All posts by Lawrence Chin

Insurance – Do You Have Too Much or Not Enough?

For many people, insurance is not a fun or exciting topic. We often mindlessly renew our existing policies and spend little time thinking about whether we have the right policies or coverage. As a result, we may have unnecessary insurance in some areas and not enough coverage in other areas.

Why should having too much insurance be a concern? While insurance serves an important function for protecting against large losses, it is not a good deal for small potential losses that you can afford. The reason for this is that insurance premiums are designed to cover not only the policyholder’s statistical share of potential claims but also the insurance company’s overhead, selling expenses, and profit. In most cases, you can do without the following insurance policies that cover relatively small potential losses:

  • Extended warranties
  • Cell phone insurance
  • Travel insurance
  • Credit card insurance
  • Comprehensive and collision coverage for older cars with low replacement value

Another way to eliminate coverage for small potential losses and reduce your premiums is to choose policy deductibles that are as high as you can afford. Is your auto insurance policy deductible $500? Unless you are accident prone or your auto lender requires a low deductible, why not increase the deductible to $2,000 if you can afford such a loss?

Why do people buy insurance for small losses? I believe it is because of two behavioral finance tendencies: (1) fear of regret and (2) assigning probabilities based on the ease of imagining the event or finding examples. It is easy to see how someone who has always had comprehensive and collision coverage could fear having his car stolen right after dropping comprehensive and collision coverage on his 15-year-old car worth $1,500 (fear of regret). Also, some people may overestimate the probability of something happening because it is so easy to imagine (e.g., misplacing one’s cell phone or getting sick right before a planned vacation).

So, what are some areas where you might have not enough insurance? First, consider the reason for insurance. The purpose of insurance is to protect you from large financial losses that you cannot afford. Most people have heard of auto insurance, homeowners’ insurance, health insurance, disability insurance, and life insurance, but there are other types of insurance that are also important. One is renters’ insurance, which is designed for those who rent their residence. An apartment renter might say, “I don’t need renters’ insurance because the things in my apartment aren’t worth much.” Renters’ insurance covers much more than the contents of your apartment. It covers your liability from bodily injury or property damage that occurs either at home or anywhere outside your home. If you are sued for this type of liability, the insurance company will provide a legal defense at their expense, even if the lawsuit is groundless. The sum of a liability judgment and attorney’s fees could become a very large loss. Of course, the details of policy terms will vary with the insurance company, but you can see the importance of having renters’ insurance.

Another important type of insurance policy is a personal umbrella liability policy, which covers your liability from bodily injury or property damage that exceeds the limits of your underlying auto, homeowners’, or renters’ policies. Some umbrella policies also cover events that may not be covered by underlying homeowners’ or renters’ insurance, such as personal injury from false arrest, slander, or libel. Although the chances of anyone filing an umbrella claim may be very small, an umbrella policy, by definition, protects you from catastrophic financial liability. Umbrella insurance is especially important if you have a sizeable net worth. Umbrella premiums are often modest, and umbrella policies are offered by many insurance companies that offer auto, homeowners’, and renters’ insurance.

Also, take a look at the liability limits of your insurance policies. Did you get a low $50,000 liability limit on your auto policy when you were a poor college student and never change it? If so, this is a good time to reassess all of your liability limits. If you have an umbrella liability policy, you can just set the liability limits on your underlying auto, homeowners’, and renters’ policies at the minimum amounts required by the umbrella policy since the umbrella policy will cover any excess liability (up to the limits of the umbrella policy).

Finally, be aware of policy exclusions. For example, homeowners’ insurance policies typically do not cover damage from earthquakes or floods unless you get add-on coverage specifically for these perils.

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.

Are You Investing Tax Efficiently? Your 1040 May Have the Answer

If you have invested in the stock market during the past few years, it may feel like the day-to-day movements of the stock market are out of your control. The stock market goes up one day or down another day based on various news and data that is released each day. No one can consistently predict the short-term movements of the stock market. There is one very real aspect of investing, however, where the investor wields a substantial degree of control: income taxes. Let’s take a short guided tour through your federal income tax return (IRS Form 1040) to see if you are investing tax efficiently.

Form 1040 Schedule B. Schedule B is used to report interest income and ordinary dividends. Does your Schedule B Line 1 include any interest income from taxable bonds? Does your Schedule B Line 5 include any ordinary dividends from bond or REIT mutual funds, where such dividends are not included in Form 1040 Line 9b as qualified dividends? If you answered yes to either question, consider placing these bond or REIT investments in your Traditional IRA or 401(k). If you currently own stock funds in your Traditional IRA or 401(k), sell the stock funds in these tax-deferred accounts and buy them in a taxable account. This will make space for the bond or REIT funds in your tax-deferred accounts. For most investors, it is preferable to hold bond or REIT funds in a tax-deferred account because these funds are generally less tax efficient than stock funds and benefit more from the tax deferral feature. If you must hold bonds in a taxable account and are in a high income tax bracket, consider tax-exempt bonds.

Form 1040 Schedule D Lines 1 or 8. Schedule D is used to report realized capital gains and losses. Are you reporting any capital gains on Schedule D Line 1 or Line 8? If so, investigate the source of such capital gains. A taxable capital gain is triggered by selling an investment at a price that is greater than the cost basis of the investment. This may sound like a good thing from an investment perspective, but from a tax perspective, it is better to defer realizing gains as long as possible. Sometimes, there are legitimate reasons for incurring capital gains, such as diversifying a concentrated stock position or replacing high-cost mutual funds with low-cost index funds. If you are trading frequently, however, in search of the next hot stock or mutual fund, consider investing in index funds instead. Not only is there a good chance that the index fund strategy will beat your previous strategy, but you will end up with a lower tax bill.

Form 1040 Schedule D Line 13. This line is entitled “capital gain distributions.” Is there a number greater than zero on Schedule D Line 13? If so, is the capital gain distribution coming from an actively managed mutual fund? If you own shares of a mutual fund that generates a capital gain within the fund, it is required to pass along that gain to you so that the IRS can tax you. The distributed gain shows up on Line 13 – not a good thing from a tax perspective. As you may have guessed by now, it is better to defer gains as long as possible within the fund. In general, actively managed mutual funds generate capital gain distributions far more frequently than index funds because actively managed funds trade more frequently. Some exchange traded equity index funds have never distributed taxable capital gains in the history of their existence (this is good!). Consider replacing your actively managed mutual funds with index funds.

Form 1040 Schedule D Lines 6 or 14. Do you show a number other than zero on Schedule D Line 6 or Line 14 (capital loss carryover)? If not, you are probably not using a strategy called tax loss harvesting. Here is how it works. Say you own a large-cap equity fund that tracks the S&P 500 index. You purchased it many years ago for $50,000. Now it is worth $30,000. You sell the S&P 500 fund at a long-term capital loss of $20,000. In order to maintain your exposure to large-cap equity, you use the $30,000 in sale proceeds to purchase immediately a large-cap equity fund that tracks another large-cap index, such as the Russell 1000. If you repurchase the same S&P 500 fund within 30 days of selling it, the IRS will not allow you to claim the capital loss, but you are allowed to purchase a similar but not “substantially identical” fund and still claim the capital loss. What is the net result? You have $20,000 in capital losses that can be used to offset any other capital gains that year. If you do not have any capital gains that year, you can use up to $3,000 of the capital loss to offset any other taxable income, such as wages, interest, and dividends. The remainder of the loss can be carried forward to future years indefinitely. In this example, if you have no other realized gains or losses that year, $17,000 ($20,000 minus $3,000) of the capital losses would be carried forward to the subsequent tax year and be reported on the subsequent tax year’s Form 1040 Schedule D Line 14. There is one caveat. You may incur transaction expenses in buying and selling funds. So, it is not a good idea to conduct tax loss harvesting trades too frequently.

As you can see, there are many strategies for managing your investment related income taxes. Use the tax law to your advantage to enhance your after-tax investment returns.