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Thursday, September 13, 2018

Personal Financial Planning: A "How-To" Guide (part 5)


Plans To Achieve Your Financial Goals
by
Charles Lamson

Reaching your particular goals requires different types of financial planning. Let's take a brief look at what each major plan category includes.


Asset Acquisition Planning

One of the first categories of financial planning we typically encounter is asset acquisition. We accumulate assets---things we own---throughout our lives. These include liquid assets (cash, savings accounts, and money market funds) used for everyday expenses, investments (stocks, bonds, and mutual funds) acquired to earn a return, personal property (movable property such as automobiles, household furnishings, appliances, clothing, jewelry, home electronics, and similar objects), and real property (immovable property; land and anything fixed to it, such as a house).


Liability and Insurance Planning

Another category of financial planning is liability planning. A liability is something we owe and is represented by the amount of debt we incur. We create liabilities by borrowing money. By the time most of us graduate from college, we have debt of some sort: education loans, car loans, credit card balances, and so on. Our borrowing needs typically increase as we acquire other assets, such as a home, furnishings, and appliances. Regardless of the source of credit, such transactions have one thing in common: the debt must be paid at some future time. The way we manage our debt burden is just as important as how we manage our assets. Using credit effectively requires careful planning.

Obtaining adequate insurance coverage is also essential. Like borrowing money, it is generally something that is introduced at a relatively early point in our life cycle (usually early in the family formation stage). Insurance is a means of reducing financial risk and protecting both income (life, health, and disability insurance) and assets (property and liability insurance). Most consumers regard insurance as absolutely essential, and for good reason. One serious illness or accident can wipe out everything one has accumulated over years of hard work. However, having the wrong amount of insurance can be costly too.

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Go to the Learning Center at www.insurance.com for
helpful information on insurance coverage.

Savings and Investment Planning

As your income begins to increase, so does the importance of savings and investment planning. Initially, people save to establish an emergency fund for meeting unexpected expenses. Eventually, however, they devote greater attention to investing excess income as a means of accumulating wealth, either for major expenditures, such as a child's college education, or for retirement. They acquire wealth through savings and subsequent investing of funds in various investment vehicles---common or preferred stocks, government or corporate bonds, mutual funds, real estate, and so on. The higher the returns on investment of excess funds, the greater wealth they accumulate.

The impact of alternative rates of return on accumulated wealth is illustrated in Exhibit 1. It shows that if you had $1,000 today and could keep it invested at 8 percent, you would accumulate a considerable sum of money over time. For example, at the end of forty years, you would have $21,725 from your original $1,000. Earning a higher rate of return has even greater rewards. Some might assume that earning, say 2 percentage points more---that is, 10 rather than 8 percent---would not matter a great deal. But it certainly would! Note that if you could earn ten percent over the 40 years, you would accumulate $45,259, or more than twice as much as you would accumulate at 8 percent.

Exhibit 1
How a $1,000 Investment Grows Over Time
Eight percent, ten percent. What's the big deal? The deal is more than twice the money over a 40-year period! Because of the power of compound interest, a higher return means dramatically more money as time goes on.

How long you invest for is just as important as how much you earn on your investments. With either rate of return you can accumulate twice as much capital by investing for 40 rather than 30 years. This is the magic of compound interest, which explains why it is so important to create strong savings and investment habits early in life.


Employee Benefit Planning

Your employer may offer a wide variety of employee benefit plans, especially if you work for a large firm. These could include, life, health, and disability insurance; tuition reimbursement programs for continuing education; pension and profit-sharing plans, and 401 (k) retirement plans; flexible spending accounts for child care and healthcare expenses; stock options; sick leave, personal time, and vacation days; and miscellaneous benefits such as employee discounts and subsidized meals or parking.

Managing your employee benefit plans and coordinating them with your other plans is an important part of the overall financial planning process. For example, such benefits as tax-deferred retirement plans and flexible spending accounts offer tax advantages. Some retirement plans allow you to borrow against them. Employer-sponsored insurance programs may need to be supplemented with personal policies. In addition, in today's volatile labor market, you can no longer assume that you will be working at the same company for many years. If you change jobs, your new company may not offer the same benefits. Your personal financial plans should include contingency plans to replace employer-provided benefits.


Tax Planning

Our tax code is highly complex. Income can be used as active (ordinary), portfolio (investment), passive, tax-free or tax-deferred income. Then there are tax shelters, which use various aspects of the tax code (such as depreciation expenses) to legitimately reduce an investor's tax liability. Tax planning considers all these factors and more. It involves looking at an individual's current and projected earnings and developing strategies that will defer and minimize taxes. Tax plans are closely tied to investment plans and will often specify certain investment strategies. Although the use of tax planning is most common among individuals with high incomes, sizable savings can also result for people with lower levels of income.


Retirement and Estate Planning

While you are still working, you should be managing your finances to attain those goals you feel are important after you retire. These might include maintaining your standard of living, extensive travel, plans for visiting children, dining out frequently at better restaurants, and perhaps a vacation home or boat. Retirement planning actually begins long before you retire. As a rule, most people do not start thinking about retirement until well into their forties or fifties. This is unfortunate because it usually results in a reduced level of retirement income. The sooner you start, the better off you will be. Take, for instance, the IRA (individual retirement arrangement), in which certain wage earners are allowed to invest up to $2,000 per year. If you start investing for retirement at age 40, put $2,000 per year in an IRA for 25 years, and earn 10 percent, your account will grow to $196,694. However, if you start your retirement program ten years earlier (at age 30), your IRA will grow to a whopping $542,049. Although you are investing a total of only $20,000 more ($2,000 per year for an extra ten years), your IRA will nearly triple in size.

Accumulating assets to enjoy in retirement is only part of the long-term planning process. As people grow older, they must also consider how they can most effectively pass their wealth onto their heirs, an activity called estate planning. We will examine this complex subject, which includes such topics as wills, trusts, and the effects of gift, estate, and inheritance taxes, in future posts.

Next post: Technology in Financial Planning

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005,  LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 20-23*

END

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