Budgeting and Cash Reserves
Establishing and Maintaining Credit
Buy or Leasing
Debt Reduction Analysis
The first step in personal financial planning is controlling your day-to-day financial affairs to enable you to do the things that bring you satisfaction and enjoyment. This is achieved by planning and following a budget, as discussed in the first article in this series.
The second step in personal financial planning, and the topic of this article, is choosing and following a course toward long-term financial goals. As with anything else in life, without financial goals and specific plans for meeting them, we drift along and leave our future to chance. A wise man once said: “most people don’t plan to fail; they just fail to plan.” The end result is the same: failure to reach financial independence.
The third step in personal financial planning, “Building a Financial Safety Net,” is discussed in the third article in this series.
There are no hard and fast rules for implementing a financial plan. The important thing is to do SOMETHING, and to start NOW.
Read the third and final article in the Introduction to Personal Financial Planning series: “Building a Financial Safety Net” to prevent financial disasters caused by catastrophic illnesses or other personal tragedies.
Protecting Your Loved Ones with Life Insurance
Estimating Your Life Insurance Needs
What Type of LIfe Insurance is
Best for You
Creating an Estate Plan with Life Insurance
Long-Term Care Options
Financial Impact of a Disability
Policy Review and Analysis
Do You Have the Right Type of Insurance?
Family Needs Analysis
Long Term Care Needs Analysis
There are two major categories of life insurance: term life and permanent (cash value) life insurance. Within the two broad categories are many types of policies that have been developed over the years in response to consumer demand, market conditions, and changes in the tax laws.
Term life insurance (also called pure insurance) policies provide life insurance protection for a specific period of time or term. If you die during the coverage period, the beneficiary named in your policy receives the policy death benefit. If you don’t die during the term, your beneficiary receives nothing. At the end of the coverage period, you must either renew your coverage or apply for a new policy. Term life insurance is often compared to automobile insurance: You must renew it at the end of every coverage period. If you get into an accident, you collect on the policy, but if you don’t have a claim, you don’t get your money back. Term insurance is available for different time periods ranging from one year to many years.
When you buy permanent insurance, the policy provides insurance protection for your entire life as long as the policy remains in force (meaning the premiums have been paid and the policy hasn’t lapsed or been canceled). In addition to the insurance protection provided by permanent life insurance, this type of policy also builds internal cash values.
Caution: Guarantees are subject to the claims-paying ability of the insurer.
Caution: Variable life insurance and variable universal life insurance policies are offered by prospectus, which you can obtain from your financial professional or the insurance company. The prospectus contains detailed information about investment objectives, risks, charges, and expenses. You should read the prospectus and consider this information carefully before purchasing a variable life or variable universal life insurance policy.
|Policies Covering One Life|
|Policy||Premium Characteristic||Cash Value Characteristic|
|Whole life||Fixed, level||Guaranteed rate|
|Ordinary level premium whole life||Fixed, level||Guaranteed interest|
|Limited-pay whole life||Fixed, level with shorter payment term||Guaranteed interest|
|Current assumption whole life||Premium may change, Guaranteed maximum||May change. Guaranteed minimum interest|
|Variable life||Fixed, level||Returns based on investment performance. Not guaranteed|
|Adjustable life||Can be adjusted by policyowner||Balance varies depending on premium payments. Guaranteed minimum interest|
|Universal life||Flexible at option of policyowner||Balance varies depending on premium payments. Guaranteed minimum interest|
|Variable universal life||Flexible at option of policyowner||Balance varies depending on premium payments. Returns based on investment performance. Not guaranteed|
|Policies Covering More than One Life|
|Joint life (first to die)||Available in many permanent policy types. Death benefit paid at first death.|
|Survivorship||Available in many permanent policy types. Death benefit at death of last person covered Premiums continue until death of last person covered.|
Congress has enacted certain tax laws to limit the use of life insurance policies as tax-preferred investment vehicles. When a policy fails to meet certain insurance definitions and criteria, access to the cash value may be subject to unfavorable tax treatment and penalties.
|Policy Types Subject to Special Tax Rules|
|Modified endowment contract (MEC)||Classification can occur when policy excessively funded in early years or material changes to the policy occur. Cash value loans and withdrawals subject to unfavorable tax treatment and penalties.|
Employer-Sponsored Retirement Plan (401K, 403b)
Strategies for Retirement Plan Distributions
Saving for Retirement
Planning for Income in Retirement
Planning for Income in Retirement
Pension Max Analysis
Retirement Needs Analysis
Retirement planning involves an analysis of the various choices you can make today to help provide for your financial future. To make appropriate choices, you need to predict–as well as you can–your future economic circumstances. You’ll also need to establish your post-retirement goals. When you’ve determined how much of an income stream you’ll probably require in the future, you’ll be in a position to make wise choices now about income, saving, investments, and employer-sponsored or other retirement plans.
Of course, you need to tailor your retirement planning to your own unique circumstances–planning methods may be different for employees and executives than for business owners. And no matter who you are, you’ll probably want to gain some familiarity with the Social Security system, with post-retirement health care insurance coverage, including Medicare and long-term care (LTC) insurance. For some people, retirement may be an eagerly anticipated event, an opportunity to enjoy so many things that working may have precluded–travel, hobbies, and more family time. For other people, even the word “retirement” may conjure up feelings of fear or dread, particularly for those employees who work without the benefit of pension or other retirement plans. And newspaper stories predicting the collapse of the Social Security system can certainly compound anxiety. Whether you are financially comfortable or are of limited means, however, retirement planning is possible and can help you take control of your own future.
To determine your retirement income needs, you’ll want to evaluate your present circumstances–your income, your expenses, your assets, and your debts. Next, you’ll need to think about your future circumstances. There are four main sources for your retirement income: Social Security, pensions or other retirement vehicles, your investment portfolio, and savings. If you predict that your current income will not provide you with your desired retirement lifestyle, there are certain steps you can take now to help change your circumstances.
You’ll want to think about your future sources of income, but also about where you’ll live. Will you continue to live in your current home, for instance, or will you move to a condominium or retirement community? And if your employer typically provides early retirement packages to its employees, you’ll need to know how to evaluate such packages from a number of perspectives.
Learning how to save for retirement is imperative. There are a number of retirement vehicles available, including traditional and Roth IRAs, employer-sponsored retirement plans, nonqualified deferred compensation plans, stock plans, and commercial annuities. Proper retirement planning requires an understanding of the workings of these tools.
In addition, your personal investment planning can help you on the road toward your retirement goals. The sooner you start, the longer you’ll have to accumulate funds for retirement.
You’ll want to understand the taxation of your retirement and investment vehicles. This is especially important since the enactment of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (2003 Tax Act). The 2003 Tax Act reduced the capital gains tax rates and the tax rates of certain dividends, making the decision to allocate assets inside or outside a retirement plan more crucial.
Finally, you may want to learn strategies for handling the competing demands of educating your children and retiring.
Effective retirement planning involves not only an awareness of the types of savings vehicles available, but also an understanding of taking distributions from these vehicles. In particular, you should be familiar with the income tax ramifications of distributions (including a possible 10 percent premature distribution penalty tax for distributions made prior to age 59 1⁄2). You may be interested in knowing whether you can borrow money from your retirement plan, whether it is better to receive your retirement money in one lump sum or in monthly checks, and whether you can roll your retirement plan balance into an IRA.
In addition, you may be concerned about naming one or more beneficiaries for your IRA or employer-sponsored retirement plan. What are the tax implications? What about required minimum distributions from the plan after you reach age 701⁄2?
A number of additional retirement planning tools are often available for executives, such as nonqualified deferred compensation plans offered by employers to their key employees. If you’re an executive, you should realize that nonqualified plans and stock plans can be valuable tools for retirement planning. You should understand the mechanics of the special benefits afforded by your employer, including the tax implications for you.
If you are a business owner, on the other hand, you have some special retirement planning concerns of your own. In particular, you may want to plan for the succession of your business to family members or to others. You may also want to know which retirement plans are best suited to your form of business.
If you’re planning for retirement, you should also consider the Social Security income (if any) you’ll be receiving in the future. In fact, it is possible for you to estimate your Social Security benefits ahead of time. You may want to check your Social Security record periodically to ensure that you have met the eligibility requirements and that your information is accurate and complete.
You’ll also want to become familiar with ways to optimize your Social Security benefits and minimize their taxation. The timing of your receipt of benefits can be important, as can the impact of post-retirement employment. Other governmental programs should also be considered when planning for retirement.
In particular, you should review the topics of Medicare and Medicaid. You should know what Medicare does and does not cover and what other health care options are available to you. How expensive are these governmental and supplemental health programs? What are the eligibility requirements? Medicaid planning can be particularly important for people of modest means. You should know the Medicaid eligibility requirements, the penalties for transferring assets inappropriately, and the various strategies available for protecting assets. In addition, you should become familiar with the specific methods of protecting your personal residence and the extent to which your state can impose liens on your property and pursue recovery remedies after your death. If you are planning for your post-retirement years, you should also gain some familiarity with long-term care insurance, nursing homes, retirement communities, assisted living, and other housing options for elders.
If you work for the federal government, a state government, a railroad, or if you are in the military, your retirement benefits may be subject to special rules. You should know how your retirement plan works, what distribution rules apply, how your survivors can benefit, how your plan may be integrated with Social Security, and what tax rules apply.
Setting Investment Goals
Designing and Managing an Investment Portfolio
Handling Market Volatility
Asset Allocation and Diversification
Taxable and Tax-Free Investing
Morningstar Investment Analysis
Separately Managed Account
If you’re fortunate enough to have money left over after paying the costs of living, you may be able to make that extra money go to work for you by investing it to earn a financial return. Investment planning involves deciding how best to put your money–your capital–to work to achieve your financial goals.
Before you begin investing, you need to secure a strong financial foundation. Be sure these basic steps have been taken:
Once you’ve decided to become an investor, you should “stick your toe in the water” and get a feel for the environment. The investment world is unique and has its own language, resources, markets, and so forth. Don’t dive in until you’re at least somewhat familiar with this new territory. Here are some ways to do this:
Here are some elementary investment terms and concepts you should know:
It may be helpful to think of investment planning as a six-step process:
1. Setting investment goals
2. Understanding your investment personality
3. Designing an investment portfolio
4. Selecting specific investments
5. Managing and monitoring the portfolio
6. Rebalancing or redesigning the portfolio, if needed
The following discussion presents a brief introduction to some issues typically involved in this process.
The first step is simply taking stock of your particular circumstances. Your current financial condition and future expectations are the basis for all further investment decisions. Who you are as an investor (i.e., your investor profile) will determine which investment strategy or strategies you should implement. For example, you may be saving part of your weekly wages for your 2-year-old child’s college education or your own retirement in 30 years. Or, perhaps you want to invest a lump sum for a short period, and then use the money to buy a new house.
To help evaluate your situation, here are a few questions you might consider when setting investment goals :
Understanding risk is a key part of the investment planning process. A smart investor needs to fully comprehend how risk is measured and its potential ramifications. You also need to determine your own risk tolerance. Remember, no investment plan is likely to be successful if it doesn’t fit your temperament and your individual financial situation.
You have reached step three in the investment planning process: designing and managing an investment portfolio . So far, you have done some research, data gathering, and a lot of thinking. Now you need to actually make some concrete decisions–matching your investment goals and personality to a combination of various investment categories, whether they be simple investments, such as CDs, or more complex investments, such as stocks or real estate. The process of determining how much of your assets to put into each of various categories of investments is known as asset allocation.
No one asset allocation strategy is appropriate for everyone. For long-term investors who want high growth and don’t need current income, an aggressive plan–one that focuses primarily on potential growth–might be established. For example, an aggressive investment plan might include 40 percent large company stocks, 25 percent small company stocks, 30 percent international stocks, and 5 percent cash alternatives. By comparison, for investors who put a higher priority on current income and stability than growth, a more conservative plan might be established; for example, it might consist of 15 percent large company stocks, 5 percent international stocks, 55 percent bond funds, and 25 percent cash alternatives. Any combination is possible; these are only hypothetical examples. The plan that suits you best depends on your own investor profile.
The major categories of investments available for inclusion in an asset allocation strategy are shown in the following table:
|Investment Category||Examples of Investment|
|Cash alternatives (liquid assets)||Bank CDs, U.S. savings bonds, Treasury bills|
|Debt instruments||Bonds, mortgage-related securities|
|Treasury securities||Issued by agencies of the U.S. government|
|Insurance-based investment products||Annuities, cash value life insurance|
|Real estate||Direct investments and via trusts|
|Collectibles||Art, antiques, gems, and collectibles|
|Alternative assets||Metals, commodities, warrants, options|
Tip: Asset allocation is extremely important. Seeking the advice of an experienced financial professional is recommended at this stage.
You’ll also need to understand the various financial markets well enough to select individual investments, which can be a daunting (and time-consuming) task. If you do not have the time or inclination to evaluate markets and investments , you can seek the advice of a money manager or financial advisor whom you trust. For the do-it-yourself investor, a wise investment decision involves some knowledge of the capital markets, investment theory, how stocks and bonds are traded, how the stock market functions, and how securities are priced, among other things. With a little education, you will soon be able to determine what rate of return you can reasonably expect to earn from a particular investment and how much risk you’ll need to take to pursue that return.
Caution: Always get professional help if you are dealing with a complicated or unusual issue. Also, remember that all investment involves risk, including the possible loss of principal, and there can be no guarantee that any investment strategy will be successful.
You have a plan, you have a list, and now you need to actually begin investing your money. It’s time to set up your investment account, select specific investments, and otherwise begin building your portfolio in a way that’s consistent with your goals and selected strategies.
Once your investment plan is set in motion, your portfolio needs ongoing management . You should review your plan regularly to make sure it’s on track. As your circumstances or the investment landscape change, your portfolio may need some adjusting. That review can occur, monthly, quarterly, semiannually, or annually, depending on the types of investments you own and your own need and desire to monitor your investments.
During your periodic reviews of your portfolio, you may find you need to make changes if it is not performing as expected. For example, you may need to rebalance or redesign your portfolio . Rebalancing means adjusting the amount invested in various categories to return to the original asset allocation; redesigning your portfolio would involve adjusting it to take into account significant changes in the market or your personal situation.
Saving for College
Repaying Studnet Loans
Education Tax Credits and Deductions
Education Needs Analysis
Section 529 plans are popular college savings vehicles. Due to the demand for them, nearly every state now operates at least one type of 529 plan (either a prepaid tuition plan or a college savings plan), and an increasing number are offering both. To choose the type of 529 plan that’s right for you, it’s important to understand how prepaid tuition plans and college savings plans work and the differences between them.
As 529 plans, both college savings plans and prepaid tuition plans offer significant federal tax advantages. Funds in each type of plan grow tax deferred, and withdrawals from either plan used for the beneficiary’s qualified education expenses are completely income tax free at the federal level. But despite these shared tax advantages, college savings plans and prepaid tuition plans are different creatures.
A college savings plan lets you build an education fund within an individual investment account. Money you contribute is invested in one or more specific investment portfolios. Each portfolio consists of a mix of investments (typically mutual funds) that are chosen and managed exclusively by the plan’s designated money manager. You generally pick your investment portfolio at the time you open an account, or else one is automatically chosen for you. Your investment return is not guaranteed.
In contrast, a prepaid tuition plan lets you purchase tuition now for use in the future. There are generally two types of prepaid tuition plans: contract plans and unit plans. A contract plan (sometimes known as a guaranteed interest plan) promises to cover a predetermined amount of tuition expenses in the future, in exchange for your lump sum or periodic contributions.
With a unit plan, you purchase a certain percentage of units or credits and the plan guarantees that whatever the percentage of college costs such units cover now, the same percentage will be covered in the future. For example, assume that 100 tuition credits are required to fund one year’s worth of tuition at State University today. You purchase 100 credits today for $8,000. The result is that when your child starts college at State University in 12 years, your $8,000 will theoretically pay the entire first year of tuition, even though tuition costs may have risen to $20,000 per year by then.
Note: Even though prepaid tuition plans typically guarantee your investment return, plans sometimes announce modifications to the benefits they’ll pay out due to projected actuarial deficits.
At one time, only states could offer prepaid tuition plans and college savings plans. (In practice, the states designate an agent, usually an experienced financial institution, to manage and administer their plans). But colleges and universities can now offer their own prepaid tuition plans. These plans are sometimes referred to as private prepaid tuition plans, and the beneficiary is limited to attending the college(s) in the plan. However, the remainder of this discussion refers to state-sponsored prepaid tuition plans.
College savings plans and prepaid tuition plans differ on the way your contributions are invested. With a prepaid tuition plan, there are no individual investment accounts. Instead, your contributions go into a general fund, and the plan’s money manager is solely responsible for investing the pooled money to meet the plan’s future obligations to its participants. Your only concern is with the predetermined amount of tuition that the plan has agreed to cover in the future, or the percentage of tuition costs that the units or credits you’ve just purchased will eventually cover.
With a college savings plan, your contributions are held in an individual investment account in one or more specific investment portfolios. The trend is for plans to let you choose your investment portfolio at the time you open an account. Typically, plans offer a variety of options–from aggressive to conservative–so you can choose a portfolio that matches your risk tolerance, time horizon, and other factors. But remember, the plan’s money manager handles the underlying investment mix in each portfolio on a day-to-day basis–you have no say in this process.
Some states may not let you choose your investment portfolio when you join the plan. Instead, they will automatically assign you a portfolio based on the beneficiary’s age (called an age-based portfolio). With an age-based portfolio, the underlying asset mix consists of more aggressive investments when the beneficiary is young (such as stock mutual funds) and then is gradually and automatically shifted to less volatile investments (like bond funds and money market funds) as the beneficiary nears college. The idea is to take advantage of the potential for higher returns (with the accompanying risk) when the beneficiary is young, and then preserve principal as the beneficiary approaches college age.
Once you’ve settled on an investment portfolio for your college savings plan account, you have limited opportunities to change it if you’re not happy with its investment performance. Under IRS rules, plans are authorized, but not required, to let you change your investment portfolio twice per calendar year or at any time you change the beneficiary. Some plans may also allow you to direct future contributions to a new portfolio. Such investment flexibility can make one plan stand out among others, so it’s always a good idea to check the specific investment rules of any plan you’re considering.
You also have another option guaranteed by federal law. You can roll over the funds in your existing college saving plan account to another 529 plan (college savings plan or prepaid tuition plan) once every 12 months without penalty. The beneficiary stays the same.
In your effort to pick a suitable portfolio, keep in mind that no investment in a college savings plan is guaranteed–you could lose money that you’ve contributed. That’s why it’s important to investigate the reputation and overall investment performance of the institution that manages the college savings plan, as well as the performance history of individual portfolios in the plan.
Yes. Most college savings plans are open to residents of every state. This means you can shop around for the plan that offers the combination of features you want. (But keep in mind that if you join another state’s college savings plan, you’ll generally be entitled only to the state tax benefits offered by your state.) Beyond that, you can open a college savings plan at any time of the year, and the account can generally remain open indefinitely. This gives you flexibility if your child decides to postpone his or her education.
By contrast, most prepaid tuition plans are limited to state residents only. And once you open an account, all tuition credits generally must be used by the time your child turns 30, and all withdrawals completed within 10 years from the time your child starts college. Also, at some point before your child starts college, you (the account owner) are required to inform the plan administrator when you expect to start redeeming credits. Finally, some prepaid tuition plans let you join only during specific enrollment periods.
College savings plans give you more flexibility in paying your beneficiary’s education expenses. Funds in a college savings plan account can be used to pay for tuition, books, equipment, fees, other costs, and room and board (assuming the beneficiary is enrolled at least half-time) at any college accredited by the U.S. Department of Education. This includes undergraduate colleges, graduate and professional schools, two-year colleges, technical and trade schools, as well as some foreign colleges and universities.
By contrast, prepaid tuition plans are typically designed to pay only for undergraduate tuition costs at in-state public colleges–other expenses like room and board, books, and graduate school may not be covered. However, such restrictions are imposed by the individual prepaid tuition plans themselves, because Section 529 of the Internal Revenue Code allows a broader interpretation of qualified education expenses. Make sure you understand exactly what education expenses your prepaid tuition plan covers, as well as the tuition equivalent you’ll receive if your child attends a private or out-of-state college.
College savings plans, like other types of managed accounts such as mutual funds and annuities, are managed by professional money managers who pass along their investment expenses to account owners. In addition, the plan manager will charge you a fee for administering your account. Both of these fees are usually equal to a percentage of your total account value. Some college savings plans may also tack on a flat annual maintenance fee, though this may be waived if you sign up for automatic payroll deduction or direct debiting of your checking account. Because fees and expenses vary among plans and can affect your account’s total return, examine them carefully.
Prepaid tuition plans typically charge a flat enrollment fee at the time you open your account, but generally there are no ongoing charges. However, you may be assessed fees for late payment, returned checks, changing the beneficiary, changing the beneficiary’s enrollment date, document replacement, or other administrative matters.
You may want to ask the following questions to help you better compare the fees of college savings plans vs. prepaid tuition plans:
Withdrawals from a college savings plan or a prepaid tuition plan used to pay the beneficiary’s qualified education expenses (as defined by the individual plan within federal guidelines) are completely income tax free at the federal level. And if your state exempts such withdrawals from income tax too, it does so for both college savings plans and prepaid tuition plans.
A withdrawal not used for the beneficiary’s qualified education expenses is called a nonqualified withdrawal. If you make a nonqualified withdrawal from a college savings plan account or a unit type of prepaid tuition plan (where you purchase tuition credits), a 10 percent federal penalty will apply on the earnings portion of the withdrawal (a state penalty may also apply). What’s more, the earnings portion of the withdrawal will be subject to federal and state income tax.
A nonqualified withdrawal isn’t possible if you have a contract type of prepaid tuition plan. If you want to get your money out of this type of plan, your only choice is to cancel your contract and have your money refunded. (If you do cancel, you may only get back your actual contributions, with no interest or earnings included. Other plans will refund your principal plus a low rate of interest, which is then taxable at regular income tax rates.)
Under the federal financial aid rules, assets are classified either as a parent’s asset or a child’s asset. This classification determines the assessment rate of the asset. The assessment rate is the portion of the asset that you are expected to use for the current year’s college expenses. (Income is also classified this way.)
The federal government treats prepaid tuition plans the same as college savings plans for financial aid purposes. These plans are reported on the federal aid application as an asset of the parent, if the parent is the account owner, and assessed at a rate of 5.6 percent (they’re not reported at all if the account owner is someone else, for example, a grandparent). Any distributions (withdrawals) from the plan that are used to pay the beneficiary’s qualified education expenses are not counted as either parent or student income.
Regarding institutional aid (aid distributed by colleges from their own endowments), most colleges treat both college savings plans and prepaid tuition plans as parental assets and withdrawals as student income.
The availability of the tax or other benefits mentioned above may be conditioned on meeting certain requirements.
Note: Investors should consider the investment objectives, risks, changes, and expenses associated with 529 plans before investing. More information about 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. As with other investments, there are generally fees and expenses associated with participation in a 529 savings plan. There is also the risk that the investments may lose money or not perform well enough to cover college costs as anticipated.
Income Tax Planning
Year-End Tax Planning
Investment Tax Planning
Alternative Minimum Tax (AMT)
Gift and Estate Taxes
Roth Conversion Analysis
Investment planning can be important for several reasons. However, any discussion of investment planning is incomplete without a thorough understanding of the applicable income tax ramifications. Tax planning can help you reduce the tax cost of your investments. Once you’ve created an investment plan to work toward your various financial goals, you should take advantage of the tax rules to ensure that you maximize the after-tax return on your investments. In other words, your goal is to select tax-favorable investments that are consistent with your overall investment plan.
In order to engage in investment tax planning, you need to understand how investments are taxed (including the concepts of capital gain income and ordinary income) and how to compare different investment vehicles. You also need to know how your own tax situation (i.e., your tax bracket, holding period, and tax basis) affects the taxation of your capital assets.
Caution: Investment choices should not be based on tax considerations alone, but should be based on several factors including your time horizons and risk tolerance.
Caution: Starting in 2013, a new 3.8 percent unearned income Medicare contribution tax will be imposed on the investment income of high-income individuals (generally, married individuals filing jointly with modified adjusted gross income (MAGI) exceeding $250,000, married individuals filing separately with MAGI exceeding $125,000, and single individuals with MAGI exceeding $200,000).
Similar investments may carry substantially different tax costs. It is important to identify the differences and evaluate the costs. Consider the following points:
A myriad of investment vehicles are available to you. For instance, you can invest in stocks, bonds, mutual funds, money market funds, real estate, commodities, or your own business. Investment earnings are taxed in many different ways . Consequently, some investments earn less after tax than others. By taking advantage of these differences, you may save money. In addition, your tax savings can preserve your investments and, as a result, enhance future investment growth.
Tax investment planning involves maximizing the after-tax return on your investments. This is beneficial because the wealth that remains after you pay your taxes is ultimately more important to you than the value of your investments. It’s the after-tax payout that enables you to finance a home, a child’s education, a vacation, or your retirement. Thus, one goal of investment tax planning is to maximize future wealth. To do so, you need to know a little bit about taxes. In particular, you need to know the following:
In order to understand how investments are taxed, you first need to become familiar with the following basic concepts:
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March 03, 2016
• Tax-deferred income
While you hold a capital asset (e.g., your home, stocks, bonds, mutual funds, real estate, collectibles), you will not pay taxes on any increase in value. However, when you sell or exchange the asset, you will realize a capital gain (if you sell it for a profit) or loss (if you sell for less than the asset’s cost). If you sell an asset after only a year or less, you will have a short-term capital gain. Short-term capital gains are taxed at ordinary income tax rates (i.e., your marginal income tax rate). If you own an asset for more than a year before you sell it, you will have a long-term capital gain.
Long-term capital gains tax rates are generally more favorable than ordinary income tax rates. Currently, the highest ordinary income tax rate is 39.6 percent whereas the highest long-term capital gains tax rate (for most assets) is 20 percent. That’s a difference of 19.6 percent. Thus, holding an asset for long-term growth is a tax-saving strategy.
Tip: Long-term capital gains are generally taxed at a capital gain rate of 0 percent for taxpayers in the 10 and 15 percent marginal tax brackets, 15 percent for taxpayers in the 25 to 35 percent marginal tax brackets, and 20 percent for taxpayers in the 39.6 percent marginal tax bracket.
You may offset capital gains with capital losses (short-term losses against short-term gains and long-term losses against long-term gains). If you have more losses than gains in a given year, you may offset up to $3,000 of ordinary income ($1,500 if married filing separately). Any remaining losses can be carried forward into future tax years. Thus, timing losses to offset gains is a tax-saving investment strategy.
Tip: You may also elect to include net capital gains from property held for investment as ordinary (investment) income. If you do so, such income will be taxed at ordinary income tax rates, not capital gains tax rates. This may be advantageous if you don’t have capital losses, but do have investment interest expenses. Investment interest expense may only be deducted to the extent of investment income (though it can also be carried forward to future years). This election must be specifically made–if you do not make the election, the IRS will classify the income as capital gain income.
Capital gain is computed by subtracting the sale price from the asset’s basis. Basis is your cost and includes the price you paid for the assets plus the cost of capital improvements. The higher your basis, the smaller your capital gain and the smaller your tax liability. Thus, you should keep careful records of the basis of an asset. This is especially important if you buy shares of stock in the same company at different times and different prices. This will allow you to control the tax consequences by picking particular shares to sell or hold.
Tip: If you want to sell an asset now but defer the recognition of the gain until later tax years, you may be able to arrange an installment sale with the buyer (but not for stocks or bonds). That way, you report and pay tax on the income as you receive it.
Qualified dividends are dividends received during the tax year by an individual shareholder from a domestic corporation or a qualified foreign corporation. Such dividends are taxable at the same rates that apply to long-term capital gains. This tax treatment applies to both regular tax and the alternative minimum tax.
Eligible dividends include dividends received directly from a domestic corporation or a qualified foreign corporation as well as qualified dividends passed through to investors by stock mutual funds, other regulated investment companies, partnerships, or real estate investment trusts (REITs). Thus, it may be advantageous to invest in vehicles that pay qualified dividends, especially if you need current income.
Distributions from tax-deferred vehicles, such as IRAs, retirement plans, annuities, and Coverdell education savings plans, do not qualify even if the funds represent dividends from stock. Thus, holding investments that pay qualified dividends within a tax-deferred plan may no longer be desirable.
Tip: Though qualified dividends are taxed at long-term capital gains tax rates, they cannot be offset by capital losses. However, as with capital gains, you can elect to include these dividends in investment income. If you do so, such income will be taxed at ordinary income tax rates, not capital gains tax rates. This may be advantageous if you have investment interest expenses in excess of investment income. Investment interest expense may only be deducted to the extent of investment income (though it can also be carried forward to future years). This election must be specifically made–if you do not make the election, the IRS will classify the income as net capital gain.
Ordinary investment income consists of any investment income that is not capital gain income, qualified dividends, or tax-exempt income, and is taxed at ordinary income tax rates. Investment income is generated by investment property such as bonds and bond mutual funds. Examples of ordinary investment income include interest and dividends that are actually interest (and therefore don’t qualify for taxation at long-term capital gains tax rates).
Generally, ordinary income tax treatment is not as favorable as long-term capital gains tax treatment.
If you borrow money to buy investment property, you probably pay investment interest. Investment interest may be used to offset investment income only. Excess investment interest may be carried forward to future years. Other investment expenses (e.g., commissions, fees) are deductible as an itemized deduction on Schedule A and are subject to the 2 percent limit.
A passive activity is an investment in a business in which you are not an active participant. Rental real estate and limited partnerships are two common examples. Income generated by a passive activity and gain from the sale or exchange of a passive activity is included in passive income and taxed at ordinary income tax rates. Generally, losses from passive activities may offset income from passive activities only–they cannot be used to offset ordinary income or capital gain income. However, excess losses in a given year can be carried forward into future tax years.
There are a number of tax-exempt investment vehicles . One of the more common vehicles is the municipal bond. Usually, interest paid on municipal bonds is not subject to federal or state tax (at least not in the state of issue). When deciding whether to invest in taxable bonds or tax-exempt bonds, it is important to compare the after-tax rate of return on municipals with that on taxable bonds with similar risk.
Caution: While the interest on municipal bonds is tax exempt, capital gains tax may be imposed when you sell the bonds.
Caution: The interest on U.S. Government bonds is not exempt from federal income tax. However, the interest on federal securities is tax exempt at the state level.
Tip: Roth IRAs , although technically vehicles for holding investments and not truly investments themselves, should be discussed under the heading of tax-exempt income. A Roth IRA is a vehicle in which you can invest a limited amount of money each year for retirement and certain other limited purposes (assuming that you satisfy certain criteria including adjusted gross income (AGI) limits). The income and gains on the account are not taxed at all as long as you follow all applicable rules. Be aware, though, that if all applicable rules are not followed, withdrawals will not only be subject to tax, they may also be subject to a penalty. Tax-free growth is clearly one of the most powerful investment tools available for creating wealth. However, you must use after-tax dollars to make the initial investment and subsequent contributions. No IRA deduction is allowed for contributions to Roth IRAs.
Tax-deferred investments produce earnings that are not taxed until withdrawn. These earnings are reinvested and continue to fuel investment growth. This is one of the most powerful investment tools available. First, there is a time-value of money advantage. The longer you can keep the money in your own pocket and out of the hands of the IRS, the greater the potential benefit will be to you. Second, since our income tax rates are progressive, you may find yourself in a lower tax bracket in the year the earnings are finally taxed. If so, the actual amount of tax paid on those investment earnings will be less. On the other hand, if you find yourself in a higher tax bracket in the year the earnings are finally taxed, the amount of tax paid on the earnings will be higher (assuming all else is equal).
Caution: Many retirement vehicles are designed to provide tax-deferred growth. The downside of this benefit is that all distributions from the retirement plan are taxed at ordinary income rates rather than at capital gains rates. This can result in potentially higher taxation in light of the progressively higher ordinary income tax rates.
To compare investments, you must understand before- and after-tax rates of return. Ultimately, you want to compare the after-tax rate of returns of similar investments. The rate of return is the ratio of the annual amount an investment earns compared to the cost of the investment. Thus, if an investment cost you $10 and earned $1, the rate of return is 10 percent.
The before-tax rate of return is the annual market-rate of return. For example, a $10 bond that pays $1 per year in interest and is sold for $10 earns a 10 percent before-tax rate of return.
The after-tax rate of return is the ratio of the after-tax income and gain to the amount invested. With the exception of tax-free investments, this rate is always lower than the before-tax or market rate of return. What do you need to know to compute the after-tax rate of return? Generally, you need to know the following:
Comparison shopping for investments allows you to compare the after-tax return on two similar investments. In order to effectively make this assessment, you must consider two other issues:
You need to know whether the investment vehicle generates capital gains, ordinary income, tax-free, or tax-deferred income. There are two components to the after-tax rate of return: the portion attributable to earnings (such as interest) and the amount derived from a subsequent sale. You also need to know whether any capital gains will be treated as long-term or short-term capital gains.
Special rules can apply to certain kinds of investments such as wash sales, qualifying small business stock, short sales, installment sales, like-kind exchanges, and others. In addition, you may wish to know about market discount rules, anti-conversion rules, and tax shelters.
Your investment tax situation depends on several factors. In particular, you’ll need to know the adjusted tax basis of your capital assets, the sale price of the assets, the holding period, the amount of the capital gain or loss , the amount of your ordinary investment income or losses , and your marginal tax bracket.
Wills and Trust
Planning for Incapacity
Creating and Preserving a Family Legacy
Using Life Insurance in Estate Planning
Strategies to Minimize Estate Taxes
Charitable Gifting Strategies
Financial Fire Drill
Simply stated, estate planning is a method for determining how to distribute your property during your life and at your death. It is the process of developing and implementing a master plan that facilitates the distribution of your property after your death and according to your goals and objectives.
At your death, you leave behind the people that you love and all your worldly goods. Without advance planning, you have no say about who gets what, and more of your property may go to others, like the federal government, instead of your loved ones. If you care about (1) how and to whom your property is distributed, and (2) ensuring that your property is preserved for your loved ones, you need to know more about estate planning.
As a process, estate planning requires a little effort on your part. First, you’ll want to come to terms with dying, at least to a degree that you can deal with the necessary planning. Understandably, your death can be a very uncomfortable subject, but unfortunately, the discussions in this area are full of references to your death, so it really can’t be avoided. Some statements may seem too businesslike and unfeeling, but tiptoeing around the subject of dying will only make the planning process more difficult. You will understand the process more easily and implement a more successful master plan if you approach it in a straightforward manner.
Estate planning may be important to individuals with a wide range of financial situations. In fact, it may be more important if you have a smaller estate because the final expenses will have a much greater impact on your estate. Wasting even a single asset may cause your loved ones to suffer from a lack of financial resources.
Your master plan can consist of strategies that are simple and inexpensive to implement (e.g., a will or life insurance). If your estate is larger, the estate planning process can be more complex and expensive.
Implementing most strategies will probably require you to hire professional help of some kind, an attorney, an accountant, a trust officer, or an insurance agent, for example. If your estate is large or complex, you should consult with an estate planning expert such as a tax attorney or financial planner for advice before the implementation stage.
In deciding on your course of action, you should always consider whether the benefit of the strategy outweighs the cost of its implementation.
You may need to plan your estate especially if:
Designing a plan is a process that is unique to each estate owner. Don’t be intimidated or overwhelmed at the prospect. Even the most complex plan can be achieved if you proceed step by step. Remember, the peace of mind that comes with developing a successful estate plan is worth the time, trouble, and expense.
Begin the estate planning process by understanding your particular circumstances, such as your age, health, wealth, etc.
You will also need to have some understanding of the factors that may affect the distribution of your estate, such as taxes, probate, liquidity, and incapacity.
When your particular circumstances and the factors that may affect your estate are clear, your goals and objectives should come into focus.
With these goals and objectives now clear, you can begin to consider the different estate planning strategies that are available to you.
Seeking professional help (an attorney or financial advisor) will help you understand the strategies that are available and formulate and implement your master plan.
Finally, after following these steps, you can formulate and implement a plan that works for you. Here are a few basic tips: (1) make sure you understand your plan, (2) rely on people you trust, and (3) keep your documents and information organized and within easy reach.
When you have implemented your master plan, be sure to perform a periodic review and, if necessary, make revisions that reflect any changing circumstances and tax laws.
There are many estate planning strategies, including some that are implemented inter vivos (during life), such as making gifts, and others post-mortem (after death), such as disclaimers. Before you choose which strategies are right for you, you need to understand your particular circumstances.
Understanding your particular circumstances results from gathering and analyzing the facts. The following questions may help you to accomplish this. If they are not easy to answer, you may have to make some estimates based on reasonable assumptions and expectations.
Information regarding your financial condition
Decide what your goals and objectives are in light of your particular circumstances and in light of the factors that may affect your estate. The primary factors that may affect your estate are your beneficiaries, taxes, probate, liquidity, and incapacity.
One of the largest potential expenses your estate may have to pay is taxes, which may include federal transfer taxes, state death taxes, and federal income taxes.
Federal transfer taxes–The federal transfer taxes include (1) the federal gift tax and estate tax and (2) the federal generation-skipping transfer (GST) tax.
State death taxes–States also impose their own death taxes. You should be aware of what the death tax laws are in your state and how they may affect your estate. There are three types of state death taxes: (1) estate tax, (2) inheritance tax, and (3) credit estate tax (also called a sponge tax or pickup tax). Some states also impose their own gift tax and/or generation skipping transfer tax.
Tip: Most states that imposed a credit estate tax have “decoupled” from the federal system (i.e., they’re imposing some form of stand-alone estate tax.)
Tip: The federal system allows a deduction for state death taxes for the estates of persons dying in 2005 and later. Prior to 2005, a credit was available.
Federal income taxes–In the estate planning context, you should be aware of three federal income tax considerations:
Probate is the court-supervised process of proving, allowing, and administering your will. The probate process can be time-consuming, expensive, and open to public scrutiny. Avoiding probate may be one of your most important goals. To develop a successful avoidance strategy, you’ll need to understand how the probate process works, how to estimate probate costs, and what is subject to probate.
Estate liquidity refers to the ability of your estate to pay taxes and other costs that arise after your death from cash and cash alternatives. If your property is mostly nonliquid (e.g., real estate, business interests), your estate may be forced to sell assets to meet its obligations as they become due. This could result in an economic loss, or your family selling assets that you intended for them to keep. Therefore, planning for estate liquidity should be one of your most important estate planning objectives.
Planning for incapacity is a vital yet often overlooked aspect of estate planning. Who will manage your property for you when you can no longer handle these responsibilities? You need to ask and answer this question because the consequences of being unprepared may have a devastating effect on your estate and loved ones. You should include plans for incapacity as a part of your overall estate plan.
Your goals and objectives are personal, but you can’t formulate a successful plan without a clear and precise understanding of what they are. They can be based on your particular circumstances and the factors that may affect your estate, as discussed earlier, but your feelings and desires are just as important. The following are some goals and objectives you might consider:
An estate planning strategy is any method that facilitates the distribution of your assets and the settlement of your estate according to your wishes. There are several estate planning strategies available to you.
Intestate succession is a strategy by default and is a means of transferring your property to your heirs if you have failed to make other plans such as a will or trust. State law controls how and to whom your property is distributed, who administers your estate, and who takes care of your minor children. Without directions, your opinions and feelings are not considered. Indeed, one of your primary goals in planning your estate may be to avoid intestate succession.
A will is a legal document that lets you state how you want your property distributed after you die, who shall administer your estate, and who will care for your minor children. This is probably the most important tool available to you. Anyone with property or minor children should have a will.
A will substitute, for example, Totten Trust and payable on death bank accounts, allows you to designate a beneficiary of certain property that will automatically pass to that beneficiary after you die and avoids passing through probate.
A trust is a separate legal entity that holds your assets that are then used for the benefit of one or more people (e.g., you, your spouse, or your children). There are different types of trusts, each serving a different purpose, and include marital trusts and charitable trusts. You will need an attorney to create a trust.
Joint ownership is holding property in concert with one or more persons or entities. There are different types of joint ownership, such as tenancy in common and community property, each with different legal definitions, requirements, and consequences.
Life insurance is a contract under which proceeds are paid to a designated beneficiary at your death. Life insurance plays a part in most estate plans.
A gift is a transfer of property, not a bona fide sale, that you make during your life to family, friends, or charity. Making gifts can be personally gratifying as well as an effective estate planning tool.
There are several important estate planning tools you can use that are offered by the federal government. These include the annual gift tax exclusion, the applicable exclusion amount, the unlimited marital deduction, split gifts, and the charitable deduction.
Buying a Home
Raising a Family
Child with Special Needs
Starting a Business
Caring for an Aging ParentGetting
Death of a Family Member
Starting or Buying a Business
Choosing a Business Entity
Business Tax Planning
Retirement Plan Options
Business Succession Planning
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