Category Archives: Financial Planning

A Few Financial Tips That Not Everyone Knows

Sometimes, little known rules can mean big money. Here are a few examples:

  1. A Roth IRA conversion is possible even after Required Minimum Distributions have started at age 70½. Just be sure to withdraw (not convert) the RMD for the year from your Traditional IRA before doing any Roth IRA conversions that year. A Roth IRA conversion is especially worth considering if you do not need all of your Traditional IRA funds to support your retirement expenses. Any funds converted into a Roth IRA will no longer have RMD requirements during your lifetime.
  2. Are you near the Social Security retirement age? Have you heard of strategies like “file and suspend” and “restricted application”? If you are married, you are entitled to a Social Security benefit based on (1) your own work record or (2) your spouse’s work record. It is possible to receive a spousal benefit while allowing your own work record benefit to grow until age 70. If any of this is news to you, do some research now!
  3. When a married couple holds community property in a community property state, 100% of the asset’s cost basis (not just one spouse’s 50% interest) gets reset at the asset’s fair market value at the death of the first spouse. This feature of the tax law can potentially save you big money on capital gains taxes. If this situation applies to you, consult a tax advisor about whether you should file an estate tax return (IRS Form 706) for the deceased spouse to document the new cost basis. You may need a valuation appraisal for real estate or closely held business interests. For publicly traded stocks or mutual funds, you can just use market trading prices.

Seven Ways to Organize Your Financial Life

Do you know where all of your financial accounts are located? Do you have a list of your insurance policies? Can you easily gather your tax records? Do you know how much cash flow comes in and goes out? If you answered “no” to any of these questions, do not feel bad. I think most people have room for improvement when it comes to getting financially organized. Here are a few tips:

  1. Take control of your paper. Gather and file important paper documents (e.g., birth certificates, real estate title documents, automobile titles documents, Social Security cards, estate planning documents). Shred any unnecessary documents.
  2. Limit paper documents. If a scanned copy is acceptable for a particular document, scan it into your computer and shred the original. Choose e-delivery (instead of paper delivery by mail) of bills and statements whenever possible. Of course, backup your data on a regular basis.
  3. Make lists of financial accounts, insurance policies, and debts owed. These lists may be helpful to your family members in the event of an emergency. In addition, you might uncover accounts that you forgot about, insurance policies that are redundant or unnecessary, or loans that can be paid off.
  4. Consolidate your accounts. Do you have five 401(k) accounts from prior employers? Unless you need a particular feature of an old 401(k) plan, roll over your old 401(k) accounts into a IRA. Do you have accounts at multiple banks? Unless you need multiple banks to magnify your FDIC insurance coverage, consider consolidating your bank accounts into two banks: one local bank for your everyday checking account and one online bank that offers a savings account with a high interest rate. Do you have five credit cards? You get the picture…
  5. Automate your finances. Do you want to save 10% of your paycheck? Set up a recurring transfer from your checking account to your online savings account after every paycheck direct deposit. Consider automatically reinvesting mutual fund dividend and capital gain distributions (especially in tax-deferred or Roth accounts).
  6. Develop a financial planning calendar. See my article posted on April 22, 2013. You can use software like Microsoft Outlook or just manually create a calendar.
  7. Track your cash flow. This is probably the most time consuming recurring task on this list, but knowing your cash flow is crucial to meeting your financial goals. I think the best way to track your cash flow is to use software like Quicken. If tracking every minor cash expenditure is too tedious for you, then track everything else (e.g., bank, credit card, and investment transactions) and assign all cash withdrawals to a “cash expense” category. You should be able to answer questions like: Do you spend less than your earn? In what major categories do you spend your money?

Financial Planning on a Schedule

I happened to drive by my local post office on April 15 and noticed more cars than usual around the post office. Then, I remembered that April 15 is the deadline for filing income tax returns. Why do people procrastinate on preparing and filing their income tax returns? Well, let’s face it. Preparing tax forms is not a fun activity for most people. So, it often gets left for the last minute.

Similarly, financial planning is not a fun activity for many people. Unlike income tax returns, however, there is no annual April 15 deadline for financial planning. So, I can understand how it would be easy to ignore financial planning until there is some triggering event, such as retirement. Some financial planning strategies are complicated. Many of the most successful strategies, however, are simple and just require consistency and self-discipline. To take advantage of these opportunities, I suggest using a tool that many of you already have – a calendar. There are no government mandated deadlines for financial planning. So, make some deadlines for yourself.

In the remainder of this article, I will provide a sample financial planning schedule. This schedule is meant to give you an idea of the concepts behind financial planning on a schedule. To keep the length of this article manageable, I will not provide a comprehensive list of every possible financial planning activity.

The first thing you need to do is to make an initial assessment and set some goals. Let’s say that it is January right now. Here are some topics that you may want to cover in your initial assessment:

  • What are your financial goals?
  • What are your assets and liabilities?
  • What are your cash inflows and outflows?
  • Set a goal on how much of your income you want to save each month
  • Plan where you want to direct your excess cash flow (e.g., emergency fund, debt reduction, 401(k) account, Traditional or Roth IRA contributions, 529 account, etc.)
  • Are you maximizing any employer matching on retirement plan contributions?
  • Does your employer offer a Roth option in its 401(k) plan? Should you take advantage of it?
  • Review your insurance policies – missing any necessary coverage? any unnecessary policies?
  • Review your investments (e.g., asset allocation, diversification, cost and tax efficiency)
  • Review your estate plan – do you have wills and other documents in place?
  • Check all of your beneficiary designations

Let’s say that you accomplished all of the above in January. Then, address the following questions in February as you get ready to prepare your income tax returns:

  • Are you using the most advantageous filing status? If you are single, do you qualify to use “head of household” instead?
  • Are you claiming all of the exemptions possible? Did you have a child born during the prior year? Did you recently start financially supporting your retired parents?
  • Are you claiming all of the deductions and credits for which you qualify?

Schedule the following activities for July:

  • Review your savings and/or debt reduction vs. targets during the past six months – are you on track?
  • Review your investment portfolio – do you need to rebalance or reinvest excess cash?
  • Check to see if you are maximizing your employer matching contributions to your workplace retirement plan
  • Check your payroll income tax withholdings – are you withholding too much or too little?

Schedule the following activities for December:

  • Review your savings and/or debt reduction vs. targets during the past year – are you on track?
  • Review your investment portfolio – do you need to rebalance or reinvest excess cash?
  • Check your workplace retirement plan account – did you contribute as planned?
  • Contribute to a Roth IRA if you qualify
  • Consider Roth IRA or 401(k) conversions
  • Consider tax loss or gain harvesting, depending on your situation, in your taxable investment accounts

I believe that financial planning on a schedule is effective because (1) it forces you to set goals and periodically check your progress and (2) it forces you to address opportunities that disappear with the passage of time (e.g., income tax opportunities, contributions to tax-advantaged investment accounts, Roth IRA conversions).

Why People Do Not Plan

How much time and effort did you put into planning your last vacation? If you are married, how much time and effort did you put into planning your wedding and honeymoon? Now, how much time and effort do you put into planning to meet your financial goals, such as personal cash flow management, risk management, tax management, college funding, retirement funding, or estate planning? It is my belief that most people put little time or effort into financial planning. The following are some possible reasons:

  1. It is not required. If you have more than a minimal amount of income, the law requires that you file an income tax return every year. If you own a car, you must obtain automobile liability insurance or post a bond in most states. There is no law, however, that requires people to implement a financial planning process.
  2. It may expose difficult choices. The first step in the financial planning process is to establish your financial goals. “That’s easy,” you might say. “I want to live in a nice house, send my children to private school, help those in need, and retire comfortably.” To that, I would ask, “how would you place these goals in priority order?” Financial planning might force some difficult personal decisions. I believe that it is human nature to avoid difficult decisions until some external event forces us to make them.
  3. It requires organization and effort. Just gathering data to prepare a financial plan is a lot of work. You will need details about your assets, liabilities, income, expenses, income taxes, insurance policies, investments, retirement benefits, etc.
  4. There are no easy and comprehensive tools for the non-professional. Sure, there are online retirement calculators that will estimate how much you need to save for retirement based on a few simple assumptions, like your retirement age, current savings, and assumed investment return. Generally, these calculators cannot, however, account for complications such as fluctuating income, equity compensation, pensions that do not adjust for inflation, required minimum distributions, varied tax rates, support for dependents, and asset sales. There are professional-grade financial planning software packages that might be able handle some of these situations, but they generally cost over $1,000 and may be difficult to learn and use for the layperson. For my clients, I create customized spreadsheet models that can account for these types of financial complications.
  5. It is expensive to hire a good financial planner. For a professional financial planner to create a proper financial plan, it takes substantial time and effort to understand your personal and financial situation, gather and organize relevant data, make judgments about assumptions, prepare financial analyses, and explain the results to you. Accordingly, a comprehensive financial plan might cost several thousand dollars.

Despite these obstacles, the benefits of implementing a financial planning process are significant. You will have more clarity about how your personal values relate to your financial goals. You will know whether you are on track to meet your goals. The planning process may expose opportunities and risks that you did not know previously. Finally, planning should give you more confidence about your financial decisions.

Be Vigilant Against Financial Fraud

Financial fraud seems to hit the news headlines on a regular basis these days. By fraud, I am referring to Ponzi schemes or other illegal activity designed to steal your money. So, how can you protect yourself against financial fraud? Here are some practical steps:

  1. “Trust, but verify.” If you initiate a money transfer from one account to another, check both accounts to ensure that the transfer occurred properly. Reconcile your bank, credit card, and investment account statements against your own transaction registers. If you pay a vendor through direct debit of your bank account, then call the intended recipient of the money to confirm that the appropriate funds were received. Check your account activity online on a regular basis. Review your credit reports on a regular basis. Be suspicious of anyone who you do not know that calls you on the telephone and asks you for personal or financial information.
  2. Know where your money is located. If you deposit money at a bank, your money is held at the bank. If you deposit money into an investment account, is your money held at the investment firm that issues the account statements? It depends. Say you purchase shares in the Vanguard 500 Index mutual fund. Does Vanguard hold your shares? Surprisingly, no. Mutual fund managers are required to hold fund assets at an outside custodian. The assets of the Vanguard 500 Index fund are held at Brown Brothers Harriman & Co. You can find this information in the mutual fund’s “Statement of Additional Information” document, which is available on Vanguard’s website. Also, be aware that some smaller brokerage firms hold their customer accounts at a third-party brokerage firm, which is known as the “clearing” broker. The largest clearing broker in the U.S. is Pershing LLC, a subsidiary of The Bank of New York Mellon Corporation.
  3. Separate investment management and asset custody. This is just a fancy way of saying that the person or firm that manages your investments should not also hold your account assets. If you hire an investment advisory firm to manage your investment portfolio, then your account should be held at a third-party brokerage firm that issues statements and trade confirmations directly to you. Review those statements and confirmations on a regular basis. This was one of the fundamental flaws in the Bernie Madoff fraud. The client funds that Madoff “managed” were held at his own firm. If someone comes to you with an investment opportunity and asks you to write a check payable to him or his firm, politely decline.
  4. Be suspicious of exotic or exclusive investments. If someone pitches a complicated investment to you, then consider a more straightforward investment instead. Words such as “exotic, exclusive, private, etc.” that are used to describe an investment opportunity should raise immediate red flags.
  5. Be wary of claims that sound too good to be true. If someone promises an attractive investment return with little or no risk, then assume that the investment is fraudulent unless you can prove otherwise beyond any doubt. Legitimate investments that have the potential for attractive returns have risk.

Do You Know Your Living Expenses?

Do you know your annual salary? You probably do. Do you know your after-tax income? Assuming your payroll withholdings are reasonably accurate, you can check your recent paychecks to get this information. Do you know your annual living expenses? What you think might be your annual living expenses could be inaccurate. To find out why, read on!

Why do we need to know our living expenses anyways? Well, this information is the basis of all long-term financial planning. Your spending determines how much money you have left to save for future financial goals. It also helps you to estimate your living expenses in retirement, which allows you to estimate how much you need to save during your working years to meet your retirement goals. Finally, I believe that knowing our cash flow helps us to make better everyday financial decisions.

You might say, “I track every penny that I spend in Quicken, and I can just print a spending report for the last year.” Well, that is a great first step, but you are probably not accounting for some recurring expenses that do not occur every year. For example, say you always pay cash for your cars and do not take out auto loans. Then, you are probably not accounting for automobile replacement costs. What about home maintenance, such as roof repair or major appliance replacements?

So, how do you estimate your living expenses while properly accounting for all recurring spending? First, you need to estimate your spending on expenses that do recur at least annually. If you track every penny in Quicken or another computer program, than you are done with this step. If not, then I suggest this method. First, track all of your spending for a few months using a notebook or spreadsheet. This should cover regular monthly expenses, such as rent or mortgage payments, utilities, groceries, etc. Then, look over your bank and credit card statements or registers over the past year and make a list of any other expenses that you are missing, such as insurance premiums, property taxes, birthday and Christmas gifts, automobile maintenance costs, etc. Finally, put everything together in a spreadsheet and express all spending on an annual basis. Let’s say that you go through this exercise and find that your total annual spending is $50,000.

After you have finished the first step of accounting for all of your yearly recurring expenses, you need to account for recurring expenses that occur less frequently than annually. Here is how. Say you normally spend $20,000 to buy a car and you replace your car every ten years on average. Let’s assume that the salvage value is negligible after ten years. Then, you want to add $2,000 ($20,000 divided by 10 years) to your annual spending. That was not too difficult. If you own a home, what about home maintenance costs? Well, that is trickier. Think of it this way. Take a look at your home. Eventually, almost every part of your home will need to be repaired or replaced – the roof, the paint, the plumbing, the carpet, furniture, major appliances, etc. Home maintenance costs vary depending on the type of home and local costs. One rule of thumb that I have seen is 1% of the home value per year. So, if your home is worth $300,000, you would estimate home maintenance costs at $3,000 per year. Let’s say that your estimated annual spending on expense items that do not occur every year totals $5,000. Then, your fully amortized total annual spending would be $55,000 ($50,000 from the first step plus $5,000).

Now that you have the magic number, what do you do with it? First, compare your fully amortized total annual spending to your after-tax annual income. Which is higher? If you find that your fully amortized spending is higher than your take-home pay, than you have a problem. Consider ways to reduce your spending so that you can save for your future. Second, you can use this information to help forecast and analyze your future finances.

Year-End Financial Checklist

Can you believe that today starts the final month of 2011? Around this time of the year, many newspapers and magazines publish articles about year-end tax planning. While year-end is certainly a good time to do tax planning, it is also a good time to take stock of your financial situation and think about broader financial issues. The following are some things that you may want to consider. I will also throw in a couple of my favorite year-end tax tips as well.

  1. Evaluate your financial goals. Is buying a house one of your goals? If so, do you know how much income and savings you need to buy a home without jeopardizing your other financial goals? What if your goal is to get out of debt? Do you know how much debt you have right now? Do you have an action plan to accomplish your goal? Do you see the pattern? Get information. Make a plan. Execute the plan.
  2. Analyze your spending and saving patterns. Different people may have different goals, but many of these goals have one thing in common. You must save money to accomplish them. Do you know your average monthly spending? Can you estimate the recurring expenses that do not occur every month or every year, such as insurance premiums, home renovation costs, and automobile purchases? Do you know what percentage of your income is being saved? If you answered “no” to any of these questions, then now is a good time to get organized.
  3. Are you missing any necessary insurance policies? Do you rent an apartment but have no renters insurance? Do you have a sizeable net worth but no personal umbrella policy?
  4. Check every beneficiary designation. Life insurance policies and retirement accounts have beneficiary designations. You can also add beneficiary designations to regular bank and investment accounts through pay-on-death or transfer-on-death provisions. Check every beneficiary designation, especially if your family situation has changed recently (e.g., getting married, having children). These beneficiary designations override any provisions in your will.
  5. Contribute to a Roth IRA if you are eligible. Contributing to a Roth IRA is an excellent way to invest for retirement. Assets in a Roth IRA grow tax-free as long as you meet certain requirements when you withdraw the funds. You can contribute to a Roth IRA as long as you have earned compensation (e.g., wages or self-employment income) and your modified adjusted gross income (“MAGI”) is below certain limits. If you are single, you can contribute up to $5,000 to a Roth IRA if your MAGI is less than $107,000. If you are married, you and your spouse can each contribute up to $5,000 to Roth IRAs if your joint MAGI is less than $169,000. The $5,000 limit increases to $6,000 for those age 50 and older. You can contribute to a Roth IRA even if you participate in a 401(k) plan at work. You can make a Roth IRA contribution for tax year 2011 any time before April 15, 2012.
  6. Consider a Roth IRA conversion. If you are in an unusually low tax bracket this year (e.g., due to a break in your career or going back to school) and you have some extra cash to invest for retirement, then consider converting some of your Traditional IRA assets into a Roth IRA. You will have to pay regular income tax on the conversion amount, but that might be a good opportunistic investment if you are temporarily in a low tax bracket. Be careful, however, that the conversion does not push you into a higher tax bracket. Also, make sure that you have cash outside of your IRA to pay the income tax due on conversion. The deadline to make a Roth IRA conversion for tax year 2011 is December 31, 2011.