Financial Planning: Achieving Financial Goals through Effective Money Management - Prof. R, Study notes of Financial Management

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Test 1 Study Guide

• Financial planning is important:
  • Need a financial plan because it’s easier to spend than to save
  • Want a financial plan since it helps you achieve financial goals
  • Use financial planning, not to make money, but to achieve goals Control your finances or they will control you -SMART goals- Specific, Measurable, Achievable, Realistic, Trackable -Insurance, salespeople, financial advisors and stockbrokers are paid on commissions
• Paying your financial planner Fee only planners- earn income only through the fees they charge (you will personally have total control of the products purchased to complete your plan) Fee and commission planners- charge fees and also collect commissions on products they recommend ( your fees may be less if you do choose to buy some of their products, if dealing with unethical person- could be directed toward higher commission products) Fee offset planners- charge a fee, but then reduce this fee by any commissions they earn Commission based planners- work on a commission basis, most available type of advisor
• Most financial products pay a commission to someone
• Refer to Figure in notes for Financial Life Cycle: Stage 1- the early years- a time of wealth accumulation (purchase a home, prepare for child rearing costs, save for a child’s education, establish an emergency fund, start retirement savings) - Develop a regular patter of saving- years before age 54 Stage 2- Approaching Retirement- The Golden Years (retirement goals are the center of attention, continuously review your financial decisions, insurance protection and estate planning)- years between 55- 64 Stage 3- The Retirement Years (less risky investment strategy, review insurance, consider extended nursing home protection, estate planning decisions are critical)
• 15 Principles 1- The Risk- Return Trade- off- savings allows for more future purchases, borrowers pay for using your savings, investors demand a minimum return to delay consumption, investors demand higher return for added risk 2- The Time Value of Money- Money received today is worth more than money received in the future, compound interest 3- Diversification Reduces Risk- “Don’t put all your eggs in one basket”, place money in several investments, not just one, diversification reduces risk without affecting expected return, won’t experience great returns or great losses- receive an average return 4- All Risk is not equal- Some risk cannot be diversified away, if stocks move in opposite directions —combining them can eliminate variability. If stocks move in same direction—not all variability can be diversified away 5- The curse of competitive investment markets- in efficient markets- information is instantly reflected in prices, cannot earn higher than expected profits from public information, difficult to “beat the market”- bargains don’t stay bargains for very long

6- Taxes affect personal finance decisions- taxes influence the realized return of investments, maximize after tax return, compare investment alternatives on an after- tax basis, benefit from available tax-deferred options, use annual income tax planning to your benefit 7- Stuff happens or the importance of liquidity- have funds available for the unexpected 8- Nothing happens without a plan- saving must be planned, “can’t save without thinking about it” 9- The best protection is knowledge- take responsibility for your financial affairs 10- Protect yourself against major catastrophes- have the right insurance before a tragedy occurs, know your policy coverage 11- The Time dimension of investing- take more risk on long term investments 12- The Agency problem- beware of the sales pitch- those who act as your agent may actually act in their own interest, find an advisor who fits your needs and is ethical and effective 13- Pay yourself first- pay yourself first so what you spend becomes the residual, reinforce the importance of long term goals, ensuring goals get funded 14- Money isn’t everything- extend financial plans to achieve future goals, know what’s important in life, money doesn’t bring happiness 15- Just do it! - Investment allies (time) is stronger now than it ever will be

• Budgeting Process 1- What is important to the individuals/ household? What values influence goals? 2- Set realistic, progressive goals based on values (short term, intermediate term, long term) 3- Determine present income- if a guess, guess low. Who? When? How much? 4- Estimate present monthly expenses- fixed, flexible, occasional or irregular, oil or misc. 5- Plan a workable spending plan and record sheet; including savings as an expense (include amount planned per expense category, amount actually spent, and any variance) 6- Implement the budge and establish a method of record keeping 7- Try, revise, adjust spending, etc Ratios: - Current Ratio- shows whether you have enough liquid assets to cover expenses currently due (Monetary assets/ current liabilities)—ratio greater than 2 recommended, track trend-if going down- make changes -Month’s living expenses covered ratio- tells how many months living expenses you can cover with your present level of monetary assets (monetary assets/ month’s living expenses)
  • The rule of thumb- 3 to 6 months of expenses
  • factors that affect the rule of thumb (available credit cards or home equity loans, potential for higher earnings on less liquid accounts, stability of income)
  • track the trend and if going down- make changes
  • Debt Ratio- tells whether you could payoff all your liabilities if you liquidate all your assets, represents percentage of assets financed with borrowing, track the trend- ratio should go down with age
  • Long- term debt coverage ratio- ratio tells how many times you could make your debt payments with your current income, ratio of 2.5 or greater recommended, consider the inverse – the percentage of take- home pay needed to repay debt
  • Savings ratio- tells what proportion of your after-tax income is being saved, U.S. rate typically 3%- 8%, varies with stage of the financial life cycle and goals Time value of money
  • Future Value = FV= PV (1+ i) ^n or FV= PV (FVIF I,n)

• Rule of 72- estimates how many years an investment will take to double in value (72/ annual compound growth rate)
• Present value- strips away inflation to see what future amounts are worth today (allows comparison of dollar values from different periods) PV= FVn {1/(1+i)^n} or PV= FVn (PVIFi,n)
• Future Value of an Annuity- FVn= PMT (FVIFi,n)
• Present value of annuity- PV= PMT (PVIFAi,n)
• Perpetuities- an annuity that lasts forever, PV= PP/i
• Marginal Tax Bracket
• Important when investing in a tax- deferred retirement plan: government allows tax deductions for contributions to retirement plans, a $1000 contribution, if you are in the 15% bracket, lowers your taxes by $
• Capital Gains - occurs when a capital asset is sold for a profit tax paid on the gain is a capital gain tax
• Capital Loss- occurs when a capital asset is sold for a loss, can offset capital gains
• Capital gains taxes- are postponed until the asset is sold
• Short term capital gains- gains made from assets held less than 12 months
• Long term capital gains- gains made from assets held for 12 months or longer, tax applies to profits from the sales of stocks, bonds, mutual funds, etc. - doesn’t apply to collectibles
• Taxes on Capital gains:
• Short term rate= “profit” is taxed at the MTB of the owner/ filer
• Long term rate= “Profit” is taxed at 10%, unless you’re in the 10% or 15% tax bracket and then it’s 5%
• Rates return to 20% (MTB of 25% or higher) and 10% (MTB of 10% or 15%) in 2009
• Capital Gains on home
• Taxpayer Relief Act of 1997- effectively eliminated capital gains taxes for most homeowners
• Exempts gains up to $500,000 for couples filing jointly ($250,000 single)
• Home must be the principal residence, must have been occupied for 2 of the past 5 years
• Must have been occupied for 2 of the past 5 years Filing Status
• single- have no dependent children
• Married filing separately- used if couples are separated or getting divorced
• Married filing jointly and surviving spouses- combine income and deductions into a single return
• Head of household- unmarried and living with at least one child or relative Calculating Taxes 1- Determining gross or total income- sum of all taxable income from all sources (active income, portfolio income, passive income) a. Sources of taxable income- wages, salaries, and tips, capital gains, dividends, and interest, alimony, pension funds and traditional IRA distributions, business and farm income, rental and royalty income, social security and unemployment benefits b. Sources of tax- exempt income- roth IRA distributions, state and local municipal bonds interest, gifts and inheritances, child support payments, federal income tax refunds, veterans’ and welfare benefits

2- Calculating Adjusted Gross Income (AGI) - gross income less allowable deductions, include: payments set aside for retirement, some moving expenses, alimony payments a. adjustments- alimony payments, selected moving expenses, selected traditional IRA and other self employed retirement contributions, 50% for social security and Medicare (self- employed only), penalties for early withdrawal of savings, student loan interest (with MAGI limitations) b. Student Loans- maximum of $2500 adjustment for student loan interest paid, MAGI applies (phase out for singles $50000 to $65000; for married filing jointly, $105,000 to $135000), eliminated the 5 year limit 3- Subtracting Deductions- choose between standard deductions or itemizing, standard deduction is the government’s best estimate of what the average person would deduct if itemizing 4- Claiming your exemptions- an exemption is as deduction for each person supported by the income on a tax return, exemptions can be personal or dependency a. Dependency exemptions- relationship or household member test (not related then lived in home all year), earnings not more than exemption amount (except for children under 19 or under 24 if full-time students), provide for more than 50% of support, US citizen or resident of Canada or Mexico 5- Calculating your taxable income, and from that, calculating your base income tax a. Taxable income= AGI – (deductions and exemptions) 6- Subtract your credits and determine your taxes due- tax credits offset taxes in a direct manner- not merely reducing taxable income but offsetting the tax liability dollar for dollar, most have restrictions, some credits are refundable but most aren’t a. Credits= child credit, Hope Scholarship credit, Lifetime Learning credit, Child and dependent care credit, Earned income credit (EIC), adoption credit, elderly and disabled taxpayer credits Balance Sheet- statement of your financial position on a given date, includes assets you own, the debt or liabilities you have incurred, and your level of wealth, which is referred to as net worth Assets: Monetary assets, investments, retirement plans, housing, automobiles, personal property) Current Debt (current bills, credit card debt) Long Term Debt (housing, automobile loans, etc) Total assets- total debt = net worth Income Statement- a statement that tells you where your money has come from and where it has gone over some period of time Take Home pay Total income- income taxes = after tax available for living expenditures Living Expenditures Total housing expenditures, food expenditures, clothing and personal care, transportation costs, recreation costs, medical expenditures, insurance expenditures After tax income available for living expenditures- total living expenditures= income available for saving and investment Causes for concern in planning: uncomfortable in discussing financial matters, motivation and time requirement