001.
How Much Is Your Estate Worth? The first step is to add up all of your assets and include cash, stocks and bonds, notes and mortgages, annuities, retirement benefits, your personal residence, other real estate, partnership interests, automobiles, artwork, jewelry, and collectibles. If you are married, also include your spouse's assets. If you own an insurance policy at the time of your death, the proceeds on that policy usually will be includable in your estate. Remember: That's proceeds. Your $1 million term insurance policy that isn't worth much while you're alive is suddenly worth $1 million on your death. If your estate is large enough, a significant share of those proceeds may go to the government as taxes, not to your chosen beneficiaries, though the estate tax impact will decrease gradually under EGTRRA.
How the Estate Tax System Works Here's a simplified way to compute your estate tax exposure. Take the value of your estate, net of any debts. Also subtract any assets that will pass to charity on your death -- such transfers are deductions for your estate. Then if you are married and your spouse is a U.S. citizen, subtract any assets you will pass to him or her. Those assets qualify for the marital deduction and avoid estate taxes until the surviving spouse dies. The net number represents your taxable estate.
You can pass up to the exemption amount during your life or at death free of gift and estate taxes.
If your taxable estate is equal to or less than the exemption and you haven't already used any of the exemption on lifetime gifts, no federal estate tax will be due when you die. But if your estate exceeds this amount, it will be subject to estate tax.
Tips for Reducing Estate Taxes
Here's a look at some of the most important estate planning tools and how you can use them to minimize taxes and maximize your estate's value as the tax rules change over the decade. You'll learn how these estate planning techniques can help you achieve specific financial goals. You will also see why it will be helpful to seek professional financial, tax and legal advice about ways to use these techniques effectively. Please let us know if you have any questions about how they might apply to your situation.
The Marital Deduction The marital deduction is one of the most powerful estate planning tools available to you. Any assets passing to a surviving spouse pass tax-free at the time the first spouse dies, as long as the surviving spouse is a U.S. citizen. Therefore, if you and your spouse are willing to pass all your assets to the survivor, no federal estate tax will be due on the first spouse's death - even before the estate tax is scheduled to be repealed completely in 2010.
This doesn't solve your estate tax problem, however. First, if the surviving spouse does not remarry, that spouse will not be able to take advantage of the marital deduction when he or she dies. Thus, the assets transferred from the first spouse could be subject to tax in the survivor's estate, depending on when the surviving spouse dies. Second, from a personal perspective, you may not want your spouse to pass all assets to a second spouse even if it would save estate taxes.
How to Preserve Both Exemptions Since assets in an estate equal to the exemption amount are exempt from estate taxes, a married couple can use their exemptions to avoid tax on up to double the exemption amount. And this amount will gradually increase until it reaches $7 million in 2009 -- the year before the estate tax repeal. An effective way to maximize the advantages of the exemption is to use a credit shelter trust, sometimes referred to as a bypass trust.
Let's look at an example: Mr. and Mrs. Jones have a combined estate of $4 million. At Mr. Jones' death in 2006, all of his assets pass to Mrs. Jones tax-free because of the marital deduction. Mr. Jones' taxable estate is zero. Shortly thereafter, and still in 2006, Mrs. Jones dies, leaving a $4 million estate. The first $2 million is exempt from estate tax (in 2006), but the remaining $2 million is subject to taxation, leaving the Jones' survivors with far less.
The problem? Mr. and Mrs. Jones took advantage of the exemption in only one estate.
Let's look at an alternative: Mr. Jones' will provides that assets equal to the exemption go into a separate trust on his death. This "credit shelter trust" provides income to Mrs. Jones during her lifetime. She also can receive principal payments if she needs them to maintain her lifestyle. Because of the trust language, Mr. Jones may allocate his $1.5 million exemption amount to the trust to protect it from estate taxes. If there were remaining assets (assets over $2 million), they would pass directly to Mrs. Jones.
Because the $2 million trust is not included in Mrs. Jones' estate, her estate drops from $4 million to $2 million. Thus, no tax is due on her estate because it does not exceed the exemption amount. By using the credit shelter trust in Mr. Jones' estate, the Joneses save hundreds of thousands of dollars in federal estate taxes.
The Joneses do give up something for this tax advantage. Mrs. Jones doesn't have unlimited access to the funds in the credit shelter trust because if she did, the trust would be includable in her estate. Still, Mr. Jones can give her all of the trust income and any principal she needs to maintain her lifestyle. However, the outcome would be quite different if both spouses didn't hold enough assets in their own names.
Control Assets with a QTIP Trust A common estate planning concern is that assets left to a spouse will eventually be distributed in a manner against the original owner's wishes. For instance, you may want stock in your business to pass only to the child active in the business, but your spouse may feel it should be distributed to all the children. Or you may want to ensure that after your spouse's death the assets will go to your children from a prior marriage.
You can avoid such concerns by structuring your estate plan so your assets pass into a qualified terminable interest property (QTIP) trust. The QTIP trust allows you to provide your surviving spouse with income from the trust for the remainder of his or her lifetime. You also can provide your spouse with as little or as much access to the trust's principal as you choose. On your spouse's death, the remaining QTIP trust assets pass as the trust indicates.
Thus, you can provide support for your spouse during his or her lifetime but retain control of the estate after your spouse's death. Because of the marital deduction, no estate taxes are paid on your death. But if your spouse dies while the estate tax is in effect, the entire value of the QTIP trust will be subject to estate tax
Of course, as with all estate planning strategies, these trusts are complex. Consider enlisting the advice of a qualified estate planning professional before proceeding further.
How the Generation-Skipping Tax Works
Perhaps you're one of the lucky people who are not only financially well off yourself, but whose children are also financially set for life. The down side of this is that they also face the prospect of high taxes on their estates. You may also want to ensure that future generations of your heirs benefit from your prosperity. To reduce taxes and maximize your gifting abilities, consider skipping a generation with some of your bequests and gifts.
But your use of this strategy is limited. The law assesses a generation-skipping transfer (GST) tax equal to the top estate tax rate on transfers to a "skip person," over and above the gift or estate tax, though this tax is being repealed along with the estate tax. A skip person is anyone more than one generation below you, such as a grandchild or an unrelated person more than 37-1/2 years younger than you are.
Fortunately, there is a GST tax exemption. Beginning in 2004, this exemption was equal to the estate tax exemption for that calendar year. Each spouse has this exemption, so a married couple can use double the exemption. If you exceed the limit, an extra tax equal to the top estate tax rate is applied to the transfer -- over and above the normal gift or estate tax.
Outright gifts to skip persons that qualify for the annual exclusion are also exempt from GST tax. A gift or bequest to a grandchild whose parent has died before the transfer is not treated as a GST.
Taking advantage of the GST tax exemption can keep more of your assets in the family. By skipping your children, the family may save substantial estate taxes on assets up to double the exemption amount (if you are married), plus the future income and appreciation on the assets transferred. Even greater savings can accumulate if you use the exemption during your life in the form of gifts.
If maximizing tax savings is your goal, consider a "dynasty trust." The trust is an extension of this GST concept. But whereas the previous strategy would result in the assets being included in the grandchildren's taxable estates, the dynasty trust allows assets to skip several generations of taxation.
Simply put, you create the trust, either during your lifetime by making gifts, or at death in the form of bequests. The trust remains in existence from generation to generation. Because the heirs have restrictions on their access to the trust funds, the trust is sheltered from estate taxes. If any of the heirs have a real need for funds, however, the trust can make distributions to them.
Special Strategies for Family-Owned Businesses
Few people have more estate-planning issues to deal with than the family-business owner. The business may be the most valuable asset in the owner's estate. Yet, two out of three family-owned businesses don't survive the second generation. If you are a business owner, you should address the following concerns as you plan your estate:
Who will take over the business when you die? Owners often neglect to develop a management succession plan. It is vital to the survival of the business that a successor, whether within the family or out, be ready to take over the reins.
Who should inherit your business? Splitting this asset equally among your children may not be a good idea. For those active in the business, inheriting the stock may be critical to their future motivation. To those not involved in the business, the stock may not seem as valuable. Perhaps your entire family feels entitled to equal shares in the business. Resolve this issue now to avoid discord and possible disaster later.
How will the IRS value your company? Because family-owned businesses are not publicly traded, determining the exact value of the business is difficult without a professional valuation. The value placed on the business for estate tax purposes is often determined only after a long battle with the IRS. Plan ahead and ensure your estate has enough liquidity to pay estate taxes and support your heirs.
The law currently provides two types of tax relief for business owners:
1) Section 303 redemptions -- your company can buy back stock from your estate without the risk of the distribution being treated as a dividend for income tax purposes. Such a distribution must, in general, not exceed the estate taxes, funeral and administration expenses of the estate. One caveat: The value of your holdings must exceed 35% of the value of your adjusted gross estate. If the redemption qualifies under Section 303, this is an excellent way to pay estate taxes.
2) Estate tax deferral -- normally, your estate taxes are due within nine months of your death. But if closely held business interests exceed 35% of your adjusted gross estate, the estate may qualify for a deferral of tax payments. No payment other than interest is due until five years after the normal due date for taxes owed on the value of the business. The tax related to the closely held business interest then can be paid over 10 equal annual installments. Thus, a portion of your tax can be deferred for as long as 14 years from the original due date. Interest will be charged on the deferred payments.
Estate Planning and 529 Plans
When you contribute to a 529 plan, you'll not only help your child, grandchild, or other loved one pay for college, but you'll also remove money from your taxable estate. This will help you minimize your tax liability and preserve more of your estate for your loved ones after you die. So, if you're thinking about contributing money to a 529 plan, it pays to understand the gift and estate tax rules.
Overview of gift and estate tax rules If you give away money or property during your life, you may be subject to federal gift tax (and, in certain states, state gift tax). The money and property you own when you die may also be subject to federal estate tax and some form of state death tax.
Federal gift tax generally applies if you give someone more than the annual gift tax exclusion amount, currently $13,000, during the tax year. (There are several exceptions, though, including gifts you make to your spouse.) That means you can give up to $13,000 each year, to as many individuals as you like, gift tax free. In addition, you're allowed a gift tax credit, which effectively exempts from gift tax up to $5 million in gifts that you make during your lifetime which would otherwise be subject to tax.
When you die, your estate will be entitled to a tax credit for federal estate tax purposes. In 2011, the credit is effectively equal to a $5 million exemption. However, the estate tax credit will be reduced by the amount of any gift tax credit used during your lifetime. Because the credit works this way, it is often referred to as the "unified credit," but the amount effectively exempted from tax is more properly known as the "applicable exclusion amount."
Note: Since state tax treatment may differ from federal tax treatment, look to the laws of your state to find out how your state will treat a 529 plan gift.
Contributions to a 529 plan are treated as (federal) gifts to the beneficiary A contribution to a 529 plan is treated under the federal gift tax rules as a completed gift from the donor to the designated beneficiary of the account. Such contributions are considered present interest gifts (as opposed to future or conditional gifts) and qualify for the annual federal gift tax exclusion. This means that you can contribute up to $13,000 per year to the 529 account of any beneficiary without incurring federal gift tax.
So, if you contribute $15,000 to your daughter's 529 plan in a given year, for example, you'd ordinarily apply this gift against your $13,000 annual gift tax exclusion. This means that although you'd need to report the entire $15,000 gift on a federal gift tax return, you'd show that only $2,000 is taxable. Bear in mind, though, that you must use up your applicable exclusion amount of $5 million (in 2011) before you'd actually have to write a check for the gift tax.
Special rule if you contribute over $13,000 in a year Section 529 plans offer a special gifting feature. Specifically, you can make a lump-sum contribution to a 529 plan of up to $65,000, elect to spread the gift evenly over five years, and completely avoid federal gift tax, provided no other gifts are made to the same beneficiary during the five-year period. A married couple can gift up to $130,000.
For example, if you contribute $65,000 to your son's 529 account in one year and make the election, your contribution will be treated as if you'd made a $13,000 gift for each year of a five-year period. That way, your $65,000 gift would be nontaxable (assuming you didn't make any additional gifts to your son in any of those five years). A married couple can make a joint gift of up to $130,000.
If you contribute more than $65,000 ($130,000 for joint gifts) to a particular beneficiary's 529 plan in one year, the averaging election applies only to the first $65,000 ($130,000 for joint gifts); the remainder is treated as a gift in the year the contribution is made.
What about gifts from a grandparent? Grandparents need to keep the federal generation-skipping transfer tax (GSTT) in mind when contributing to a grandchild's 529 account. The GSTT is a tax on transfers made during your life and at your death to someone who is more than one generation below you, such as a grandchild. The GSTT is imposed in addition to (not instead of) federal gift and estate taxes. Like the basic exclusion amount, though, there is a GSTT exemption ($5 million for 2011). No GSTT will be due until you've used up your GSTT exemption, and no gift tax will be due until you've used up your basic exclusion amount.
If you contribute no more than $13,000 to your grandchild's 529 account during the tax year (and have made no other gifts to your grandchild that year), there will be no federal tax consequences--your gift qualifies for the annual federal gift tax exclusion, and it is also excluded for purposes of the GSTT.
If you contribute more than $13,000, you can elect to treat your contribution as if made evenly over a five-year period (as discussed previously). Only the portion that causes a federal gift tax will also result in a GSTT.
Note: Contributions to a 529 account may affect your eligibility for Medicaid. Contact an experienced elder law attorney for more information.
What if the owner of a 529 account dies? If the owner of a 529 account dies, the value of the 529 account will not usually be included in his or her estate. Instead, the value of the account will be included in the estate of the designated beneficiary of the 529 account.
There is an exception, though, if you made the five-year election (as described previously) and died before the five-year period ended. In this case, the portion of the contribution allocated to the years after your death would be included in your federal gross estate. For example, assume you made a $50,000 contribution to a college savings plan in Year 1 and elected to treat the gift as if made evenly over five years. You die in Year 2. Your Year 1 and Year 2 contributions of $10,000 each ($50,000 divided by 5 years) are not part of your federal gross estate. The remaining $30,000 would be included in your gross estate.
Some states have an estate tax like the federal estate tax; many states calculate estate taxes differently. Review the rules in your state so you know how your 529 account will be taxed at your death.
When the account owner dies, the terms of the 529 plan will control who becomes the new account owner. Some states permit the account owner to name a contingent account owner, who'd assume all rights if the original account owner dies. In other states, account ownership may pass to the designated beneficiary. Alternatively, the account may be considered part of the account owner's probate estate and may pass according to a will (or through the state's intestacy laws if there is no will).
What if the beneficiary of a 529 account dies? If the designated beneficiary of your 529 account dies, look to the rules of your plan for control issues. Generally, the account owner retains control of the account. The account owner may be able to name a new beneficiary or else make a withdrawal from the account. The earnings portion of the withdrawal would be taxable, but you won't be charged a penalty for terminating an account upon the death of your beneficiary.
Keep in mind that if the beneficiary dies with a 529 balance, the balance may be included in the beneficiary's taxable estate.
Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about specific 529 plans is available in the issuer's official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.
Gifting Strategies for Estate Planning
The federal government imposes a substantial tax on gifts of money or property that exceed certain levels. Without such a tax, someone with a sizable estate could give away a large portion of his or her property before death and escape death taxes altogether. For this reason, the gift tax acts more or less as a backstop to the estate tax. And yet, few people actually pay a gift tax during their lifetime. A gift program can substantially reduce overall transfer taxes; however, it requires good planning and a commitment to proceed with the gifts.
Advantages of Gift Giving You may have many reasons for making gifts -- for some gift giving has personal motives, for others, tax planning is what motivated them. Most often, you will want your gift-giving program to accomplish both personal and tax motives. A few reasons for considering a gift-giving plan include:
Assisting someone in immediate financial need
Providing financial security for the recipient
Giving the recipient experience in handling money
Seeing the recipient enjoy the property
Taking advantage of annual exclusion allowance
Paying gift tax now to reduce overall taxes later
Giving tax advantaged gifts to minors
Gift and Estate Taxes
If you give away money or property during your life, those transfers may be subject to federal gift tax and perhaps state gift tax. The money and property you own when you die (i.e., your estate) may also be subject to federal estate taxes and some form of state death tax. You should understand these taxes, especially since the passage of the Economic Growth and Tax Relief Reconciliation Act of 2001 (the 2001 Tax Act) and the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 Tax Act). The 2001 and 2010 Acts contain several changes that are complicated and uncertain, making estate planning all the more difficult.
Federal gift tax and federal estate tax--background Under pre-2001 Tax Act law, no gift tax or estate taxes were imposed on the first $675,000 of combined transfers (those made during life and those made at death). The tax rate tables were unified into one--that is, the same rates applied to gifts made and property owned by persons who died in 2001. Like income tax rates, gift and estate tax rates were graduated. Under this unified system, the recipient of a lifetime gift received a carryover basis in the property received, while the recipient of a bequest, or gift made at death, got a step-up in basis (usually fair market value on the date of death of the person who made the bequest or gift).
The 2001 Tax Act and the 2010 Tax Acts substantially changed this tax regime.
Federal gift tax The 2001 Tax Act increased the applicable exclusion amount for gift tax purposes to $1 million. The 2010 Act increased the applicable exclusion amount for gift tax purposes to $5 million in 2011 and 2012 (plus indexing in 2012). The top gift tax rate is 35 percent in 2010 to 2012 (the top marginal income tax rate in 2010 to 2012 under the 2001 Tax Act and the 2010 Tax Act). In 2013, the gift tax rates are scheduled to revert to pre-2001 Tax Act levels, with a top gift tax rate of 55 percent. In 2013, the applicable exclusion amount is scheduled to be $1 million. The carryover basis rules remain in effect.
However, many gifts can still be made tax free, including:
·Gifts to your U.S. citizen spouse (you may give up to $136,000 (in 2011, $134,000 in 2010) tax free to your noncitizen spouse) ·Gifts to qualified charities ·Gifts totaling up to $13,000 (this figure is indexed for inflation so it may change in future years) to any one person or entity during the tax year, or $26,000 if the gift is made by both you and your spouse (and you are both U.S. citizens) ·Amounts paid on behalf of any individual as tuition to an educational organization or to any person who provides medical care for an individual
A small number of states also impose their own gift tax.
Federal estate tax Under the 2010 Tax Act, the applicable exclusion amount is $5 million in 2011 and 2012 (plus indexing in 2012), and the top estate tax rate is 35 percent. In 2011 and 2012, the unused basic exclusion amount of a deceased spouse is portable and can be used by the surviving spouse. In 2013, the applicable exclusion amount is scheduled to be $1 million and the top estate tax rate is scheduled to be 55 percent.
Note: Under the 2001 Tax Act, the federal estate tax was scheduled for repeal for one year in 2010. The 2010 Act reinstated the tax in 2010 with an applicable exclusion amount of $5 million and a top tax rate of 35 percent. An estate of a decedent dying in 2010 can elect to have the estate tax not apply, but a modified carryover basis would then apply instead of the step-up in basis.
Federal generation-skipping transfer tax The federal generation-skipping transfer tax (GSTT) taxes transfers of property you make, either during life or at death, to someone who is two or more generations below you, such as a grandchild. The GSTT is imposed in addition to, not instead of, federal gift tax or federal estate tax. You need to be aware of the GSTT if you make cumulative generation-skipping transfers in excess of the GSTT exemption, $5 million in 2011 and 2012 (plus indexing in 2012), scheduled to be $1 million as indexed in 2013. A flat tax equal to the highest estate tax bracket in effect in the year you make the transfer (35 percent in 2011 and 2012, scheduled to be 55 percent in 2013) is imposed on every transfer you make after your exemption has been exhausted.
Note: Under the 2001 Act, the GSTT was scheduled for repeal for one year in 2010. The 2010 Tax Act reinstated the GSTT for 2010 with a GSTT exemption of $5 million, but applied a zero percent tax rate to GSTs in 2010. GSTT exemption should generally be allocated to generation-skipping trusts created in 2010 if the trust will have GSTs in years after 2010.
Note: The GSTT exemption is the same amount as the applicable exclusion amount for estate tax purposes in 2011 and 2012.
Some states also impose their own GSTT.
State death taxes The three types of state death taxes are estate tax, inheritance tax, and credit estate tax, which is also known as a sponge tax or pickup tax.
Charitable Remainder Trusts
A Charitable Remainder Trust normally is used as a strategy for converting highly appreciated assets into income producing assets, without income tax liability. The Charitable Remainder Trust is an irrevocable trust with both charitable and non-charitable beneficiaries.
The donor transfers highly appreciated assets into the trust and retains an income interest. Upon expiration of the income interest, the remainder in the trust passes to a qualified charity of the donor’s choice.
If properly structured, the CRT permits the donor to receive income, estate, and/or gift tax advantages. These advantages often provide for a much greater income stream to the income beneficiary than would be available outside the trust.
Unitrust vs. Annuity Trust
There are two types of CRT the Unitrust and the Annuity Trust. The main difference between the two is the way your annual income, paid to you by the trust, is calculated.
Under the provisions of a Unitrust, the annual payment to you must be a fixed percentage of the market value of a trust's assets as determined each year or, alternatively, the lesser of 5 percent of such value or the trust's income. You can see that there are no guarantees of the specific amount you will receive. Your payments will depend upon the changing values of the trust property or income from year to year.
Using an Annuity trust, the trust specifies an annual amount to be paid to you. This guarantees that you will receive a specific amount which you can depend upon every year.
Charitable Remainder Trust - Potential Benefits
Eliminate Capital Gains Tax
Tax deductible transfers to trust
Trust income can be significantly greater than income generated outside trust
You choose duration of income from trust
Increased retirement income
Eliminate estate tax on trust assets
Preserve estate for family & heirs through survivorship policy funded with added income
Provide charitable bequests to the causes of your choice
Those Who Would Benefit Most From a CRT May Have Some of the Following Characteristics
Own highly appreciated assets
Would like to reposition such assets
Are in a high income tax bracket
Are subject to estate tax at death
Have philanthropic desires
One key to reducing estate taxes is to limit the amount of appreciation in your estate. We talked earlier about giving away assets today so that the future appreciation on those assets will be outside of your taxable estate. There may be no better gift than your company stock - it could be the most rapidly appreciating asset you own.
For example, assume your business is worth $500,000 today, but is likely to be worth $1 million in three years. By giving away the stock today, you will keep the future appreciation of $500,000 out of your taxable estate.
A flexible strategy for the business owner was reinstated in late 1990 when Congress retroactively repealed the estate freeze provisions that became law in 1987. Before 1987, business owners commonly recapitalized their businesses, retained preferred stock interests and gave some or all of the common stock to their beneficiaries. This way, they retained control of their companies and froze the value of their stock for estate tax purposes. All future appreciation affected only the common shares, not the owners' preferred stock.
Congress saw the loophole and created Section 2036(c) in an attempt to prevent future estate freezes. The section had been under constant attack since its creation and was finally repealed retroactively in 1990. In its place, Congress passed legislation that once again permits estate freezes, but only if certain requirements are met.
Gifting family business stock can be a very effective estate tax saving strategy. Beware of some of the problems involved, however. The gift's value determines both the gift and estate tax ramifications. The IRS may challenge the value you place on the gift and try to increase it substantially. Seek professional assistance before attempting to transfer portions of your business to family members.
A recent law change requires the IRS to make any challenges to a gift tax return within the normal three-year statute of limitations, even though no tax is payable with the return.
Let's face it: Nothing in life ever goes exactly as planned. And that goes double for money matters. How many times has this happened to you? Just when you think you finally have some breathing room in your budget, an unexpected expense comes along and wipes it out.
One way to prepare for the unexpected is through budgeting. In technical terms, budgeting is the systematic allocation of one's limited resources (income and liquid assets) toward a potentially unlimited number of needs and wants (expenses). To put it simply, budgeting is merely balancing your outgo versus your income.
Unfortunately, the word "budget" -sort of like "diet" or "economize" -- has negative connotations. Although sometimes tedious and difficult to stick with, smart budgeting can help you better control how your income is being spent - leaving you with more money to invest or put away for those inevitable rainy days. A budget is a financial plan for spending; not a bookkeeping chore of keeping track of every penny.
The Budgeting Process Budgeting is essentially a management process that follows these steps:
1. Establishing your goals. 2. Estimating your monthly household income. 3. Estimating your monthly expenses. 4. Balancing the budget. 5. Putting your plan into action. 6. Adjusting the budget as necessary.
Step One: Establishing Your Goals First, review your family situation (marital status, dependents, family additions or departures). This review will set the table for establishing your short-, intermediate-, and long-term goals. Short-term goals may be purchasing a new car, taking a vacation or building a new home theater. Intermediate-term goals might include changing careers, sending a child or children to college, or saving for a house downpayment. Longer-range goals include accumulating a retirement portfolio, buying a vacation home, and leaving a financial legacy to your heirs. Each of these takes money - and planning, including budgeting.
Step Two: Estimate Your Income Whether your household income is regular, such as a paycheck every two weeks, or irregular, such as that received by a farmer or other person in business for him or herself, helps determine how a budget is established and followed. Whether expenses are regular or irregular also makes a difference in the budget.
Add together all your income sources including take-home pay, interest, dividends, bonuses, pensions, alimony and child support, etc. If you're self-employed, determine just how much you have available for living expenses by examining personal and family goals, business goals, and living and business expenses. If your income fluctuates, underestimate your income and overestimate expenses. Avoid relying heavily on bonuses or overtime pay.
Step Three: Estimate Your Expenses Your expenses will likely fall into four categories: 1) fixed expenses, such as rent or mortgage, car payment, utilities, telephone, cable, and the like; 2) periodic expenses such as annual homeowners insurance, car insurance and maintenance; 3) flexible expenses including food and clothing, entertainment, travel, and other leisure activities; and 4) emergency expenses such as car accidents, home repairs, medical expenses, and so on.
Are you planning a major change during the coming year such as a move, changing jobs, buying a house, getting married, having a child, entering the job market or buying a new roomful of furniture? Be sure to account for these changes, because every major life event affects your budget.
Step Four: Balance Your Budget Subtract fixed expenses, including an amount for investing and saving, from your expected income. Then, subtract the total amount of flexible expenses from what is left of income. If you need to cut back on your expenses, start first with the flexible expenses, then move to irregular expenses, and finally, to fixed expenses. If you have a surplus after subtracting expenses from income, consider adding more to your goal-related savings and investing.
Step Five: Put Your Plan into Action This is probably the most difficult part of using a budget. Keep records of actual spending and compare them with your budget plan at the end of the month. By keeping records, you can better understand exactly where your money goes each month, discover if you've over- or underestimated certain expenses, and identify areas you might be able to cut back (like those daily $3 gourmet coffee drinks!).
Step Six: Adjust Your Budget Adjust budget plan figures if necessary, based on the recordkeeping in Step 5. It may take several months of adjusting and re-adjusting before your plan works smoothly.
The real payoff of working with a budget plan and keeping records will come when you use your past year's budget and records to plan for the future. Budget records can help you pinpoint spending leaks or spot potential trouble before it occurs.
Some Smart Budgeting Tips
Keep it simple. Don't detail your plan to the penny. Keep track to the nearest dollar or even the nearest five dollars. This works only if you set your "breaking point" and stick to it. For example, if you prefer to keep track to the nearest dollar, set $.50 as your breaking point. If the amount to be recorded is $49.49, you drop the cents and write down $49. But if the amount is $49.50, you write $50. Such a system keeps some of the drudgery out of recordkeeping.
Be realistic. Consider all expenses, including vacations, spending money, alcohol, tobacco and hobbies. To build in a margin of safety in your plan, overestimate your expenses and underestimate your income.
Provide for personal allowances for everyone in your plan. Then give each person total control of his or her allowance. By providing everyone with an allowance, no matter how small, you are giving everyone money to spend as they wish when the urge comes. This is especially helpful in helping children learn that money is not an infinite resource!
Don't expect someone else's budget to work for you. When you see a budget in the newspaper or magazine, realize it is for a particular situation or for an "average" or "typical" family. It's important to tailor a spending plan to your individual needs and situation.
Distinguish between wants and needs. Buy what you need first. The wants belong in the "what's left over" category.
Borrow with care. Remember, you create a fixed expense each time you charge something or pay "on time." Even though it might give you pleasure to own something right now, consider all the interest you'll be paying and ask yourself if it's really worth the price. If possible, use cash for ALL your impulse purchases.
Plan for and develop an emergency fund! This is perhaps the most important element of all.
If you would like help in developing a budget that meets your income and expenses of today while designed to provide financial security for tomorrow, I can help. Please feel free to contact me for advice and guidance.
Welcome to "Life Cycle Planning"
Financial planning means something different to everyone. For some, it's about getting by month to month on their paycheck, for others it's about watching how their stock portfolio performs each day.
Unfortunately, few of us feel completely prepared to meet our ongoing financial obligations and objectives. Worries about money have become one of the greatest anxieties of our day - witness the dramatic rise in financial-related publications, radio and television shows, and websites.
Because each person's situation, lifestyle, and goals are so different, there is no single turnkey solution for successful money management. However, we can identify several steps that successful people take in pursuing their financial goals. We call these steps "Life Cycle Planning" because each step can be tied to the attainment of certain life-defining events that almost everyone goes through.
Development of Human Capital Human capital refers a person's ability to turn their skills and abilities into a livelihood. The development of these skills and abilities helps us maximize our income potential in a competitive marketplace.
In our early years, usually between age 18 and 25, we set ourselves on a course that largely defines our human capital potential. Each of us makes an investment in human capital, whether we realize it or not. For some this is an investment of time, gaining experience and skills on the job. For others it is an investment in trade school or college.
It should also be noted that, although our greatest focus on human capital development generally takes place in our early years, this is an investment we should continue to make and assess throughout our working careers. Your ability to earn income, now and in the future, is the most valuable asset you own.
Expense Management and Budgeting Once your "human capital" investment begins to pay dividends in the way of regular income, you must begin to develop and apply management skills to your newfound earnings.
Without managing your expenses, your wants and needs will invariably outpace your ability to earn. By implementing some form of budgeting, you can begin to set your sights on saving and meeting your longer-term financial objectives.
A beginning budget can be as simple as setting aside a predetermined percentage of your earnings each month for saving, spending what is left until it is gone, then spending nothing more until next month. A more sophisticated budget takes into account irregular and flexible expenses, emergency expenditures, establishment of a "rainy day" fund, as well as saving and investing.
Ensuring Adequate Liquidity As your budget begins to pay off in a healthy savings account, you might begin to wonder how best to apply your limited savings to your unlimited needs and wants.
Without exception, the first financial need you should meet is to have an emergency fund. An emergency fund allows us to cover unexpected short-term needs using cash instead of leveraging your future earnings through costly loans. As a general rule of thumb, your emergency fund should be adequate to maintain your standard of living for six months.
Ample Insurance Protection A major disability, the loss of a family breadwinner, a fire in your home, a family member's major medical problem or need for skilled nursing care ... the most dramatic emergencies can seldom be paid for completely using personal savings.
Although such tragedies can create devastating individual financial hardship, the financial risk of such events can be shared by very large groups of families and individuals through insurance.
Life insurance, disability income insurance, property and casualty (P&C) insurance, long-term-care insurance, and major medical insurance all have a place in your "Life Cycle Planning."
Long-Term Funding Objectives Once you've accumulated sufficient funds to cover your emergency needs and purchased protection against financial risks, you can begin saving for your long-term goals in earnest. We can help you design a plan to pursue your retirement objectives that fits with your personal financial goals, risk tolerance, and time horizon.
It's True - Time Is Money!
People often overlook the time value of money. Economists know full well that a dollar received today is worth more than a dollar received a year from now. Why? Because that dollar could be invested, saved, or used to purchase an asset such as real estate that will appreciate in value. What's more, inflation slowly but steadily erodes the purchasing power of your money, rendering tomorrow's dollar less valuable than today's.
The relationship between time and money provides the foundation for virtually every financial decision you will make. Whether you are saving money for a future event or considering a loan to pay for a current financial need, you will be greatly affected by the time value of money. The following are some tips for making the most of your dollars, today and tomorrow.
Time Value Tips Whether you are saving for retirement or a down payment on a home, college funding or dependant care needs, you will be greatly affected by these simple time value tips.
Time Value Tip #1: The longer you have to prepare, the less your objectives will cost. Assuming you are able to invest your savings and earn a positive return, you will always be better off saving for your goals in advance. Not only will your savings earn interest, but the interest you earn will also begin to earn interest. This is called "compounding" and was referred to by Albert Einstein as the "the most powerful force in the universe." (No one knows whether he was serious or joking.)
Time Value Tip #2: The higher the rate of return you are able to secure on your savings, the faster your money will grow. Generally, the amount of risk you are willing to take on your investments will determine your long-term rate of return. The longer you have to save for your goals, the more risk you should take on your investments, and the greater rate of return you should expect.
Time Value Tip #3: It's almost always better to postpone paying taxes on your investment proceeds. When you have the choice, you should usually choose to delay paying taxes on investment proceeds as long as possible. That's because as long as you retain all your investment's growth, instead of losing some to taxes, you can continue to earn more interest on that growth. Once you pay the taxes, you will never earn interest on those lost funds again. One way to postpone the payment of taxes is to invest in qualified retirement plans, such as IRAs and 401(k) accounts. Another tactic is to invest in annuities, which also allow your money to grow tax-free until withdrawn.
Time Value Tip #4: Factor inflation into your long-term plans. When preparing for long-term financial objectives, you must factor inflation into your plan. Over the last 20 years, inflation has averaged about 4% per year. At that rate, in 20 years a salary of $50,000 will buy what only $22,100 does in today's dollars - that's less than half. Looked at another way, that $30,000 luxury car you've had your eye on will cost you a whopping $67,872 just two decades from now!
The cost of some financial objectives will grow even faster than this -- college costs, for example, have increased by some 8% annually on average. Planning for such cost increases will ensure that your asset accumulation level is sufficient to meet your objectives.
What's the best time to start preparing for a sound financial future? Twenty years ago, goes the old joke. Failing that, the second-best time is today. Why not start now by contacting me?
Selling Your Home for Maximum Gain in Minimal Time
If you're like many Americans, your home probably represents your biggest investment. But the current tax treatment of capital gains from the sale of personal residences is favorable - gains of up to $250,000 for singles and $500,000 for married couples are generally tax-free, provided you have occupied the property for at least 2 years and it is your primary residence. So depending on your circumstances, moving up to a larger home or one in a better school district, or trading down to a smaller dwelling and realizing gains for your retirement, certainly can be appealing.
Once you have decided to try to sell your home, the next big decision you will face is whether you want to sell it yourself of go through a real estate broker. A broker usually charges 5-6% of the selling price for his or her services. However, realtors often earn their commission (and then some) by knowing the local market, helping you determine a reasonable selling price, and saving you a lot of time and hassles, not to mention the risk and liability that come with selling your home yourself.
In selecting a broker, invite several realtors to tell you what they would deem to be a fair selling price, explain their commissions and fees, and present a marketing plan. They'll probably do this for free in return for the chance to win your business. You will also want to ask about their past experience in the area.
Nearly 90% of all home sales are through agents and brokers. But if the market is a "sellers market" - that is, homes are selling quickly and at or above asking price - and your home is in stellar condition, perhaps you might want to try selling it yourself. There are a number of resources on the Internet designed to help you do just that.
HEAD: Does My House Need Fixing Up Before Listing? It doesn't hurt to do minor repairs and cosmetic touch-ups prior to showing your home to potential buyers. We hear a lot about "curb appeal" -- how a house appears from the street. Is it attractive enough for a buyer to even want to come in and look? If there are major repair problems, you may have to lower your price in the end. Maybe what you think is important to do to fix up the house will not appeal to potential buyer - they'd rather do it the updating to suit their own taste.
Most real estate and interior design experts will tell you that two of the best "bang for your buck" upgrades are new carpet and a fresh coat of paint. Select neutral colors that will appeal to the maximum number of buyers. Odors from pets, smoking, and unconventional foods should be eliminated as much as possible, or masked by baking cookies or putting a few drops of vanilla into a hot sauce pan for a moment or two. Reduce clutter and consider moving some items into your garage or storage to make the home appear larger. And above all, keep it clean - especially during those times when you know prospective buyers will or may be visiting.
How Much Should You Charge? This is a more complex question than it appears at first glance. In this situation, you and the buyer are at odds - you want the highest price possible, they want to pay as little as possible. But listing your house for more than it's really worth can backfire. You'll attract fewer buyers to begin with, as your house may be above the top end of their budget, and you may turn away buyers with the resources to purchase your home. Once that initial flush of interest wanes - since realtors and home seekers usually flock to a new listing early - you'll be left with fewer and fewer people who may buy your home.
By definition, the value of any asset is whatever someone is willing to pay for it. A buyer and seller generally find it easier to reach an agreement upon when both parties have access to all the relevant facts. With homes, there are several ways to arrive at a "starting point" from which to begin this process.
A good first step is to see what similar houses in similar locations in your community have sold for in the recent past, known as "comparable sales" or "comps." A good local real estate agent should have ample information about recent sales in your area. Don't be overly impressed by the asking price of comparable homes, which may be inflated or unrealistic; instead, look to actual sales prices as your best guides.
You may also want to enlist the help of a professional home appraiser. For a cost generally between $300 and $500, an appraiser will prepare a detailed evaluation of the estimated value of your home. Then, in conjunction with your agent, arrive at a price low enough to entice a high number of buyers but high enough to meet your goals. In a market where homes are selling briskly, don't worry too much about pricing your home too low - such a tactic could actually result in multiple offers and may even trigger a bidding war for your home!
What If Nothing Happens? If the real estate market is slow in your community due to national or local economic issues, there isn't much you can do (besides continually lowering the price, which you probably won't want to do). If no one is expressing any interest in your home, or it simply does not sell, you could consider the following:
Lower your asking price.
Make some obvious repairs or upgrades.
Confirm your real estate agent is working aggressively to sell your home and change agents if you do not feel they are.
Try selling the house yourself, lowering the price to reflect the commission you won't have to pay (please note, however, that the buyer's agent will still expect a commission).
Offer to finance all or part of the purchase price yourself.Offer to include items from the home, such as hot tubs, certain furniture or built-ins, lighting fixtures, and perhaps even a big-screen TV that would be costly to move anyway.
Selling your home may take time and patience, but it deserves your most detailed attention as it is one of the largest transactions you will undertake in your financial life. If you're successful, you'll be saying "Home Sweet Home!" after the sale has closed.
Your Personal Financial Statements
Personal financial statements are the roadmap that guides us from where we are today, to where we want to be tomorrow. They also provide fixed points of reference from which we can measure our progress over time.
What are Personal Financial Statements? There are two basic personal financial statements that everyone should prepare, or have a financial advisor prepare, at least once each year: the cash flow statement and the balance sheet.
This process is a critical first step in financial planning. Tracking your financial position and progress gives you a great feeling of control -- you know where you are going financially. It helps you to make smarter decisions about financial matters.
The Cash Flow Statement Simply put, "cash flow" is a measure of the money coming in and going out each month. A cash flow statement is an ongoing financial document that tracks your sources of income, your uses of income, and the difference between the two (surplus funds which can be invested towards future financial objectives or saved for a rainy day.)
If you keep a budget, you are, in essence, keeping a running cash flow statement. By tracking your cash flow on a monthly basis, you'll be better prepared to meet your financial needs:
Short-term expenses - your day-to-day expenses and standard of living items such as food, transportation, childcare, rent or mortgage, utilities, telephone, cable, etc.
Recurring expenses - periodic payments for items such as periodic insurance premiums, tax payments, medical and dental expenses, etc.
Financial emergencies - an emergency fund of between three and six months salary that provides cash for emergencies instead of using debt.
Intermediate- and long-term goals - systematic planning and saving that helps you meet pursue your financial objectives.
Balance Sheet Your balance sheet is a snapshot of your personal net worth.
TOTAL ASSETS less TOTAL LIABILITIES equals your NET WORTH
Estimating Your Net Worth
Total Assets: A list of current estimated value of your assets might include the following: cash in banks and money market accounts, cash surrender value of life insurance policies, IRA & Keogh account balances, pension and 401(k) accounts, equity in real estate, and personal possessions. Add them up and you'll have a figure that represents your Total Assets at the moment.
Total Liabilities: Next, make a list of your liabilities, which might include the following: mortgage, bank loans, car loans, charge accounts, taxes owed, college loans, etc. Add these up and you'll have a list of your Total Liabilities. Hopefully, it's less than your assets!
Your Net Worth: Your personal net worth is the difference between your total assets and your total liabilities.
As the control you gain through cash flow management turns into increased savings, your success is reflected in an increasing net worth. The process of preparing personal financial statements will bring you closer to controlling your personal finances and accumulating sufficient assets to meet your objectives.
Year-End Financial Planning: A Checklist
The best financial decisions are made with the benefit of time, thoughtful consideration, and trusted professional advice. As tax time approaches, take the time to prepare for sound long-term financial decisions and minimize expenses, taxes, and the headache of organizing your finances at the last minute.
Organize Your Tax Records Early In preparing for this year's tax filing, begin to organize tax records including year-end investment statements, capital gains and losses from asset sales, transaction records from real estate transactions, interest and dividend records for the year (1099s), payroll and withholding statements (W-2s), records corresponding with deductible expenses such as property taxes and insurance, business income and expense records, etc. Some of these will not come until January or February of the following year.
Review Your Insurance Coverages At least once each year, gather your insurance records together and review the adequacy of your insurance policies. Be sure to evaluate all coverages, including life insurance, disability income insurance, homeowners insurance, auto insurance, liability insurance, renters insurance, long-term-care insurance, etc.
Store Your Documents Safely All your hard-to-replace legal and financial documents should be stored in a safe and fireproof location. Consider renting a safe-deposit box at your local bank or credit union, or purchase a fireproof lockbox from your local office supplies outlet. Documents you should store include wills, trusts, powers of attorney, titles of ownership (your home, cars, etc.), Social Security cards, birth certificates, photographic negatives, list of personal possessions, and so forth.
Review Your Estate Plan Does your will still fairly reflect your personal wishes for the distribution of your assets? Have the personal or financial circumstances or your beneficiaries significantly changed over the past year? Have you considered a gifting program to move assets from your estate to those you wish to enrich? Have you reviewed your estate plan in light of changing estate tax laws or changes in your personal financial position?
Prepare to Reduce Your Income Tax Liability Consider estimating your federal and state income tax liabilities periodically to ensure proper withholding levels and quarterly estimated tax payments. This will prove especially important if you sell significant assets during the year or experience large swings in your income level. Consider maximizing your deductible expenses and savings such as qualified retirement plans, charitable giving, deductible expenses, etc. Be careful to meet all IRS dates and deadlines for withholdings and filings.
Review and Improve Your Balance Sheet The one true path to financial independence over the long term is increasing your long-term saving and decreasing your debt. If you are not maximizing your tax-deductible employer sponsored retirement plans and your individual tax-advantaged saving plans, evaluate your monthly cash flows with an eye toward increasing your monthly saving. The other side of your balance sheet, the liabilities side, is equally important in maintaining a healthy personal financial position. Every effort should be made to eliminate completely the need for short-term debt (credit cards and debit balances) and to efficiently manage your long-term debt (mortgages).
Simplify Your Financial Holdings Simplifying your financial holdings can eliminate much of the drudgery of financial recordkeeping. If you have credit cards you don't use, cancel them and eliminate the extra statements. Consider consolidating your credit lines to the greatest extent possible. Review your investment holdings for non-performing assets or redundant accounts and consolidate your investments.
To Sum Up... Although you may be able to think of more exciting ways to spend your time, organizing your financial records and planning your financial future will pay huge dividends in the long run. Do what you can on your own and seek professional advice from a trusted advisor where additional planning needs to be done.
(Updated May 10, 2011)
How Much Life Insurance Do You Really Need?
Some people equate life insurance with tragedy and death. In truth, life insurance is for the living. Without it, the sudden demise of a key breadwinner could leave a family stranded without the resources to maintain their lifestyle - or even retain their home.
Not so long ago, professionals recommended that families carry a life insurance policy with a death benefit of between five and seven times their annual household income. Today, however, in light of rising house prices in many parts of the country and spiraling college costs, most advisors now recommend eight to 10 times income.
Unfortunately, most American families are underinsured. According to statistics from industry research and consulting firm LIMRA International, the average American household carries just $126,000 in life insurance - approximately $300,000 less than they actually need - and only 61% of adult Americans have life insurance protection, a decline from 70% in 1984.1
A Cornerstone of Sound Financial Planning Financial professionals generally consider life insurance to be a cornerstone of sound financial planning, for two key reasons. First, it can be a cost-effective way to provide for your loved ones after you are gone. And second, life insurance can be an important tool in the following ways:
Income replacement - For most people, their most valuable economic asset is their ability to earn a living. If you have dependents, then you need to consider what would happen to them if they could no longer rely on your income. A life insurance policy can also help supplement retirement income, which can be especially useful if the benefits of your surviving spouse or domestic partner will be reduced after your death.
Pay outstanding debts and long-term obligations - Without life insurance, your loved ones must shoulder burial costs, credit card debts, and medical expenses not covered by health insurance using out-of-pocket funds. The policy's death benefit might also be used to pay off a mortgage, supplement retirement savings, or fund college tuition.
Estate planning - The proceeds of a life insurance policy can be earmarked to pay estate taxes so that your heirs will not have to liquidate other assets to do so.
Charitable contributions - If you have a favorite charity, you can designate some or all of the proceeds from your life insurance to go to this organization.
Determining How Much: A Four-Step Process Determining how much life insurance coverage you need is a four-step process:
Step 1: Determine Your Family's Short-Term Needs Short-term needs are financial obligations and/or expenses arising within six months of death. Examples of short-term needs include expenses you pay now such as:
Loan balances (automobile loans, etc)
Outstanding credit balances (credit cards, revolving lines of credit, etc)
Mortgages (first and second mortgage, home-equity loans, lines of credit)
Add to these current expenses any death-related expenses that must be paid in the short term:
Final medical costs
Estate settlement costs and probate
Estate taxes due
Charitable bequests you would like to make upon your death
If you don't already have one, your survivors should be left with a liquid emergency fund sufficient to get them through any unexpected financial needs. Most advisors recommend between three and six months' worth of living expenses.
Step 2: Determine Long-Term Needs In addition to covering your survivors' short term needs, some level of monthly income will be needed to maintain their current standard of living and meet financial goals such as saving for retirement and funding college for children.
The value of these future obligations is discounted back to present value amounts to provide a dollar amount that, if invested, could provide an adequate income stream to fund all of your long-term goals.
Step 3: Calculate Your Total Available Resources By this point, you should have a good idea of your family's total cash needs in the event of your untimely death. With any luck, you have already begun to set money aside to cover some of these costs. Other resources that may be available to your family include pensions, annuities, funds from retirement accounts, employer-provided life insurance, and Social Security.
The Social Security program offers benefits to survivors under age 17, and those whose spouses were receiving retirement income from Social Security can also count on survivorship benefits.
The total value of these future resources is discounted back to present value amounts. This gives us a single dollar amount that we can use to offset your total needs.
Step 4: Provide Funds To Cover A Shortfall In most cases, comparing total needs to total resources will result in a shortfall. That's where life insurance comes in. Without it, your survivors will be left with the choice of either finding or creating additional resources (such as having the surviving spouse return to work) or experience a decline in the quality of their lifestyle.
Life insurance is uniquely suited for covering such a shortfall. It is a means of sharing the financial risk of premature death with many, many others who have similar concerns.
You pay a relatively small premium to an insurance company in exchange for their promise to pay your beneficiaries a specified death benefit in the event of your death. You may find it ironic that a financial need arising from death can be alleviated by a financial resource that is created after death. That's why life insurance, although something no one hopes to ever need, is indeed for the living. It's also a vital issue we can help you investigate in greater detail to ensure your family's financial future will be protected.
1."Life Insurance Awareness Month," LIMRA International, August 2004
(Updated May 10, 2011)
Understanding Term Life Insurance
In days gone by, life insurance used to be simple. You figured out how much death benefit you needed, and then you chose between term and whole life.
The life insurance industry has gotten a whole lot more complicated in recent years. Besides term and whole life (now often called "permanent life"), there are universal policies ... variable universal policies ... variable life ... even a new type of term life called "return of premium". How can you weigh your options and decide which type is right for you?
This article introduces you to the concept of term life insurance.
Term Insurance: An Overview Term life insurance is often referred to as "pure insurance" because its premise is very simple: You pay a premium to an insurance company in exchange for their promise to pay a death benefit to your survivors if you die while the contract is still in force.
Term life insurance provides protection for a specified period and is usually renewable at the end of each period at progressively higher premiums. As you get older, your risk of dying increases, so the cost of term insurance goes up. Term insurance carries no cash value element, making it less expensive than permanent alternatives.
Annual Renewable Term -- Annually renewable term, or "ART" (sometimes called yearly renewable term, or "YRT"), is an example of a term insurance policy that has a constant face value and premiums that are adjusted upwards each year to reflect the increasing probability of your death in any given year.
Decreasing Term -- Decreasing term insurance refers to a type of annual renewable term life insurance policy with a decreasing death benefit (face amount) and level premiums. Decreasing term is ideal for insuring a liability that is gradually being paid off, like a home mortgage.
Level Term -- If you prefer, you may select a "level term" policy which guarantees that you will pay the same annual premium for a set number of years (usually 5, 10, 15, or 20) for the same amount of death benefit. The longer the guaranteed term, the greater the initial premium, but the longer the premium stays fixed. In most cases, if you know you will need your term insurance for an extended period of time, a level term policy will prove less costly than an annual renewable term policy.
Return of Premium - A relatively new type of policy, "return of premium" life insurance provides the benefits of traditional term life while the policy is in force, and then at the end of the policy period, pays back all the premiums you have paid. The catch, of course, is that you must still be alive to collect your premiums.
Understanding Permanent Life Insurance
As the name implies, permanent (cash value) insurance is best suited for the individual with a long-term (often indefinite) need. A permanent policy is really a combination of "pure insurance" and an asset accumulation element. Premiums are considerably higher than term rates in the beginning years, but may drop significantly, or even disappear, in later years. Other differences may include an increasing death benefit, a "cash value" associated with the policy, and tax-advantaged borrowing privileges against your cash value.
Whole Life -- This type of coverage covers you for as long as you live, as long as you make premium payments. Usually, this type of policy has a level premium for the life of the policy. Initial premiums are generally high compared with term insurance premiums, but eventually they become lower than the premiums you would pay if you had kept renewing a term policy. Over time, a whole life policy builds cash value at a rate of interest set by the issuing insurance company.
Universal Life -- With universal life coverage, which also covers you for as long as you live, you can vary your premium payments and the face amount of your coverage. Most of your premium payment goes into an account, which earns interest. You may borrow against the cash value, but eventually, if the balance continues to drop, your coverage will end. To prevent that, you would have to start making premium payments again, increase your premium payments, or lower your death benefits. Generally, your policy will state that it will pay the premiums from the cash value of your policy. Variable universal life also falls into this category; the difference is that a portion of your premium in "invested" in subaccounts that resemble mutual funds and can own stocks, bonds, cash, or some combination thereof.
Variable Life - This type of policy gives you an element of control over the cash value portion of your policy. Variable life allows you to allocate your cash value among a variety of investment subaccounts. Although the premiums you pay are fixed throughout the life of the contract, the performance of your chosen subaccounts determines the growth of your cash value and also can determine the value of your death benefit. No matter how your subaccounts perform, the death benefit of your variable life policy is guaranteed. Although contracts may vary, your premiums generally won't change. And as long as you pay your fixed premiums, your death benefit cannot go away. This is not the case with universal or variable universal life insurance. Please note guarantee is subject to the claims paying ability of the insurer.
Of course, your insurance needs will be determined by your individual situation. And keep in mind, the cost and availability of the type of life insurance that's right for you depends on factors such as your age, health, and the type and amount of insurance you need. If you are considering purchasing life insurance, we recommending consulting us to explore all your options and determine the solution that best fits your unique needs.
Health Insurance - Don't Bet Your Life On It
Unless you live in a cave, you know that healthcare costs have accelerated in recent years. According to a recent study, more than 15% of the United States' total gross domestic product (GDP) was spent on health care, and by 2014, this figure is expected to represent nearly one in every five dollars we spend!1
What's more, a growing number of Americans - more than 40 million, by latest count - don't have any health insurance coverage at all.2 Without health insurance, a single illness can cause serious, and often irreversible, financial hardship.
Insurance of any kind is intended to transfer financial risk to an insurance company in exchange for a reasonable insurance premium. Where most insurance coverages pay once a loss has occurred, health insurance has the added benefit of paying to keep your loss from getting worse. Health insurance is probably your most important coverage since it can be the difference between life and death. Fortunately, most employers offer some form of health insurance. Often you will have to select from several different alternative plans with differing coverages and premiums.
Health Insurance Categories There are two broad categories of health insurance coverage. One is fee-for-service and the other is managed health care, which is further divided into health maintenance organizations (HMOs), preferred provider organizations (PPOs), and point-of-service (POS) plans.
Fee-For-Service - A primary difference between fee-for-service and managed health plans in the amount of control you enjoy in choosing doctors and hospitals. Fee-for-service plans give you the greatest amount of choice, allowing you to select doctors and hospitals based on your needs and preferences. This greater amount of choice comes at a cost, however, as fee-for-service plans are usually more expensive than managed care plans.
Under a fee-for-service plan, your doctor will submit a bill to your insurance provider, or, if he or she does not have a relationship with your provider, you may have to pay the bill directly and get reimbursed by your provider. Under this plan, you can generally see any doctor you wish. You will most likely be responsible for a percentage of every expense, typically 20% but sometimes higher or lower.
Fee-for-service plans also have an annual deductible; these generally start at $100 for individuals and $500 for families. Typically, the higher the deductible, the lower your premiums. You'll have to meet the deductible amount before receiving any reimbursement,
If your doctor charges more than is "reasonable" as defined by your policy, you will have to pay the difference. You can appeal this if you feel the doctor is charging the same as the other doctors around your area.
Fee-for-service plans usually limit how much you will have to pay before the plan reimburses you at 100%. Some plans also have a lifetime limit on benefits, usually at least $1,000,000. This seems very high but it is not uncommon with serious accidents or illnesses that this number is met.
Managed Care There are three major types of managed care health plans -- HMOs, PPOs, and POSs - which generally charge a co-payment of $10 or $20 a visit. One limitation of an HMO is that you must use the doctor and hospitals that participate in the plan. The premiums are generally lower than fee-for-service plans.
With a managed care plan, you will have to select a primary care physician (PCP) who will be responsible for coordinating your care. You will need to be approved by the PCP to seek care by a specialist. You must also get authorization for any hospitalization you may require. As you can see, the lower premiums associated with managed care are the result of allowing the managed care provider to make many of your health care decisions for you.
PPOs and POSs differ from HMOs in that you can choose between the organization's network of providers but can see physicians outside the network if you desire.
Other Considerations If you choose not to utilize the coverage offered at work, or if no coverage is available through your employer, you could get your own personal policy or go through a group. Group policies have lower premiums. Also, some group policies do not ask questions about your health. Nevertheless, some policies will not cover pre-existing conditions for up to 12 months. You will want to understand all the pre-existing limitations that your coverage includes. If you have had health coverage for at least two years and change employment, you won't be affected by the exclusion.
If you are terminated from or leave a job in which health insurance was provided for you, the government has established guidelines for maintaining your old coverage at your own expense until you can find new coverage. Created by the Consolidated Omnibus Budget Reconciliation Act, this so-called COBRA program gives workers and their families who lose their health benefits the right to choose to continue health benefits provided by their group health plan for limited periods of time under certain circumstances such as voluntary or involuntary job loss, reduction in the hours worked, transition between jobs, death, divorce, and other life events.
Decoding MSAs and HSAs For small businesses and the self-employed, a Medical Savings Account, or MSA, is a tax-exempt account established for the purpose of paying medical expenses in conjunction with a high-deductible health plan. Like an IRA, an MSA is established for the benefit of the individual, and is "portable." Thus, if the individual is an employee who later changes employers or leaves the work force, the MSA does not stay behind with the former employer, but remains with the individual.
Introduced in 2004, Health Savings Accounts, or HSAs, are similar to MSAs. However, MSA eligibility is restricted to employees of small businesses and self-employed individuals, while HSAs are open to everyone with a high-deductible health insurance plan. The interest and investment earnings generated by the account are also not taxable while in the HSA. Amounts distributed are not taxable as long as they are used to pay for qualified medical expenses. Amounts distributed that are not used to pay for qualified medical expenses will be taxable, plus an additional 10% penalty is applied to prevent the use of the HSA for nonmedical purposes.
Given the bills you could face for an unanticipated illness or injury, health insurance is probably the most important coverage you can have. Although you might be in fine health now and think you'll never need it, don't bet your life on it - or your financial future.
1) "Health Tracking," Office of the Actuary, Centers for Medicare and Medicaid Services, February 23, 2005
2) National Coalition on Health Care, based in 2003 statistics
Homeowners Insurance: Protecting Hearth and Home
Your home is likely the largest investment you will ever make, and the things you keep inside it - wedding photos, collectibles, silver and china, jewelry, antique furniture - are probably your most prized possessions. That's why it's crucial to carry enough insurance to safeguard your home and everything in it.
You should have insurance on the land, the physical structure of the house, and also its contents against theft, fire, windstorm, or some other disaster. It's also wise to be insured for personal liability. This would cover an accident that might occur to someone who is visiting or working in your home.
Homeowners Insurance - What's Included A standard policy provides limited protection against, for example, fire and theft. Broader coverage gives you insurance for additional losses except those specifically excluded from the policy. You can also get special insurance with separate premiums for items such as jewelry, artwork, and collectibles.
What's NOT Covered No basic policy covers losses resulting from war, riots, police actions, nuclear explosion, or "acts of God." You can sometimes get an endorsement to your policy to cover circumstances that are normally excluded, such as floods and earthquakes, but it will likely be expensive. If you're in an area prone to such events, however, it could prove well worth the cost.
Other Considerations Consider liability coverage, which protects you if you are sued for causing property damage or injuring someone. As for deductibles, amounts vary. Your insurance costs less if you take a larger deductible, but, of course, you will have to pay the amount of any loss up to the deductible.
How Much Insurance Should You Buy? You should insure your house for at least 80% of its replacement value. However, most financial planners recommend that you insure your house for its full replacement value, and perhaps the replacement value of the contents of your home. Carefully read the terms of the policy so there will be no surprises in the event of a loss. Some policyholders believe their homeowners insurance will pay to completely rebuild their house, only to discover caps that limit the insurance company's liability and force them to spend thousands out of pocket.
One word of caution . . . when buying a home, if your down payment is less than 20% of the purchase price, you will probably be required to purchase mortgage insurance. Do not pay it as part of your mortgage; instead, pay it separately and cease paying it when your equity reaches 20% of the home's value. Mortgage insurance is designed to benefit the mortgage lender, not the homeowner.
The Role of Private Mortgage Insurance
If you put a downpayment of less than 20% when you bought your home, chances are good that you had to purchase private mortgage insurance, or PMI, in order to qualify for your loan. A mortgage insurance policy protects the bank in the event they are forced to repossess your house and sell it at a loss. As with most other types of insurance, you pay a monthly premium on top of your monthly mortgage payment for this policy. A mortgage insurance policy provides the means for purchasing a house you may otherwise be unable to afford, due to a limited down payment.
The good news is, PMI makes it possible for a homebuyer to obtain a mortgage with a down payment as low as 5% and for low-to-moderate income homebuyers as low as 3%. PMI may be also required when buying a second home or refinancing an existing mortgage with cash out. Mortgage insurance protects the mortgage lender against financial loss if a borrower defaults.
Low-down-payment mortgages are becoming more popular. Mortgage insurance allows borrowers to purchase a more expensive home than they might otherwise be able to afford. With lower downpayment, you might retain more funds for home furnishings or remodeling, buying a car, or other investments.
The mortgage insurance premium is based on loan to value ratio, type of loan, and amount of coverage required by the lender. The good faith estimate of closing costs provides the estimated premium and monthly cost for the PMI coverage.
It may be possible to cancel PMI at some point, such as when your loan balance is reduced to a certain amount - below 75% to 80% of the property value. The law in certain states requires that mortgage insurance be cancelled under some circumstances. But because of the wide variation in lender, investor and state requirements, it is necessary to find out the specific requirements for cancellation before you commit to paying for mortgage insurance.
Federal legislation enacted in 1999 made it a little bit easier to rid yourself of your monthly mortgage insurance premium. It requires lenders to automatically eliminate your mortgage insurance once you own 22% of your personal residence. Unfortunately the 22% equity is based on the value of your loan compared to the home's original purchase price so the lender does not take into account the appreciation of your home - just the gradual paydown of your mortgage. However, some lenders will consider your home's appreciation in deciding whether or not PMI is still required, so it doesn't hurt to ask.
Mortgage insurance should not be confused with mortgage life insurance, which is designed to pay off a mortgage in the event of the borrower's death.
Automobile Insurance: For Those on the Go
If you own a house, you need homeowners insurance. If you have dependents, you need life insurance. And if you own a car, you need ... you guessed it, automobile insurance. Understanding auto insurance is the first step towards ensuring that you have the right coverage at the best price.
The cost of your individual coverage depends on many factors -- factors that the insurance company calls risks. The lower risk you represent to the insurer, the lower your insurance will cost. The cost of your insurance will be impacted significantly by the type of car or truck you buy. Some of the factors that affect your risk include:
-Safety features on your vehicle -Crash test results for your vehicle -Average repair cost for your vehicle -How many miles you drive each month -If in school, your grade-point-average (some companies give discounts to better students) -Your age (younger and very old driver statistically have more accidents) -Your gender (males typically have more accidents than females) -Your geographic location (premiums will be higher areas of where theft and accidents are more common) -Your driving recordYour marital status (married drivers typically pay less) -How you use your vehicle -The make and model of your vehicle (sportier and the most-stolen models carry higher premiums) -Your claim history
Reducing the Cost of Your Auto Insurance You can often significantly reduce your auto insurance coverage costs by taking advantage of discounts offered by insurers. Discounts are available to drivers who seem like better risks to insurance companies. Look for the following types of discounts when pricing your insurance needs:
-Insure all your vehicles with the same insurance company -Insure your home and car with the same insurer -Consider purchasing your life insurance coverage and car insurance from the same company -Take a driver's education courseIf a student, meet your insurance company's minimum GPA standards -Buy a car with safety equipment like air bags, automatic seat belts, and antilock brakes, as well as built-in antitheft devices -Invest in anti-theft devices if the vehicle doesn't already have them. -Keep your mileage low (the less you drive, the less risk you have of being in an accident -Drive safely (a good driving record is your most valuable cost cutting opportunity)
Coverage Options Many features of your auto insurance coverage will be based on your state of residence, but many are the same across state lines. Here are a few coverage options you will have to consider:
1. Liability Insurance: This coverage protects the owner against losses from legal liability arising from bodily injury or property damages caused by an accident. This coverage can be in one single amount for each accident, or it can be broken down and "split" such as $50,000 / $100,000 / $25,000 (per person / per accident / per property damage).
2. Medical payment coverage: This provision covers medical and/or funeral expenses incurred though bodily injury resulting from an auto accident. The coverage is generally $5,000 to $10,000 per person per accident.
3. Physical Damage Coverage: This helps to cover the physical damage to the insured auto. Collision covers collision costs. Comprehensive covers losses from non-collision incidences. Some examples of this would be theft or storm damage. Policy limits for physical damage are generally based on the value of the insured automobile and are typically limited to the lesser of repair cost or actual cash value.
4. Uninsured/Underinsured Motorist: Although most states require car owners to have insurance, some motorists do not. Uninsured motorist coverage pays for injuries sustained in an accident with an uninsured (or hit and run) driver. Uninsured motorist insurance covers the difference between actual losses sustained and what an insured can collect from an at-fault driver, up to policy limits.
Endorsements Enhance Protection In addition to standard coverages, you may want to consider additional coverages called endorsements. Two of the most common are:
1. Extended Liability: This insurance is used to cover automobiles that are not legally owned by the insured, such as an auto owned by the employer but furnished for the use of the insured, which would not generally be insured.
2. Miscellaneous Type Vehicle Endorsement: This insurance allows other vehicles to be covered such as motorcycles, campers, golf carts, snowmobiles, etc.
Other Considerations When purchasing auto insurance or in reviewing your existing policies, keep these basic guidelines in mind. Make sure the policy provides as much protection as is necessary. Know the maximum dollar amount the insurance company will pay. Be aware of your deductible amount, which is the amount you must pay before your insurance company will pay anything. Know what your responsibilities are if an accident occurs. And above all, drive safely and defensively!
Investment Planning: The Basics
Why do so many people never obtain the financial independence that they desire? Often it's because they just don't take that first step--getting started. Besides procrastination, other excuses people make are that investing is too risky, too complicated, too time consuming, and only for the rich.
The fact is, there's nothing complicated about common investing techniques, and it usually doesn't take much time to understand the basics. The biggest risk you face is not educating yourself about which investments may be able to help you achieve your financial goals and how to approach the investing process.
Saving versus investing Both saving and investing have a place in your finances. However, don't confuse the two. With savings, your principal typically remains constant and earns interest or dividends. Savings are kept in certificates of deposit (CDs), checking accounts, and savings accounts. By comparison, investments can go up or down in value and may or may not pay interest or dividends. Examples of investments include stocks, bonds, mutual funds, collectibles, precious metals, and real estate.
Why invest? You invest for the future, and the future is expensive. For example, college expenses are increasing more rapidly than the rate of overall inflation. And because people are living longer, retirement costs are often higher than many people expect. Though all investing involves the possibility of loss, including the loss of principal, and there can be no guarantee that any investment strategy will be successful, investing is one way to try to prepare for that future.
You have to take responsibility for your own finances, even if you need expert help to do so. Government programs such as Social Security will probably play a less significant role for you than they did for previous generations. Corporations are switching from guaranteed pensions to plans that require you to make contributions and choose investments. The better you manage your dollars, the more likely it is that you'll have the money to make the future what you want it to be.
Because everyone has different goals and expectations, everyone has different reasons for investing. Understanding how to match those reasons with your investments is simply one aspect of managing your money to provide a comfortable life and financial security for you and your family.
What is the best way to invest?
·Get in the habit of saving. Set aside a portion of your income regularly. ·Invest in financial markets so your money can grow at a meaningful rate. ·Don't put all your eggs in one basket. Though it doesn't guarantee a profit or ensure against the possibility of loss, having multiple types of investments may help reduce the impact of a loss on any single investment. ·Focus on long-term potential rather than short-term price fluctuations. ·Ask questions and become educated before making any investment.
Invest with your head, not with your stomach or heart. Avoid the urge to invest based on how you feel about an investment.
Before you start Organize your finances to help manage your money more efficiently. Remember, investing is just one component of your overall financial plan. Get a clear picture of where you are today.
What's your net worth? Compare your assets with your liabilities. Look at your cash flow. Be clear on where your income is going each month. List your expenses. You can typically identify enough expenses to account for at least 95 percent of your income. If not, go back and look again. You could use those lost dollars for investing. Are you drowning in credit card debt? If so, pay it off as quickly as possible before you start investing. Every dollar that you save in interest charges is one more dollar that you can invest for your future.
Establish a solid financial base: Make sure you have an adequate emergency fund, sufficient insurance coverage, and a realistic budget. Also, take full advantage of benefits and retirement plans that your employer offers.
Understand the impact of time Take advantage of the power of compounding. Compounding is the earning of interest on interest, or the reinvestment of income. For instance, if you invest $1,000 and get a return of 8 percent, you will earn $80. By reinvesting the earnings and assuming the same rate of return, the following year you will earn $86.40 on your $1,080 investment. The following year, $1,166.40 will earn $93.31. (This hypothetical example is intended as an illustration and does not reflect the performance of a specific investment).
Use the Rule of 72 to judge an investment's potential. Divide the projected return into 72. The answer is the number of years that it will take for the investment to double in value. For example, an investment that earns 8 percent per year will double in 9 years.
Consider working with a financial professional Whether you need a financial professional depends on your own comfort level. If you have the time and energy to educate yourself, you may not feel you need assistance. However, don't underestimate the value of the experience and knowledge that a financial professional can offer in helping you define your goals and objectives, creating a net worth statement and spending plan, determining the level and type of risk that's right for you, and working with you to create a comprehensive financial plan. For many, working with a professional is the single most important investment that they make.
Review your progress Financial management is an ongoing process. Keep good records and recalculate your net worth annually. This will help you for tax purposes, and show you how your investments are doing over time. Once you take that first step of getting started, you will be better able to manage your money to pay for today's needs and pursue tomorrow's goals.
Six Keys to More Successful Investing
A successful investor maximizes gain and minimizes loss. Though there can be no guarantee that any investment strategy will be successful and all investing involves risk, including the possible loss of principal, here are six basic principles that may help you invest more successfully.
Long-term compounding can help your nest egg grow It's the "rolling snowball" effect. Put simply, compounding pays you earnings on your reinvested earnings. The longer you leave your money at work for you, the more exciting the numbers get. For example, imagine an investment of $10,000 at an annual rate of return of 8 percent. In 20 years, assuming no withdrawals, your $10,000 investment would grow to $46,610. In 25 years, it would grow to $68,485, a 47 percent gain over the 20-year figure. After 30 years, your account would total $100,627. (Of course, this is a hypothetical example that does not reflect the performance of any specific investment.)
This simple example also assumes that no taxes are paid along the way, so all money stays invested. That would be the case in a tax-deferred individual retirement account or qualified retirement plan. The compounded earnings of deferred tax dollars are the main reason experts recommend fully funding all tax-advantaged retirement accounts and plans available to you.
While you should review your portfolio on a regular basis, the point is that money left alone in an investment offers the potential of a significant return over time. With time on your side, you don't have to go for investment "home runs" in order to be successful.
Endure short-term pain for long-term gain Riding out market volatility sounds simple, doesn't it? But what if you've invested $10,000 in the stock market and the price of the stock drops like a stone one day? On paper, you've lost a bundle, offsetting the value of compounding you're trying to achieve. It's tough to stand pat.
There's no denying it--the financial marketplace can be volatile. Still, it's important to remember two things. First, the longer you stay with a diversified portfolio of investments, the more likely you are to reduce your risk and improve your opportunities for gain. Though past performance doesn't guarantee future results, the long-term direction of the stock market has historically been up. Take your time horizon into account when establishing your investment game plan. For assets you'll use soon, you may not have the time to wait out the market and should consider investments designed to protect your principal. Conversely, think long-term for goals that are many years away.
Second, during any given period of market or economic turmoil, some asset categories and some individual investments historically have been less volatile than others. Bond price swings, for example, have generally been less dramatic than stock prices. Though diversification alone cannot guarantee a profit or ensure against the possibility of loss, you can minimize your risk somewhat by diversifying your holdings among various classes of assets, as well as different types of assets within each class.
Spread your wealth through asset allocation Asset allocation is the process by which you spread your dollars over several categories of investments, usually referred to as asset classes. These classes include stocks, bonds, cash (and cash alternatives), real estate, precious metals, collectibles, and in some cases, insurance products. You'll also see the term "asset classes" used to refer to subcategories, such as aggressive growth stocks, long-term growth stocks, international stocks, government bonds (U.S., state, and local), high-quality corporate bonds, low-quality corporate bonds, and tax-free municipal bonds. A basic asset allocation would likely include at least stocks, bonds (or mutual funds of stocks and bonds), and cash or cash alternatives.
There are two main reasons why asset allocation is important. First, the mix of asset classes you own is a large factor--some say the biggest factor by far--in determining your overall investment portfolio performance. In other words, the basic decision about how to divide your money between stocks, bonds, and cash is probably more important than your subsequent decisions over exactly which companies to invest in, for example.
Second, by dividing your investment dollars among asset classes that do not respond to the same market forces in the same way at the same time, you can help minimize the effects of market volatility while maximizing your chances of return in the long term. Ideally, if your investments in one class are performing poorly, assets in another class may be doing better. Any gains in the latter can help offset the losses in the former and help minimize their overall impact on your portfolio.
Consider liquidity in your investment choices Liquidity refers to how quickly you can convert an investment into cash without loss of principal (your initial investment). Generally speaking, the sooner you'll need your money, the wiser it is to keep it in investments with comparatively less volatile price movements. You want to avoid a situation, for example, where you need to write a tuition check next Tuesday, but the money is tied up in an investment whose price is currently down.
Therefore, your liquidity needs should affect your investment choices. If you'll need the money within the next one to three years, you may want to consider certificates of deposit or a savings account, which are insured by the FDIC, or short-term bonds or a money market account, which are neither insured or guaranteed by the FDIC or any other governmental agency. Your rate of return will likely be lower than that possible with more volatile investments such as stocks, but you'll breathe easier knowing that the principal you invested is relatively safe and quickly available, without concern over market conditions on a given day.
Note: If you're considering a mutual fund, consider its investment objectives, risks, charges, and expenses, all of which are outlined in the prospectus, available from the fund. Consider the information carefully before investing.
Dollar cost averaging: investing consistently and often Dollar cost averaging is a method of accumulating shares of stock or a mutual fund by purchasing a fixed dollar amount of these securities at regularly scheduled intervals over an extended time. When the price is high, your fixed-dollar investment buys less; when prices are low, the same dollar investment will buy more shares. A regular, fixed-dollar investment should result in a lower average price per share than you would get buying a fixed number of shares at each investment interval.
Remember that, just as with any investment strategy, dollar cost averaging can't guarantee you a profit or protect you against a loss if the market is declining. To maximize the potential effects of dollar cost averaging, you should also assess your ability to keep investing even when the market is down.
An alternative to dollar cost averaging would be trying to "time the market," in an effort to predict how the price of the shares will fluctuate in the months ahead so you can make your full investment at the absolute lowest point. However, market timing is generally unprofitable guesswork. The discipline of regular investing is a much more manageable strategy, and it has the added benefit of automating the process.
Buy and hold, don't buy and forget Unless you plan to rely on luck, your portfolio's long-term success will depend on periodically reviewing it. Maybe your uncle's hot stock tip has frozen over. Maybe economic conditions have changed the prospects for a particular investment, or an entire asset class.
Even if nothing bad at all happens, your various investments will likely appreciate at different rates, which will alter your asset allocation without any action on your part. For example, if you initially decided on an 80 percent to 20 percent mix of stocks to bonds, you might find that after several years the total value of your portfolio has become divided 88 percent to 12 percent (conversely, if stocks haven't done well, you might have a 70-30 ratio of stocks to bonds in this hypothetical example). You need to review your portfolio periodically to see if you need to return to your original allocation. To rebalance your portfolio, you would buy more of the asset class that's lower than desired, possibly using some of the proceeds of the asset class that is now larger than you intended.
Another reason for periodic portfolio review: your circumstances change over time, and your asset allocation will need to reflect those changes. For example, as you get closer to retirement, you might decide to increase your allocation to less volatile investments, or those that can provide a steady stream of income.
Investing for Major Financial Goals
Go out into your yard and dig a big hole. Every month, throw $50 into it, but don't take any money out until you're ready to buy a house, send your child to college, or retire. It sounds a little crazy, doesn't it? But that's what investing without setting clear-cut goals is like. If you're lucky, you may end up with enough money to meet your needs, but you have no way to know for sure.
How do you set goals? The first step in investing is defining your dreams for the future. If you are married or in a long-term relationship, spend some time together discussing your joint and individual goals. It's best to be as specific as possible. For instance, you may know you want to retire, but when? If you want to send your child to college, does that mean an Ivy League school or the community college down the street?
You'll end up with a list of goals. Some of these goals will be long term (you have more than 15 years to plan), some will be short term (5 years or less to plan), and some will be intermediate (between 5 and 15 years to plan). You can then decide how much money you'll need to accumulate and which investments can best help you meet your goals. Remember that there can be no guarantee that any investment strategy will be successful and that all investing involves risk, including the possible loss of principal.
Looking forward to retirement After a hard day at the office, do you ask, "Is it time to retire yet?" Retirement may seem a long way off, but it's never too early to start planning--especially if you want your retirement to be a secure one. The sooner you start, the more ability you have to let time do some of the work of making your money grow.
Let's say that your goal is to retire at age 65 with $500,000 in your retirement fund. At age 25 you decide to begin contributing $250 per month to your company's 401(k) plan. If your investment earns 6 percent per year, compounded monthly, you would have more than $500,000 in your 401(k) account when you retire. (This is a hypothetical example, of course, and does not represent the results of any specific investment.)
But what would happen if you left things to chance instead? Let's say you wait until you're 35 to begin investing. Assuming you contributed the same amount to your 401(k) and the rate of return on your investment dollars was the same, you would end up with only about half the amount in the first example. Though it's never too late to start working toward your goals, as you can see, early decisions can have enormous consequences later on.
Some other points to keep in mind as you're planning your retirement saving and investing strategy:
·Plan for a long life. Average life expectancies in this country have been increasing for many years. and many people live even longer than those averages. ·Think about how much time you have until retirement, then invest accordingly. For instance, if retirement is a long way off and you can handle some risk, you might choose to put a larger percentage of your money in stock (equity) investments that, though more volatile, offer a higher potential for long-term return than do more conservative investments. Conversely, if you're nearing retirement, a greater portion of your nest egg might be devoted to investments focused on income and preservation of your capital.
Consider how inflation will affect your retirement savings. When determining how much you'll need to save for retirement, don't forget that the higher the cost of living, the lower your real rate of return on your investment dollars.
Facing the truth about college savings Whether you're saving for a child's education or planning to return to school yourself, paying tuition costs definitely requires forethought--and the sooner the better. With college costs typically rising faster than the rate of inflation, getting an early start and understanding how to use tax advantages and investment strategy to make the most of your savings can make an enormous difference in reducing or eliminating any post-graduation debt burden. The more time you have before you need the money, the more you're able to take advantage of compounding to build a substantial college fund. With a longer investment time frame and a tolerance for some risk, you might also be willing to put some of your money into investments that offer the potential for growth.
Consider these tips as well:
·Estimate how much it will cost to send your child to college and plan accordingly. Estimates of the average future cost of tuition at two-year and four-year public and private colleges and universities are widely available.
·Research financial aid packages that can help offset part of the cost of college. Although there's no guarantee your child will receive financial aid, at least you'll know what kind of help is available should you need it.
·Look into state-sponsored tuition plans that put your money into investments tailored to your financial needs and time frame. For instance, most of your dollars may be allocated to growth investments initially; later, as your child approaches college, more conservative investments can help conserve principal.
Think about how you might resolve conflicts between goals. For instance, if you need to save for your child's education and your own retirement at the same time, how will you do it?
Investing for something big At some point, you'll probably want to buy a home, a car, maybe even that yacht that you've always wanted. Although they're hardly impulse items, large purchases often have a shorter time frame than other financial goals; one to five years is common.
Because you don't have much time to invest, you'll have to budget your investment dollars wisely. Rather than choosing growth investments, you may want to put your money into less volatile, highly liquid investments that have some potential for growth, but that offer you quick and easy access to your money should you need it.
What's Your Risk Comfort Level?
By definition, all investments involve a trade-off between risk and return. A certain amount of risk is inevitable if you want your money to grow. The key is determining how much risk you feel comfortable with.
Understanding Your Risk Tolerance Are you uncomfortable with change? Can you stick with your long-term strategy even if you face short-term losses? Will you be overly anxious the first time your investments drop in value? These are all questions to answer before developing your strategy.
Understanding your personal risk tolerance will help you create a plan you can stick with through good times and bad. Many investors forget the risks involved with buying stocks when the market is soaring. It's easy to be tempted by the lure of sky-high returns and to forget the possibility of a market downturn, or worse, of a bear market. Likewise, during a bear market or a sharp drop in the market, many investors suddenly become extremely risk averse. But if you create a plan built around your personal risk tolerance and stick with that plan, you will avoid having to make sudden changes in your investment strategy as the market changes.
Factors That May Affect Your Risk Tolerance Although your personality will affect your underlying risk tolerance, your stage of life also will affect it. Are you just getting started, supporting a growing family or approaching retirement? The amount of risk you feel comfortable taking may be very different at each of these stages in your life.
Most people aren't prepared for the risk posed by being 100% invested in stocks. But younger investors saving for retirement may be able to afford the risk of placing the bulk of their money in stocks. Why? Because in modern U.S. stock market history, investors have never lost real money investing over a 15-year period. Over a 10-year period, the odds of making money are more than 90%. So stocks have proven to be the best investment over the long term and will likely continue to be unless the U.S. economy crashes to a halt. What's more, younger investors have the ability to "catch up" by continuing to earn money they can put away toward retirement.
On the other hand, as you move closer to retirement, or if you will need a portion of your money in the short term, you may be better off foregoing the highest returns and putting your money in investments that are more secure, such as short-term bonds or money market accounts.
But even investors with similar personalities and in the same stage of life may have different risk tolerances because of the following factors.
Job security and future employment prospects. If you work in an industry with high turnover, you may be willing to risk less than if you are in a stable position with room for growth.
The amount of disposable income available for investing. If you are investing millions you may be more comfortable taking risks than if you have only a few thousand dollars to work with.
The risk of an unexpected financial burden. If you are the sole income provider for your family, your tolerance may be lower than if your spouse also earns a good living.
"No pain, no gain," the exercise gurus of the past once told us. And while there can be painless gains in the short term with more volatile investments such as stocks, recent history has taught us that staying the course and recognizing our tolerance for risk can ease the pain even as we pursue gains. Let us help you determine what your risk tolerance is, then develop a program tailored to it.
A Tutorial on Stocks
If you're completely new to investing, you might be wondering what, exactly, is a "stock"? Simply put, a share of common stock represents a tiny piece of ownership in a public company. If there are one million shares outstanding of Company X, and you own one share, you in effect own one-millionth of that company - its assets and the profits it is able to produce over time. The more shares you own, the more you benefit from a company's growth.
Why Do Companies Issue Stock? Businesses need money, or "capital," to grow and thrive. A company will typically issue stock to raise money for financing operations, acquiring new equipment or other companies, fund research and development, and other such uses.
Another term for raising money through stock issuance is "equity financing," and the capital produced through this method is referred to as equity capital. Companies might also issue bonds to finance various activities; this is referred to as "debt issuance."
What Categories of Stock Exist? Also called "equities," stock can be categorized several ways. The first is by size, or "market capitalization": A company's net market capitalization is measured by its share price multiplied by the number of shares on the market. To use the example above, if Company X's share price is $10, its market capitalization (or "cap" for short) would be $10,000,000 - one million shares outstanding multiplied by $10 per share. Generally, companies with $1 to $1.5 billion in market capitalization are considered "small cap" stocks, those with between $1-1.5 billion and $5 billion are considered "mid cap" stocks, and those with market caps above $5 billion are considered "large cap" stocks.
Another way to categorize stocks is by style. "Growth" stocks are those considered to have the potential to expand their sales, revenue, and profitability quickly. "Value" stocks are those believed to be undervalued by investors and thus selling for less than their intrinsic value.
A third way to divide stocks is by geography. Stocks of U.S. companies are considered "domestic" stocks, while those of companies outside the U.S. are considered "international" stocks. Typically, international equities are further divided into "developed" (such as Europe or Japan) or "emerging" (China, Southeast Asia, Latin America) markets. Foreign investing involves additional risks, such as currency fluctuations and political uncertainty. Investment return and principal uncertainty. Investment return and principal value will fluctuate so shares, when redeemed, may be worth more or less than their original costs.
Finally, stocks can be categorized by sector and industry. Common categories include technology, communication, healthcare, energy, financial services, consumer goods and basic materials, which may respond differently to economic changes.
How Can I Buy Stocks? Typically, investors purchase stocks through entities known as exchanges. These marketplaces include the New York Stock Exchange, the American Stock Exchange, and the NASDAQ Stock Market. The exchanges are merely a way to connect those who want to buy shares with those willing to sell them. How do you know what a stock is selling for? Stock prices, or "quotes," can be located in newspapers, on certain television programs, and through the Internet.
Another way to own stocks is through mutual funds.
Why Should Individuals Own Stocks? Over time, stocks have proven themselves to be the most powerful way to accumulate wealth, outpacing bonds, government securities, and inflation. Stocks provide individuals with the opportunity to benefit from growth in the U.S. economy as companies expand their sales and profits.
Stockholders can benefit from owning stocks in two ways: First, through price appreciation, as the price of their shares goes up; and second, through dividends, which many companies pay on a regular basis. Together, these factors make up your stock's total return.
What About the Risk? Many people have heard of or experienced events such as "Black Tuesday," in October 1929, when the Dow Jones Industrial Average nosedived 12.8%, and, more recently, "Black Monday" in October 1987, when the Dow lost 22.6% of its value (still the worst single trading day on record). More recently, we saw stomach-churning drops in 1997 and 1998, and endured a long bear market from 2000 through 2002.
And it is true that, in the short term, investing in the stock market can be risky. Markets tend to be volatile, responding quickly and forcefully to events and news such as the 9/11 terrorist attacks, rumors of economic changes, presidential elections, and geopolitical happenings. Individual stocks face risks as well. A company, because of poor business conditions or poor management, could become unable to make dividend payments. Or it could fail completely, leaving your stock essentially worthless.
Over the long term, however, stocks have earned higher and more positive returns than any other financial investment. These higher returns help offset the risks of investing in stocks.
Diversification Can Reduce Risk Among the risks you face in the stock market is the risk that you will have to sell an investment for less than you paid for it. If you buy stock in many different companies, in many different sectors of the market, you can minimize your risk. After all, it is highly unlikely that every company in which you have invested will suffer at the same time. However diversification does not protect against loss.
You can also minimize your risk by investing some money in international stocks. Historically, when the U.S. stock market has dropped, markets in Europe and Asia have dropped less, or even risen in value. Although we live in an increasingly global economy where economic events have an impact everywhere, global diversification should still be a part of your plan.
What Role Should Stocks Play In Your Portfolio? In general, your stock market investments should represent money you won't need for at least 10 years. That time frame allows enough time for your investments to ride out the inevitable growth/recession economic cycles and bull/bear market cycles. Certainly younger people investing for their retirement should consider putting a substantial portion of their funds in stocks. One very general rule of thumb is that the percentage of your invested assets should be at least 100 minus your age - 70% for a 30-year-old.
Investing in stocks may also be appropriate for retirees who don't need all of their money and are trying to maximize what they will pass onto their heirs. Your best bet is to work with a financial advisor to determine the optimal amount you should allocate to stocks.
Investing in Stocks
Businesses sell shares of stock to investors as a way to raise money to finance expansion, pay off debt, and provide operating capital. Each share of stock represents a proportional share of ownership in the company. As a stockholder, you share in a portion of any profits and growth of the company. Dividends from earnings are paid to shareholders, and growth is realized by the increase in value of the stock.
Stock ownership also generally gives you the right to vote on management issues. Company executives work for the shareholders, who are represented by an elected board of directors. The goal of management is to increase the value of the corporation's equity. If shareholders are dissatisfied with the corporation's performance, they can vote for a change in management.
Why invest in stocks? The main reason that investors buy stock is to seek capital appreciation and growth. Although past performance is no guarantee of future results, stocks have historically provided a higher average annual rate of return over long periods of time than other investments, including bonds and cash alternatives. Correspondingly, though, stocks are generally considered to have more volatility than bonds or cash alternatives.
Can you lose money? Yes, you can. There are no assurances that a stock will increase in value. Several factors can affect the value of your stocks:
·Actions of investors: If a large number of investors believe that the nation is entering a recession, their actions can affect the direction of the stock market ·Business conditions: A new patent, an increase in profits, a pending merger, or litigation could affect investor interest and stock prices ·Economic conditions: Employment, inflation, inventory, and consumer spending influence the potential profit of a company and its stock price ·Government actions: Decisions on interest rates, taxes, trade policy, antitrust litigation, and the budget impact stock prices ·Global economy: Changes in foreign exchange rates, tariffs, or diplomatic relations can cause stocks to go up or down
All investing involves risks, and there can be no assurance that any investing strategy will be successful. However, understanding these factors can help you make sound investment decisions and keep losses to a minimum.
What are the different classifications of stocks? Stocks are often classified in the following ways:
·Growth stocks have earnings that are increasing at a faster rate than the market average. These are usually in new or fast-growing industries and have the potential to give shareholders returns greater than those offered by the stocks of companies in older, more established industries. Growth stocks are the most volatile class of stock, however, and may be just as likely to go down in price. ·Value stocks are those of companies with good earnings and growth potential that are currently selling at a low price relative to their intrinsic value. Due to some problem that may be only temporary in nature, investors are ignoring these stocks. Since it can take quite some time for their true value to be reflected by their price, value stocks are usually purchased for the long term. ·Income stocks are generally not expected to appreciate greatly in share price, but typically pay steady dividends. Utilities are an example of companies that have historically been considered income-oriented. ·Blue chip stocks are the stocks of large, well-known companies with good reputations and strong records of profit growth. They also generally pay dividends. ·Penny stocks are very risky speculative stocks issued by companies with short or erratic performance histories. These stocks are so named because they sell for under $5 per share. Their low price appeals to investors willing to assume a total loss in exchange for the potential for explosive growth.
It is usually best to diversify among the different classifications and not own stock in just one or two companies or industries (though diversification alone cannot guarantee a profit or ensure against a loss).
How are stocks bought and sold? During an initial public offering (IPO), new issues of stock are sold on the basis of a prospectus (a document that gives details about a company's operation) that is distributed to interested parties. Investment bankers or brokerage houses buy large quantities of the stock from the company and sell them to investors. After the IPO, the stock may trade on a stock exchange or over the counter.
Normally, stock is purchased through a brokerage account. The buy order you place will be directed to the appropriate stock exchange. When someone who owns the stock is willing to sell at the price you are willing to pay, the sale takes place. A commission or fee is charged on your transaction.
Stock certificates may be transferred from one owner to another since they are negotiable instruments. The certificates are issued in the buyer's name or, more typically, held by the brokerage house in street name (i.e., the brokerage firm's name) on behalf of the investor. The advantage of a street-name registration is that if you decide to sell, you do not have to sign and deliver the stock certificates before the sale can be completed. And you don't have to worry about losing the stock certificates.
How do you set up a brokerage account? You will need to complete a new account agreement and make three important decisions:
Who will make the investment decisions? You will--unless you give discretionary power to your broker or agent. Discretionary power allows a broker or agent to make decisions based on what he or she believes is best for you. Unless you limit the broker's or agent's discretion, this may be done without consulting you about the type of security and number of shares involved, or about the time and price at which to buy or sell. Do not give discretionary power to your broker or agent without seriously considering if it is right for you.
How will you pay for the stock? A cash account requires you to pay for each stock purchase in full at the time you buy it. A margin account allows you to borrow money from the brokerage firm. Securities that you own are held as collateral, and interest is charged on the loan. If the account value falls below the specified amount required to maintain the loan (even as the result of a one-day market decline), you must pay down the loan balance to an amount determined in relation to your new account balance. This is known as a margin call and can potentially require the payment of a sizable amount of money.
What level of risk can you handle? You will be asked to specify your investment goals in terms of risk. Choices such as income, growth, or aggressive growth may be given. Make sure you understand the meaning of each term, and be certain that the level of risk you choose truly reflects your ability to handle risk. Any investment your broker or agent recommends should be based on the category of risk you selected.
Read the account agreement Never sign a document without reading and fully understanding it. Early precautions can prevent later misunderstandings.
Keep good records of:
·Documents you sign ·Documents outlining the details of an account or investment ·Periodic account statements ·Transaction confirmations ·Documents verifying an account error was corrected ·Correspondence with your broker or agent
Review these as soon as you receive them. Discuss any discrepancies you find with your broker or agent at once, and follow up on any actions taken until you are satisfied. Never allow your broker or agent to mail statements and transaction confirmations to someone other than you. It's important that you check the accuracy of your own accounts.
Be patient Some stock investors have made money quickly. But they are the exception rather than the rule. Investing in stocks requires a long-term outlook. Read books, attend seminars, and take advantage of professional advice. Education, good judgment, common sense, and above all, patience increase your chances of achieving your goals.
Bond Market Basics
A bonds is essentially a loan from the bond buyer (an individual or institutional investor) to the bond issuer (a corporation, municipality, or other government entity). Bonds are often referred to as "income securities" because, in return for the use of your money, the bond's issuer agrees to pay a certain rate of interest at regular intervals for a set period until the bond matures or the principal is otherwise repaid.
Bonds can be for varying lengths of time (maturities) and of varying quality. Short-term bonds are defined as those that mature in three years or less. Intermediate bonds mature in three to 10 years, and long-term bonds have maturities of 10 years or more. The quality of a bond relates to its risk of default, or non-repayment by its issuer. Bonds issued by the U.S. government are of higher quality than those issued by many state and municipal governments, because U.S. government securities are backed by you, the taxpayer, and thus are far less likely to default. Company-issued bonds can vary even more dramatically in quality. As with any investment, the higher the risk associated with an investment, the higher the potential return you generally can expect from it. Of course, the taxability of a bond's interest also will have an impact on the return.
What Are the Risks of Investing in Bonds? Just like other investments, bonds expose you to certain types of risks. Depending on the quality of the bond, you may face the risk that the issuer could experience economic problems and be unable to make its interest payments. You can minimize this risk by investing in higher-quality bonds, but they will have a lower return than high-yield debt securities, otherwise known as "junk bonds."
Bond investments are also sensitive to movements in market interest rates. Typically, if interest rates rise, the value of your bonds will likely decline. Or, if interest rates decline, your bonds may increase in value but provide less income as they mature and are replaced with new ones. If you have invested in the bonds because you need that income for living expenses, this can pose a problem. You can minimize this risk by diversifying your bond portfolio among investments with a variety of different maturities, and by keeping some of your portfolio invested in stocks, which react to interest rate changes differently than bonds do.
The Relationship Between Bonds and Interest Rates People often get confused by the inverse relationship between interest rates and bond prices. Here's why bond prices RISE when interest rates fall, and vice versa.
Let's say you want your bond to earn $50 in interest by year's end. If interest rates are 5%, you need to have a bond with a face value of $1,000 to earn $50 in interest. If interest rates fell to 4%, however, you would have to increase that face amount to $1,250 to earn the same $50. On the other hand, if interest rates rose to 6%, you would only have to buy a bond worth $832,50 to earn $50.
Here's another example. Ike and Holly each purchased a newly issued $20,000, 10-year U.S. government bond with a 5.5%* coupon rate (the bond's interest rate). The bonds were issued "at par" and thus they each paid $20,000. In exchange for "loaning" the government $20,000, Ike and Holly will each receive $1,100 a year for 10 years. At the end of the 10 years, Ike and Holly will get their $20,000 back.
Five years after purchasing his bond, Ike needs to sell it. The interest rates have risen since Ike purchased the bond, and newly issued 10-year government bonds are paying 7%. To find a buyer for his 5.5% bond, Ike is forced to sell it for less than the $20,000 face value.
Two years later, Holly also decides to sell her bond. Interest rates have dropped since Ike sold his bond, and new 10-year bonds are paying only 5% interest. Because of this, Holly is able to sell her bond for more than $20,000.
Taxable or Tax Exempt? Some bonds offer special tax treatment on the interest they pay. There is no state or local income tax on the interest from U.S. Treasury bonds, and no federal income tax on the interest from most municipal bonds, and often no state or local income tax either.
Which is better for you, taxable income or income that is tax-exempt? The answer depends on your income tax bracket - and the difference between what can be earned from taxable versus tax-exempt securities - not only now but also throughout the period until your bonds mature. An investment advisor can show you how much taxable income you would need at each income tax bracket to match the return from a tax-exempt security.
The bond market is far more complex than the stock market in many ways. There are significantly more bonds on the market, more types of bonds than stocks, and pricing is not as transparent. Many people own bonds through mutual funds. Contact me to learn more about how bonds can help you pursue all your financial goals.
Investing in Bonds
Bonds may not be as glamorous as stocks or commodities, but they are a significant component of most investment portfolios. Bonds are traded in huge volumes every day, but their full usefulness is often underappreciated and underestimated.
Why invest in bonds? Bonds can help diversify your investment portfolio. Interest payments from bonds can act as a hedge against the relative volatility of stocks, real estate, or precious metals. Those interest payments also can provide you with a steady stream of income.
How bonds work When you buy a bond, you are essentially loaning money to a bond issuer in need of cash to finance a venture or fund a program, such as a corporation or government agency. In return for your investment, you receive interest payments at regular intervals, usually based on a fixed annual rate (coupon rate). You are also paid the bond's full face amount at its stated maturity date.
You can purchase bonds in denominations as low as $100 (though individual brokers may have a higher minimum purchase). Some are backed by tangible assets, such as mortgage contracts, buildings, or equipment. In many other cases, you simply rely on the issuer's ability to pay. You can buy or sell bonds in the open market in the same manner as stocks and other securities. Therefore, bonds fluctuate in price, selling at a premium (above) or discount (below) to the face value (par value). Generally, the longer a bond's duration to maturity, the more volatile its price swings. These factors expose bonds to certain inherent risks.
Bond risk factors Although many bonds are conservative, lower-risk investments, many others are not, and all carry some risk. Because bonds are traded in the securities markets, there is always the chance that your bonds can lose favor and drop in price due to market risk. Much of this volatility in prices is tied to interest-rate fluctuations. For example, if you pay $1,000 for a 10 percent bond, that same $1,000 might buy you an 11 percent bond the following month, if interest rates rise. Consequently, your old 10 percent bond may be worth only about $900 to current investors.
Since bonds typically pay a fixed rate of interest, they are open to inflation risk. As consumer prices generally rise, the purchasing power of all fixed investments is reduced. Also, there is a chance that the issuer will be unable to make its interest payments or to repay its bonds' face value at maturity. This is known as credit or financial risk. To help minimize this risk, compare the relative strength of companies or bonds through a ratings service such as Moody's, Standard & Poor's, A. M. Best, or Fitch. Finally, bonds also involve reinvestment risk: the risk that when a bond matures, you may not be able to get the same return when you reinvest that money.
Corporate bonds Bonds issued by private corporations vary in risk from typically super-steady utility bonds to highly volatile, high-interest junk bonds. Also, many corporate bonds are callable, meaning that the debt can be paid off by the issuing company and redeemed on a fixed date. The company pays back your principal along with accrued interest, plus an additional amount for calling the bond before maturity.
Some corporate bonds are convertible and can be exchanged for shares of the company's stock on a fixed date. You can also purchase zero-coupon bonds, which are issued at a discount to (below) face value. No interest is paid, but at maturity you receive the face value of the bond. For example, you pay $600 for a 5-year, $1,000 zero-coupon bond. At the end of 5 years, you receive $1,000. Corporate bonds have maturity dates ranging from one day to 40 years or more and generally make fixed interest payments every six months.
U.S. government securities The securities backed by the full faith and credit of the U.S. government carry minimal risk. United States Treasury bills (T-bills) are issued for terms from a few days to 52 weeks. They are sold at a discount and are redeemed for their full face value at maturity. Other Treasury securities include Treasury notes, which have terms from 2 to 10 years, Treasury Inflation Protected Securities (TIPS), which have terms from 5 to 30 years, and Treasury bonds, which have a term of 30 years. Although the interest earned on these securities is subject to federal taxation, it is not subject to state or local taxes.
Various federal agencies also issue bonds. As with any investment, these bonds carry some risk. However, because the U.S. government guarantees timely payment of principal and interest on them, they are considered very safe. Some of these bonds use mortgages as collateral. Most mortgage-backed securities pay monthly interest to bondholders.
Municipal bonds Municipal bonds (munis) are issued by states, counties, or municipalities, and are generally free from federal taxation (with some exceptions). Some may be completely tax free if you are a resident of the state, county, or municipality of issuance. Though municipal bonds generally offer lower interest payments compared with taxable bonds, their overall return may be higher because of their tax-reduced (or tax-free) status.
Munis come in two types: general obligation (GO) bonds and revenue bonds. GO bonds are backed by the taxing authority of the issuing state or local government. For this reason, they are considered less risky but have a lower coupon rate. Revenue bonds are supported by money raised from the bridge, toll road, or other facility that the bonds were issued to fund. They pay a higher interest rate and are considered riskier. Therefore, research the project being funded to the extent possible before you invest, to make sure that it will generate sufficient income to make payments.
How to begin investing in bonds Thousands of books, newsletters, and websites can provide you with investment information that can help you evaluate and choose bonds. The major bond-rating services offer concise letter grades regarding the relative strength of a corporation or bond.
However, if you don't want to go it alone, a brokerage firm or financial advisor can evaluate and recommend choices for you. Keep in mind that brokers or advisors may charge a fee for this service.
You can buy bonds from a broker, from a commercial bank, over the Internet, or (for Treasury securities) directly from the U.S. Treasury. Shares in bond funds can be purchased through a mutual fund or bond trust.
Monitoring your bond portfolio Of course, you'll want to keep an eye on your bond portfolio, as you should with all of your investments. Although other factors may affect them, bond prices are often closely tied to interest rates. When rates go up, the market price of your bonds tend to go down; when interest rates fall, your bonds generally rise in value.
Interest rates also tend to affect a bond's current yield, which measures the coupon rate of your bond in relation to its current price. The current yield rises with a corresponding drop in the price of a bond, and vice versa. In addition, inflation, corporate finances, and government fiscal policy can affect bond prices.
Mutual Funds: From Mystery to Mainstay
With more than 10,000 mutual funds now available, and most working Americans contributing to them via their employer-sponsored plans, mutual funds are no longer the mystery they once were. Instead, they're the mainstay of many family's investment portfolios.
But if you're new to investing, you may have some questions. What is a mutual fund? And how do they work? This article is designed to answer these and other important questions.
Designed for the Smaller-Net-Worth Investor So you want to invest in, say, the stock or bond market. But you don't have enough cash to diversify your investments. Mutual funds may be the answer.
At its most basic, a mutual fund is a financial intermediary that manages a pool of money from investors who share the same investment objectives. By pooling their money together, the investors can purchase stocks, bonds, cash, and other assets as far lower trading costs than they could on their own. What's more, rather than trying to manage their assets themselves - a daunting challenge even for experienced investors - a mutual fund is overseen by professional asset managers. These experienced managers are responsible for identifying and investing in the securities they believe will best help the fund pursue its investment objective.
A Range of Investment Objectives When you invest in a mutual fund, you are essentially buying shares in the pooled assets and you become a shareholder in the fund.
One of the reasons for the popularity of mutual funds is that not only are they extremely cost efficient and easy to invest in, but you can choose from a wide range of investment options. Some mutual funds, such as money market funds and short-term bond funds, are quite conservative and offer a degree of stability and preservation of your principal. Others, such as aggressive growth funds, pursue above-average returns, generally with the volatility and risk that go along with them. And there are options all along the risk/reward spectrum.
The Added Benefit of Diversification Earlier in this article, the topic of diversification was mentioned. Diversification is the concept of spreading out your money across many different types of investments to reduce the affect of any one investment on your overall returns. When growth stocks are declining, value stocks may be rising. When U.S. stocks are appreciating, international stocks may be falling. Diversifying your investment holdings across asset classes (stocks, bonds, and cash), sectors and industries, and geographic regions can significantly reduce your risk. However diversification does not protect against risk.
The most basic level of diversification is to buy multiple stocks rather than just one stock. A stock mutual funds generally holds many stocks, often between 50 and 100 but frequently many more. Achieving a similarly diversified portfolio on your own by purchasing individual stocks would not only be exponentially more difficult, but also more expensive as the trading costs for buying and selling stocks can quickly eat away a smaller portfolio's value.
Reading A Mutual Fund Prospectus Before investing in any mutual fund, you should read its prospectus. This is a legally mandated document that provides specific information about the fund's investment objectives, managers, the types of securities it may buy, fees and costs, and other pertinent information. Recent legislation mandates that a prospectus must be written in clear, common-sense language that the general public can easily understand.
A mutual fund prospectus should outline these six factors that allow you to evaluate the fund and its potential place in your plan.
1. Investment objective. Is the fund seeking to make money over the long term or to provide investors with cash each month? You'll find the answers in this section of the prospectus.
2. Strategy. This section should spell out the types of stocks, bonds or other securities in which the fund plans to invest. It may look for small, fast-growing firms or large, well-established companies. If it's a bond fund, it may hold corporate bonds or foreign debt. This section may also mention any restrictions on securities in which the fund can invest.
3. Risks. The prospectus should explain the risks associated with the fund. For instance, a fund that invests in emerging markets will be riskier than one investing in the United States or other developed countries. A bond fund should also discuss the credit quality of the bonds it holds and how a change in interest rates may affect those holdings.
4. Expenses. Different funds have different sales charges and other fees. The prospectus will spell out those fees so you can compare them with the fees of other funds. It should also explain the percentage of the fund's return that is deducted each year to pay for management fees and operation costs.
5. Past performance. Although you shouldn't judge a fund solely by its past performance, this can show how consistently the fund has performed and give some indication of how it may fare in the future. This section of the prospectus will also show you the fund's income distributions and its total return.
6. Management. This section may do nothing more than list the fund manager or managers, or it may give specific information about the management team's experience. If the prospectus doesn't contain enough detail, you may be able to find this information in the fund's annual report.
Mutual funds provide investors with a convenient, effective tool for investing in the stock, bond, and cash-equivalent markets. Let me show you how they can apply in your specific situation.
The Importance of Asset Allocation
At first glance, "asset allocation" sounds like a technically complex term but the concept is really quite simple. It refers to how you divide your investable assets among various options including stocks, bonds, real estate, and cash.
Why is this important? Let's consider two examples. A 25-year-old worker who wants to retire a millionaire won't get very far putting all of her money into a bank savings account earning 2% per year. And a 90-year-old retiree certainly wouldn't sleep very well at night knowing his retirement portfolio made up solely of aggressive stocks could suffer major drops in value, which stocks did recently during the bear market of 2000-2002.
Asset allocation is the process of dividing your assets among stocks, bonds, real estate, and cash in a way that fits your financial goals, risk tolerance, and time horizon. Younger workers with decades until retirement and who plan to work for many years can afford to be more aggressive, with a higher percentage of their portfolio in stocks and high-yield bonds. Middle-aged workers approaching retirement and college funding for their children will likely opt for a more conservative approach, with higher portions of their portfolio invested in bonds, real estate, and cash. Retirees who can't afford to risk the volatility of the stock market and living on a fixed income will likely focus on bonds and cash.
Diversifying your funds among different types of investments is an important way to minimize your investment risks. It can also play a large role in the return you can expect. The objective of any asset allocation plan should be to find the asset mix that provides the appropriate combination of expected return and expected risk that will allow you to pursue your financial goals. Choosing the optimal asset allocation for your investments can be pose serious challenges, however.
What may be appropriate for one investor may be entirely inappropriate for another of the same age, income, and wealth - if only because of their tolerance for risk. And the asset allocation that might be right for someone who desires a simple lifestyle might be wholly wrong for someone who dreams of making their retirement truly their "golden years."
We can guide you through the asset allocation process and help you choose the mix of assets that can help you achieve financial goals, whether short, intermediate, or long term.
Exploring Other Investment Alternatives
Investing isn't limited solely to stocks, bonds, and cash (and mutual funds that hold stocks, bonds, and cash). For many Americans, real estate is their largest investment - usually their family home. But there are other ways to invest in real estate too.
Often, some of the best real estate investments may be those you make on your own, such as purchasing your own home, vacation properties, or investment properties ranging from vacant land to apartment buildings and office buildings. Real estate investments are also available through the financial markets. These include real estate investment trusts (REITs) and partnership investments ranging from small "private placements" to larger nationally syndicated and publicly traded partnerships. The era of the real estate tax shelter ended in the mid-1980s, but some of the current partnerships provide some tax-shelter elements. More important today, though, is an evaluation of a project's potential for financial success and its liquidity. If you invest in a partnership, be prepared for the additional delay and complication that a partnership Schedule K-1 may add to your own tax return.
Other Investments Many other investment opportunities exist. These include complex and often very risky instruments such as futures and options; precious metals; and art, antiques, and collectibles of all kinds such as coins and jewelry. In general, these investments carry far greater risk than typical stock and bond portfolios, are less liquid, and may require larger transaction costs to buy and sell. Reliable information regarding these types of investments may also be more difficult to obtain. In some cases, you can acquire publicly traded stocks that will, to some extent, track the appreciation of such items - for instance, stock in a mining company.
At one time, conventional investment portfolio theory dictated that you maintain a small portion of your portfolio in gold or related investments. This is no longer common wisdom. Given these negative aspects, it is also important to point out that many individuals have enjoyed spectacular investment returns from these types of investments. This may often be particularly true for individuals who have more knowledge of certain asset types than the general public. And, of course, for some people these types of investment represent a hobby in which earning money is secondary to their enjoyment.
One way to think of your investment portfolio is as a pyramid. The base is made up of safe, secure holdings such as bank accounts and personal real estate, which each successive tier representing a smaller, more risky, and potentially higher-returning part of your investment mix. As always, we are available to help you make the asset allocation decisions for your individual situation.
Why Working With a Professional Makes Good Sense
You wouldn't think of being operated on by anything less than a board-certified surgeon. Or going into court without qualified legal representation. Or even repairing your late-model car without a trained mechanic. Then why do so many people believe they can manage their own financial affairs without professional guidance?
Investing is often a complex and confusing process. Even success can throw your investment strategy out of kilter. For instance, let's say you want to have 60% of your portfolio invested in stocks. If the market does really well and you are realizing higher than expected returns on your stock investments, after a couple of years you may find that you now have 80% of your portfolio invested in stocks, even though you haven't changed a thing. Without rebalancing to your target asset allocation, you might find yourself getting whipsawed by a volatile market, which happened to literally millions of investors in 2000 through 2002.
No matter what type of investor you are, it's crucial to keep your plan on track. Revisit your asset allocation periodically (every year or so, depending on market conditions) to determine whether it needs adjustment. You should also periodically re-examine your risk tolerance and investment profile, especially as you get closer to your goal. You may discover you need to tweak your portfolio's risk exposure over time.
Sitting down regularly to reassess your goals, time frame, and asset allocation allows you to fine-tune your strategy, keep your risk within acceptable levels, and make sure you're on track. A skilled professional can help you identify investments that not only achieve the greatest absolute return over the years, but also subject you to the lowest overall taxes along the way. Your advisor will also show you how to properly allocate investments among your various accounts and work with you to integrate your investment and financial goals. A truly knowledgeable advisor will also help you stay abreast of developments in the financial marketplace as innovative new products and services become available.
Just as you see your doctor for checkups, your lawyer for legal advice, and your mechanic for tune-ups, consult a qualified financial advisor for financial planning.