Financial Management Tips (2019)
This blog explores 50+ best financial management tips to plan and manage your wealth in the right direction. And explains the financial planning process using the PADD approach to achieving lifetime wealth. The steps in this approach are as follows:
Protect your assets.
Accumulate monetary wealth.
Defend your wealth.
Distribute this wealth during your lifetime for the benefit of yourself and your family. Let’s begin!
The Steps in the Financial Planning Process
As put forward in the Certified Financial Planner Board of Standards Financial Planning Practice Standards, there are six steps in the personal financial planning process:
Establishing and defining the relationship with the financial planning client
Gathering client data and determining goals and expectations
Determining the client’s financial status by analyzing and evaluating client information
Developing and presenting the financial plan
Implementing the financial plan
Monitoring the financial plan
Although these steps are intended for the professional Certified Financial Planner (CFP) certificate, there are several tasks that you, as an individual intent on beginning the financial planning process, should also undertake.
The first task is to gather your financial and personal records. A formal, very detailed data-gathering form and personal financial planning questionnaire help you with this undertaking. Keeping good personal records has one very obvious advantage: it lets you know where and how you are currently spending your money.
In turn, these records will assist you in constructing a budget for your monthly income and expenses—a critical money-management tool for most individuals.
Record keeping also assists you in determining where you are financially today. You can’t begin the journey of personal financial planning without knowing your starting point.
What type of financial and personal records should you keep, and for how long should you keep them? In most instances, there is no single answer to these questions, because the type and number of records you need really depend on personal preference.
Some of us keep everything (for as far back as we can imagine), whereas others try to rid ourselves of paper almost as soon as we receive it.
However, documents like copies of insurance policies, brokerage account statements, mortgage statements, deeds, and leases, notes receivable, and current statements of vested amounts in 401(k) plans or other company-sponsored retirement plans should be kept indefinitely. In addition, it is important to keep personal income tax returns for at least three years.
No single document can tell you more about your financial life than your annual income tax return.
Think about it: this return forces you to not only disclose the amount of your income but also identify the source of that income— an extremely important part of the budgeting and financial planning process.
Under the law, you are required to keep (unless you’re committing fraud) your income tax return and supporting details for only three years from April 15 of any given year.
However, because of the wealth of information provided by the return and its importance as a guide to your financial past, you may wish to consider retaining it for much longer.
Once you have determined what type of financial and personal records you should keep, the next step is to determine where to keep them.
Again, there is no single answer to this question, but I tell my estate planning clients to keep these documents somewhere in their home where they can easily be obtained in the event of an emergency.
The reason that I advise them in this way is to encourage them to consider the disadvantages of a safe-deposit box. In addition to the often high fees charged for safe-deposit box rentals, many individuals make the mistake of listing only their name as a signatory for access to the box.
In the event of an unanticipated injury or death, no other individual can access the important documents stored in it. You should consider instead a locked desk or fireproof case kept in your house or apartment for storing all your important records.
Another critically important task to launch you on the path toward financial independence is to specify in writing your long-term (more than ten years), medium-term (five to ten years), and short-term (one to five years) financial goals. Be as specific as you can with respect to these goals.
For example, “to become wealthy” not only is hard to quantify for most people but, as mentioned previously, may not even mean the accumulation of actual dollars. If monetary wealth is important to you (as it is for most people), determine how many dollars you need to accumulate in order to satisfy your written financial goals.
Here are some of the most common financial goals mentioned to financial planners:
To retire early or at normal retirement age with an adequate level of income
To fund a child’s (or children’s) college education
To buy a house or vacation home
To make home improvements
To take a dream vacation
To reduce debt service (for example, to pay off credit cards with an outstanding balance)
To buy a luxury car
To minimize income or transfer (estate) taxes
To start my own business
You may add other objectives to this list, depending on your own personal and financial situation, but it is important to recognize that these goals should be quantified and monitored.
In other words, you should establish a plan to meet these goals and then track how you are doing. As with determining an investor’s “time horizon,” it is important to match your goals to a specified time frame and categorize them according to a long-term, medium-term, or short-term planning period.
What about the possibility that your goals cannot be achieved with your current financial resources? In that event, you have one of three (or a combination of three) choices:
You can prioritize away the meeting of some financial goals (in other words, recognize that only some, but not all, of your specified financial goals, are achievable in the specified time frame).
You can attempt to increase cash inflows (your income potential).
You can reduce your cash outflows (adjust your standard of living).
Until you have determined your financial goals and specified a time frame for their achievement, you likely won’t know how to begin planning, which may keep you from planning at all!
Financial Management Tip 1:
Determine Where You Are Now
One of the primary assumptions of the financial-planning and wealth-building process is that your net worth (assets minus liabilities) should experience a steady increase as you continue to invest.
There is no benchmark percentage increase (or dollar amount) by which your net worth should grow annually, only the suggestion that you should strive for as great a percentage increase as possible given your current financial resources.
For example, if you are in your peak wage-earning years (typically age 45 to 55), you should establish a goal of at least a 10 percent increase in your net worth annually. When we apply the Rule of 72 to this increase (72 divided by 10), your net worth will double in a period of only 7.2 years.
You should monitor and track the increase (or decrease) in your net worth at least once a year. (Many individuals calculate this number at year-end). How do you go about tracking and determining this very important number?
By preparing the first of two personal financial statements that you should keep among your important financial records: the statement of personal financial position, commonly referred to as the personal balance sheet.
An example of a statement of personal financial position is produced next. Before you examine it closely, there are a couple of considerations that you should keep in mind when preparing and interpreting such a statement:
Be sure to list all assets at their current fair market value without reducing them to reflect any outstanding indebtedness; for example, list your personal residence at the value you believe it will sell for in the local market without taking into account the mortgage balance you may currently owe.
Break down your assets into cash equivalents, investments, and use assets. Cash equivalents are those assets that you can access quickly to pay ongoing expenses (bills) or, in the event of a financial emergency, without fear that they may be worth less than when you purchased them.
Alternatively, investments are longer-term assets (greater than one year in maturity or holding period) that may experience a fluctuation in daily value.
List liabilities at their current balance or what you owe to the creditor as of that given point in time.
There is no right or wrong answer when preparing your statement of financial position. Certainly, as you proceed along the path of wealth building, the objective is that the value of your assets will exceed the balance of your liabilities (thereby increasing your net worth), but do not become too judgmental of yourself as you construct your first statement.
The danger is that you will become discouraged (or even give up), which runs counter to why you are preparing the statement in the first place—as a tool to help you assess your current financial situation and what you want to see happen in the future.
When planning your estate, it is helpful to identify on the statement of personal financial position how each asset is titled. For example, if your primary residence is held in joint tenancy with right of survivorship between you and your spouse, place a (JT) for joint tenancy next to Primary Residence.
Note, however, that retirement accounts, such as individual retirement accounts (IRAs), may only be owned individually, even in community property states like California.
Financial Management Tip 2:
For many people, putting together and sticking to a budget is one of life’s little burdens. Sometimes the thought of limiting their spending (and therefore their lifestyle) is so threatening that people refuse to even think about preparing a budget. I have heard it said, “What budget? I spend what I make, so that’s my budget!”
However, living without a budget damages your long-term financial health. Look at a budget as an opportunity to prove your own financial self-discipline. You could even pay yourself (and add to your savings) if you come in under budget each month and show that you can live within your means. Over time, that practice will significantly increase your net worth.
As mentioned, a budget looks forward and is a benchmark for what you plan to spend. It may take you a few months to get it right, but get it right you must!
If you are just starting to prepare (and comply with) a budget, be conservative in the assumptions you make. For example, an underlying assumption of any budget is that your current employment is secure; if it is not (if you anticipate a job change or layoff), you probably need to set aside even more savings and (hopefully) spend even less.
This will help you build up an emergency or contingency fund—another financial planning practice that is critical to your long-term financial well-being.
Normally, a budget is developed in several steps. First, it is very helpful to have determined your financial goals and the amount of savings necessary to accomplish them.
Next, be as realistic as you can when estimating your future income and forecasting your anticipated expenses for the budget period. Finally, a well-developed budget should be flexible enough to accommodate financial emergencies or one-time major expenses.
If you do not use it, you are likely better off attempting to meet your short- and long-term financial goals by focusing on some other planning technique.
Financial Management Tip 3:
Monitor Your Progress and Life-Cycle Planning
How often you review your financial progress depends on your age and the time frame you have specified to meet your financial goals. In most cases, an annual review is sufficient.
This may be done with or without the assistance of a professional financial planner. If you go it alone, ask yourself the following questions:
What life cycle or life stage are you in?
Are your short-and long-term goals representative of peers in the same financial planning cycle or stage?
In other words, are your financial goals realistic?
Have these goals remained the same throughout the review period?
Are you living at or below your means?
How much money did you save during the review period?
With respect to your savings, are you earning the investment rates of return you need to meet your goals?
Has anything changed in your personal and financial situation that may cause you to reconsider either the priority of the financial goals you established or the time frame in which you anticipate meeting them?
It is generally agreed that there are four financial planning life cycles. Although there are no hard-and-fast ages at which individual transitions from one life cycle to the next, during each, certain financial goals are typically more important than others.
The first of these stages is the accumulation stage (between ages 25 and 45 for most consumers). In this stage, individuals are usually in the early-to-middle years of their employment career and, if married, are raising young children.
Typically, their net worth is relatively small and their debt load may be excessive, normally due to the student or personal loan obligations. Their major financial goals are likely to be reducing their debt, buying a house, and beginning the financing of their children’s education.
The next of the financial planning life cycles is the consolidation stage (ages 45 to 62 or other normal retirement age). In this stage, individuals are typically past the midpoint of their careers and are likely approaching their peak wage-earning years. Most, if not all, of their debts, have been paid off and their net worth is growing rapidly.
Their children are in college or graduate school, and those expenses have also been satisfied or are in the course of payment. Financial goals for individuals in the consolidation stage of life are likely to include making home improvements, taking a dream vacation, buying a luxury car or vacation home, and minimizing income taxes.
The third life-cycle stage, the spending phase (ages 62 to 85), is sometimes combined with the fourth phase, the gifting phase. The spending phase is characterized by the individual’s approaching retirement or the early years of retirement.
In this phase, their peak earning years have likely concluded and, from an investment perspective, the focus turns from growth to income.
The individual’s children have likely begun their own careers and have moved from the family home. Financial goals for individuals in the spending stage shift to early retirement, retirement with adequate income, and, perhaps, the starting of their own business.
Finally, the fourth and final life-cycle phase, the gifting phase, is synonymous with an individual’s retirement years. Excess assets, if any, may be used to benefit family members during life or in the event of the individual’s death.
Estate planning becomes very important in this phase, and as such a primary financial goal is the minimization of transfer (estate and gift) taxes. Also characteristic of this phase is a very conservative investment approach and withdrawal rate, due to the fear of outliving the number of retirement monies the individual has saved.
Now, let’s proceed to an often-asked question: Do I need a professional financial planner to help me get control of my financial life, or can I do it myself? The answer to this question is the focus of the next section.
Financial Management Tip 4:
Elements of Personal Financial Planning
Academic studies have shown that following a financial plan will help you build wealth more rapidly than is possible without one. This is because a financial plan enforces self-discipline, the key to any future accumulation of wealth.
People earning between $20,000 and $100,000 per year who follow a financial plan typically have up to twice as much savings as those in the same income bracket who have no financial plan.
For those earning more than $100,000 per year and following a financial plan, the savings rate is some 60 percent greater than that of their peers. Clearly, people who adhere to some form of a financial plan—either in writing or informally by matching their savings practice to a predetermined set of financial goals—have a significant advantage.
Financial Management Tip 5:
Personal Financial Planning
The concept of personal financial planning has had an interesting and somewhat complicated past.
Although financial planning has always been about the process of determining whether and how individuals can meet their financial goals through the proper management of financial resources, planners have occasionally been sidetracked and focus too much on the resources component of the definition instead of the process component.
In other words, financial products—such as an attractive stock or the newest insurance product—that are necessary to implement the planning process become predominant.
Alternatively, some financial planners prefer to think of themselves as wealth builders or wealth managers to differentiate themselves from the product side of the business and, hopefully, attract the client with a higher net income or net worth.
There is likely no subject in the personal financial planning process more important than the others, but planners who think of themselves as primarily wealth builders tend to place a large amount of emphasis on investment selection and investment management.
As a result, those planners prefer to work only with high-net-worth clients and specify a minimum amount of investable assets (usually in the high six figures or even in the low seven figures) that can immediately be put to work in the capital markets.
But wealth managers and financial planners are really beginning at the same place: the client’s financial goals.
It is only the amount of financial resources a client can bring to bear in accomplishing their goals that distinguishes a financial planner from a wealth builder or wealth manager.
Regardless of whether these financial professionals think of themselves more as wealth managers or planners, they typically provide six main services for their clients:
Insurance and risk management
Employment benefits (often simply referred to as fringe benefits)
Income tax planning and management
Planning for retirement
I suggest that you use these general categories to examine and review your own financial life. Keep in mind that numerous issues need to be addressed within each of these areas.
Determining your own status in each category may help you begin the process of record keeping. Additionally, a professional financial planner will orient their work around each of these areas, and some will demonstrate a specialty in one or more of the subjects.
Is there any importance to the order in which I have listed the general areas of financial planning? In terms of thinking about your financial life, there is.
Your employment status determines whether you have any employment benefits to consider, but think of these benefits as nothing more than a temporary safety net that you can use to protect your financial well being. When you change jobs, these benefits may or may not be portable (they probably will not be).
This is why it is much better to build a permanent safety net constructed from individual life insurance and other benefits that you purchase on your own and that are intended to remain with you throughout your lifetime, regardless of your employment status.
Because both temporary and permanent benefits are primarily secured so as to provide protection against possible future financial loss, they should be thought of sequentially as first in the financial planning process.
The PADD approach to building and managing wealth places the general categories of personal financial planning in a real-life context that can be used as a blueprint to financial independence:
Protect yourself against the risk of catastrophic financial loss.
Accumulate wealth through investments.
Defend that wealth through prudent income tax planning and management.
Distribute that wealth for your retirement and as part of your estate at death.
First, however, because of their importance in the overall financial planning process as the “engine” in generating substantial wealth, we need to spend some time discussing investments and investment strategies. This begins with the need for a well-thought-out investment policy statement.
Financial Management Tip 6:
The number of investment strategies that may be pursued to build your wealth is probably limited only by the constraints of your own imagination and securities law, but let’s talk about a few of the most common strategies.
Dollar-Cost Averaging and Share Averaging
Dollar-cost averaging is sometimes euphemistically referred to as “the poor man’s method of saving.” Using dollar-cost averaging, an investor purchases additional shares of stock in a mutual fund at regular intervals, usually in equal amounts, regardless of market conditions.
Often, this is done through the use of an automatic withdrawal plan offered by the stock issuer or mutual fund company. When withdrawals are made from your paycheck in order to make 401(k) plan contributions, you are essentially pursuing a dollar-cost averaging strategy.
The practical result of dollar-cost averaging is to gradually increase the number of mutual fund shares you own over a long period of time. In the event that the current price of the fund is below its previous price, you have succeeded in purchasing more shares of the investment.
Because more shares are acquired when the price of the fund declines, this has the effect of reducing the average cost per share. Subsequently, if the price of the fund rises, you earn more profits on lower-priced shares, thereby increasing your overall rate of percentage return.
For example, assume that you purchased a $5,000 portion of ABC mutual fund in January 2017, when its share price was $20. You purchased a total of 250 shares ($5,000 divided by $20).
Now, instead, assume that you made five separate purchases of ABC mutual fund during 2017 using this same $5,000, but you did so in $1,000 increments when the price of the fund fluctuated as follows:
Month Share Price # of Shares Purchased
March 2017 $22.00 45.45
May 2017 $19.50 51.28
July 2017 $18.00 55.55
September 2017 $17.50 57.14
December 2017 $20.25 49.38
Further assume that you plan to sell all the separately purchased ABC shares in January 2019, when ABC’s per share price will be $24. Your total sale price will be $6,211.20 ($24 times 258.80 shares), and you will have recognized a gain of $1,211.20 ($6,211.20 less $5,000).
What if you had sold your original January 2017 shares? Your gain would have been only $1,000 ($6,000 less $5,000). Using dollar-cost averaging, you increased your annual compounded rate of return by almost 2 percent (from 9.54 percent to 11.46 percent).
As the previous example illustrates, dollar-cost averaging works best when markets are declining or fluctuating. It does not work well when the market is steadily increasing; in that event, you are better off buying as many shares as possible, as soon as possible, when the price per share is lower.
If an experienced investor learns one lesson throughout their years of investing, it is that markets rarely go straight up or straight down. Rather, fluctuation in share values is the rule and not the exception.
Therefore, dollar-cost averaging should be a valuable wealth-building strategy for you, as it has been for millions of other investors.
A variation of the dollar-cost averaging technique is shared averaging. When an investor dollar-cost averages, the amount of dollars spent on stock or mutual fund purchases at regular intervals is held constant, but the number of shares purchased with these dollars varies.
Conversely, when an investor share averages, the number of shares purchased remains constant, but the amount of dollars spent to make those purchases varies. With share averaging, the investor purchases a fixed number of shares, regardless of how low the price falls.
Thus, they do not obtain the reduction in the average cost of the shares to the same extent as is possible with dollar-cost averaging. This is why, as a wealth-building technique, more investors implement dollar-cost averaging than share averaging.
As you can see from our example involving dollar-cost averaging, an investor can leverage their gain by buying more shares when the price of a certain asset declines (as long as the price eventually goes back up before the investor sells). Is there a strategy that results in buying additional shares only when the price goes down?
Yes. It is referred to as averaging down. In our example, you would have bought ABC shares only in May 2017, July 2017, and September 2017, when the share price fell below the original $200 purchase price, and not in March 2017 and December 2017, when the price was more than $20.
Is pursuing this strategy a good idea? The answer depends on whether you are more interested in purchasing the stock or the company issuing the stock.
If you are interested only in the stock, share averaging may not be a good strategy, because (like dollar-cost averaging) the ability to make a profit ultimately depends on the share price increases.
If the share price does not increase, you will have purchased more shares of a stock that you likely should have considered selling in the first place.
In other words, you will now have more shares of a losing stock. Alternatively, if you are purchasing the company issuing the stock, presumably you have researched the prospects of that company and the industry in which it does business.
Accordingly, you should have greater confidence in the possibility of an increase in the price of that company’s stock, as well as reasonable assurance that a decline in price is only temporary. Therefore, if you are using the strategy in this manner, averaging down may make more sense as a long-term investment technique.
In any event, proceed carefully. Unless you are an experienced investor, averaging down is an investment strategy you should not try without the help of a professional.
Financial Management Tip 7:
Dividend Reinvestment Programs
Unlike averaging down, which is only for experienced investors, stocks that offer a dividend reinvestment program (DRIP) should be considered by any investor.
With a DRIP, dividends declared are automatically reinvested in the stock, adding to the investor’s overall ownership share. If you want to build an ownership percentage in a company, this is the way to do it.
DRIPs offer some other advantages. If the dividends are reinvested automatically—instead of paid directly to the shareholder—the investor purchases the additional shares of company stock without having to incur a broker’s commission.
Also, because the company tracks your purchases and keeps records of the purchase price, it can easily provide you with cost basis information in the event that you want to sell.
Many mutual funds have similar programs. If you are working with an investment advisor or financial planner who has positioned your holdings in some form of advisory account, ask them whether you can opt to reinvest any capital gain or dividend distributions (or both) into the purchase of additional shares of the fund.
If this option is available, consider taking advantage of a DRIP as an easy way to save and build wealth.
Financial Management Tip 8:
You can go about laddering or staggering the maturity of fixed income investments, such as bonds or certificates of deposit, in a number of ways. The most popular is to figure out the longest- and shortest-term maturities you want to assume and then sequence your purchases between those maturity dates.
For example, if you have $50,000 to invest, and you want to invest in bonds with a maturity of no longer than ten years and no shorter than one year, consider ten purchases of bonds in $5,000 increments with a maturity date each year from the end of year one to the end of year ten.
This has the effect of minimizing the impact of the price changes in the bonds due to interest-rate fluctuations, also known as interest rate risk. In addition, as the short-term bonds mature, their principal may subsequently be invested at potentially higher market interest rates.
You can adopt the same approach with respect to bank certificates of deposit and also obtain the advantage of Federal Deposit Insurance Corporation (FDIC) insurance on each certificate, as long as the total ownership in each bank and certificate does not exceed $250,000 per depositor.
Financial Management Tip 9:
Value versus Growth Investing
Value and growth investing are really just different sides of the same investment coin. In this case, the investment coin is the price to earnings ratio (P/E ratio) of stocks.
Value investing is an investment strategy that is concerned with the market price of stocks: specifically, finding stocks that are currently undervalued by the market. Thus, investors who practice value investing attempt to find stocks with high dividend yields and low P/E ratios.
The strategy assumes that the current P/E ratio of the stock is below its proper level (or what the ratio should be, given current market conditions) and that an efficient market will soon accommodate for this discrepancy and drive the price of the stock up.
Growth investing, on the other hand, focuses on the potential earnings of the company that is issuing the stock. As a result, growth investors look for growth stocks—stocks of a company that has shown a proven ability to develop products quickly and efficiently with a minimum of marketplace competition.
Such stocks usually have a superior rate of earnings growth (typically 15 percent a year or more), low dividend payouts, and an above-average P/E ratio.
There is some practical evidence that in a bull market, a growth investing strategy tends to outperform a value investing approach. Conversely, in a declining or fluctuating market, value investing may be more appropriate. As an investor, you should likely consider both strategies as appropriate methods of building wealth.
Financial Management Tip 10:
Investing in Real Estate
Most Americans have made an investment in real estate—whether they realize it or not—in the form of their own home. Is your home a good investment?
Although the answer to this question depends on many factors, not the least of which is the geographical location of your home, studies have shown that the average annual real (after inflation) return on residential real estate historically lags that of stocks and bonds.
According to a Fidelity Research Institute report, which used data obtained from Global Financial Data and Winans International that predated the Great Recession of 2007–2009, the average annual ten- year real (after inflation) rate of return on the residential real estate is only 1.62 percent.
This compares to an average annual real rate of return of 5.85 percent for stocks and 3.18 percent for bonds over the same period.
Despite this low rate of real return, homeownership is very important in our society because it allows the investor to build equity, which is the difference between the fair market value of their home and the amount they owe on it.
In addition, the financial obligation of making mortgage payments may make the investor or homeowner a better saver than an individual who rents.
The ability to save (or, more accurately, the exercise of financial self-discipline) is a very important trait for any effective wealth builder. As a result, studies show that the net worth of homeowners is some eight times greater on average than that of renters, regardless of age or income level.
We have now covered the basics of the financial planning process. Next, we will go into detail about the specified subject-matter areas of the process, beginning with the protection of your lifetime earning capacity, your family, and your property.
Financial Management Tip 11:
Ensuring Yourself and Your Family
This section of this blog introduces the first step in the PADD approach to accumulating and managing wealth: protecting yourself against the risk of catastrophic financial loss.
In this blog, we discuss the most important form of risk management: ensuring your life (and protecting your loved ones from the resulting loss of income at death) by purchasing life insurance.
Before we begin, you should keep in mind the following guiding principles with respect to purchasing any type of insurance:
Never risk more than you can afford to lose. In other words, buy only the amount of insurance required to ensure that you and your family will be restored to the before-loss status quo.
Do not buy insurance you don’t need. This is particularly important when considering the purchase of an annuity, an insurance product providing for lifetime income, but also including a death benefit.
If you do not need the death benefit, think twice before purchasing the annuity, because there are less expensive ways to provide for a lifetime income stream.
Financial Management Tip 12:
Do I Need Life Insurance? How Much?
Few financial questions are likely to be more troublesome than, “Do I need life insurance?” This is in part because it prompts the asker to confront their own mortality. In addition, the need for life insurance is a philosophical issue for some individuals.
For example, historically, farmers and people who make their living off the land and intend to pass this land down to their families do not believe that a financial product such as life insurance can substitute for something God did not create.
Let’s accept for a moment that we are all going to die someday. Once you have accepted your mortality, figure out what you want to have happened in the event of your death. Most people with spouses and children want to protect the financial lifestyle of their heirs.
In other words, they don’t want their families to have to suffer financially because they have lost a source of income. It makes sense, then, that the amount of life insurance you need is primarily determined by how much income needs to be replaced after your death.
As a rule of thumb, many life insurance agents say that you should purchase a life insurance death benefit to replace between five and seven times your annual gross income.
For instance, if your annual gross income is $100,000, you should purchase between $500,000 and $700,000 of life insurance coverage.
But, like most rules of thumb (and contrary to the financial planning process that should guide your decision), nowhere in this rule is any consideration given to financial goals or particular individual needs and family circumstances.
As such, two primary methods are used by most financial planners to determine the amount of life insurance that an individual should purchase.
The first of these two methods is the human life value approach. This approach estimates the amount of income your family would need, based on the financial loss they would incur, if you were to die today, anticipating the number of possible working years that remained.
This amount is then adjusted downward for what you would have personally consumed or paid in taxes (referred to as the family’s share of earnings).
Utilizing a rate of return known as a discount rate, the present value of your life to your family is estimated.
For example, let’s say you currently make $70,000 per year in salary and have approximately 20 years left in your working career. Your amount of personal consumption and taxes due on this income is $20,000, resulting in a family’s share of earnings of $50,000 ($70,000 less $20,000).
By applying a rate of return to these earnings of 5 percent annually and using a financial function calculator or software program, we can determine a life insurance need of approximately $625,000.
The human life value approach focuses only on your income-earning potential and the income loss to your survivors resulting from your death. As such, it is a relative method that assumes that your life only has value as it impacts the financial life of your survivors.
It does not consider the recurring nature of your dependents’ expenses or any unusual expenses that may result from your death, such as the future need for college education for minor children. Rather, these expenses are part of the alternative computation known as the needs approach to life insurance planning.
The needs approach to determining the optimal amount of life insurance an individual should purchase is very sophisticated and usually computed via a computer software program.
Very briefly, the approach considers your marital status, whether your spouse is employed outside the home, the size of your family, and any separate income earned by your dependents (children or elderly parents). For example, an individual who is single and has no dependents has little need for life insurance coverage.
As a result, life insurance for this person may only be necessary to repay debts and expenses related to their death. A married person or a single working parent who supports dependents have a need for life insurance to continue the flow of income to these dependents in the event of the person’s death. The needs approach is suitable to determine the amount of this need.
Here are some of the typical needs of an insured person and their family in the event of death:
Burial or cremation expenses, including funeral costs
An adjustment fund, which is a short-term fund intended to cover one-time expenses incurred by the family as it adjusts to the loss of the primary (or other) wage-earner
An income continuation fund, including an amount for mortgage payoff (if the insured’s house is not paid off)
An educational fund for the college education of minor children
An amount to provide a lifetime income for the surviving spouse, the need for which arises if the spouse is unemployed and does not have the necessary skills to enter the workforce or cannot otherwise earn sufficient income to replace the insured’s income
As the potential insured of a single-income family, you should consider that even if your surviving spouse could potentially generate sufficient income to cover the loss of your earnings, your spouse’s entry into the workforce might not be preferable to purchasing additional life insurance for this need.
In other words, do you intend to require your spouse to work? The answer depends on what you have agreed on with your spouse, but if you do not wish to have this discussion, you should purchase the necessary additional life insurance.
Term versus Cash Value Insurance
Many life insurance companies offer various life insurance policies. All these policies generally consist of only two basic methods of providing life insurance: term (also known as temporary life insurance) and cash value (also known as permanent life insurance).
Term insurance protects you only for a specific period; if you die during this period and are currently in your premium payments, the company will pay your family the contractual death benefit that is due. Cash value insurance protects you for life and also offers a savings component in the form of a cash value buildup.
Types of term life insurance policies include the annual renewable term, level premium term, and decreasing term insurance. Types of permanent life insurance policies featuring a cash value buildup include traditional whole life, universal life, variable life, and variable universal life (VUL) coverage.
Both term and cash value life insurance can be very valuable in protecting yourself and your family.
You should not think of either term or cash value insurance as an all-or-nothing proposition; many thoughtful individuals purchase both forms of coverage. But generally, as you age, term insurance coverage will become more expensive, whereas the cost of cash value coverage will remain fixed.
The reason is that cash value expenses are front-loaded as part of the policy structure because some of the premium expenses (beyond the pure mortality cost associated with any life insurance policy) go to build a cash reserve or cash fund that you can potentially access for emergency needs.
Just as in determining the amount of life insurance that may be needed, there are rules of thumb pertaining to whether it is best to purchase term or cash value insurance. One of the most common is to buy term insurance and invest the difference.
In other words, given the fact that term is at least initially less expensive than cash value (the younger you are, the longer your life expectancy and the less the mortality costs associated with term insurance), take the savings and invest it in higher-yielding financial investments, such as mutual funds.
Although the appeal of this strategy is obvious, permanent insurance advocates counter that the buy-term-and-invest-the-difference concept depends on several flawed assumptions:
The difference will always be diligently invested every year the insured owns term insurance, regardless of the insured’s personal financial circumstances or ongoing standard of living.
The alternative investment will always be financially superior to the incremental cash value buildup. Somehow the need for insurance will magically disappear as the insured ages.
Ultimately, the final decision with respect to how to best meet your life insurance needs is yours. In providing for these needs, you should remember that life insurance should be purchased to protect yourself and your family; investments, on the other hand, should be purchased to accumulate wealth.
Although cash value policies have some investment characteristics (particularly the newer forms of universal and variable universal life), life insurance is first and foremost a risk-management product and not a product designed to generate significant investment growth.
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Types of Term Insurance
Today, most buyers of term insurance purchase either annual renewable term or level premium term. Historically, decreasing term insurance has been a popular form of temporary protection and has been used as a mortgage-payoff vehicle at the insured’s death.
However, the decreasing term has fallen out of favor in recent years, primarily because it does not reduce protection at the same rate as the typical mortgage balance, thus resulting in an unnecessary premium cost to the insured.
With an annual renewable term, you pay the premium each year, and the policy remains in force.
As you age, the cost to the insurance company increases, and the premium goes up each year. But the level of protection—the death benefit—afforded your family remains constant.
Level premium term insurance, on the other hand, initially costs more per year than annual renewable term, but the premium remains level for a fixed period of time (generally anywhere from 5 to 30 years).
Thus, as you age, presuming you still want a relatively inexpensive temporary life insurance policy, you should probably consider replacing the annual renewable term with the level premium term.
But beware: as you approach the expiration date of your level term policy, you should begin to set aside some additional funds for premium payments once the policy expires.
Typically, depending on your age and the length of your original level term policy, you will experience a significant increase in premiums when you purchase a new term policy.
An attractive feature of some term policies is the ability to convert from term or temporary coverage to cash value or permanent life insurance protection without evidence of insurability. This means you can obtain permanent protection without having to pass a medical examination.
Accordingly, the opportunity to convert is particularly valuable for insureds whose health may have declined during the term. As such, if your health has changed for the worse and you currently own a term policy, you should probably consider converting to a cash value policy as soon as possible, because it is unlikely that you will be able to qualify for permanent coverage at a later date.
Types of Cash Value Insurance
There are three basic types of cash value policies: traditional whole life, universal life, and variable life. A fourth type, variable universal life (VUL), combines the features of universal and variable policies.
Traditional whole life is the standard form of cash value insurance that has been offered by life insurance companies for many years. It features a fixed premium for the life of the policy as well as a savings component that grows on a tax-deferred basis.
The policy is initially very expensive and, unless you continue to make premium payments, will lapse, potentially causing you to lose coverage.
In addition, at your death, your beneficiaries will receive only the death benefit payable from the policy and not the accumulated cash value. If you choose to access the cash value or savings portion during your lifetime, you must do so through a policy loan or withdrawal, which in turn reduces the amount of the death benefit paid.
Next, universal life takes the concept of “buy term and invest the difference” in a new direction. Yes, you are able to invest the premium amounts charged in excess of pure term coverage and generate some additional return, but you must do so by investing in what the insurance company chooses for you—which are usually conservative, fixed-income vehicles, such as investment-grade bonds.
Thus, the return generated by a universal life policy, although higher than that of a traditional whole life policy, still lags that of a variable life policy, where equities (common stocks) are the primary form of investment.
The primary advantage of a universal life policy is its flexibility with respect to premium payments. That is, the policy premium is not fixed or tied to the amount of death benefit protection purchased, except in the first year of the policy.
The premiums are then deposited into an accumulation fund from which the insurance company withdraws monthly mortality charges.
A minimum payment is required to keep the policy in force only when the accumulation fund is close to zero. The policyholder, subject to their continued insurability, may increase the death benefit of a universal life policy.
The third kind of cash value insurance, variable life insurance, differs from traditional whole life and universal life in one primary respect: you (and not the insurance company) are in charge of your investment choices.
Variable life policies allow you to invest in various combinations of stocks, bonds, and mutual funds and feature subaccounts in which you can allocate your assets (very similar to the variable annuity form of insurance).
Although the premium payments due on a variable life policy are fixed (as in traditional whole life), the death benefit may increase, as can the underlying cash value accumulated within the policy subaccounts.
The VUL policy, finally, takes this concept one step further by combining a choice of investments and increasing death benefit protection with the ability to make flexible premium payments.
Which of these cash value life insurance forms is best? It almost invariably depends on your comfort level by assuming investment risk.
If you consider yourself to be a moderately aggressive or aggressive investor (remember, a primary advantage of working with a financial planner is that the planner helps you determine your risk-tolerance level), variable life or VUL policy may be preferable.
If you are relatively uncomfortable with assuming investment risk or you do not like making investment decisions, a traditional whole life or universal life policy may be more to your liking.
Financial Management Tip 13:
Investing in Real Assets
For most people, owning a home is not an investment in the same sense that owning stocks and bonds or rental real estate is an investment. Rather, your home or primary residence should be thought of as a useful asset and should be listed as such on the statement of personal financial position.
This is to be contrasted with direct investments in real estate, such as the ownership of a rental home, a vacation home, or even raw land, and indirect investments in real estate, such as a share of a real estate limited partnership (RELP) or a real estate investment trust (REIT).
Direct Investments in Real Estate
Direct investments in real estate are made primarily by wealthy individuals who understand the real estate selection process and are comfortable with riskier assets.
Many direct investments in real estate are also made for purposes of improving an individual’s cash flow (income) and not only for purposes of enjoying the capital appreciation of an asset (growth).
Financial Management Tip 14:
According to American Demographics magazine, approximately 70 percent of Americans view the purchase of a vacation home as the number-one indication that an individual has accumulated wealth. Further, partly as a reflection of this fact, some 60 percent of Americans anecdotally say they would like to own a vacation home.
Although this is a common financial goal, it is not of tantamount importance for many people, because buying a vacation home is beyond their financial means. (With any luck, this blog will show you how to change that situation!)
However, if you are interested in purchasing a vacation home, you should take three major factors into consideration: the location of the home; the financing costs associated with buying and maintaining the property; and how long you plan to own the home, including how you may wish to ultimately divest yourself of ownership.
Financing a second home, particularly if you do not have much equity in your first home or primary residence, is always an issue. Most lenders expect you to put down at least 20 percent of the second home’s fair market value before closing.
Renting out the home is a good way to recover some of this down payment, but if you do so, charge a rent that is approximately 10 to 20 percent higher than your mortgage payment to take care of maintenance expenses.
You will also very likely need to hire a property manager, particularly if the second home is some distance from your primary residence or in another country.
If you can avoid it, try not to tap into the equity of your first home to make the down payment on the second. If the property value of your first home declines, it will be all the more difficult to recover the lost equity. It will also present a cash-flow challenge if you used an interest-only adjustable rate mortgage (ARM) to finance the first home.
Do not expect your vacation home to pay for itself immediately. Over the long term, a vacation home can be self-sustaining (particularly if you are renting it out when you are not there), but only if you exercise careful financial planning.
As with most real assets, the longer you own the vacation home, the greater the chances of its significant capital appreciation. Ultimately, you must determine whether you wish to pass your vacation home on to family members now or at your death, or whether you wish to sell it and realize a (hopefully) sizable percentage return on it.
Financial Management Tip 15:
Most individuals become landlords in one of two ways: as a result of a conscious decision to buy homes and rent them to others, or because their primary residence does not sell in the time frame they anticipate and they convert the residence to a rental property. The obvious practical disadvantage of becoming a landlord is that, unless you hire a property manager, you have to deal with tenants.
However, there are tax advantages associated with rental homes. Notably, as a landlord, you can depreciate the home and, at least to a limited extent, take an annual operating loss if your annual adjusted gross income is not deemed to be too high.
Under current tax law, a rental activity is treated as a passive activity, or one that involves the conduct of any trade or business in which the taxpayer does not materially participate.
But there is a lesser standard of participation— active participation—that most individuals can easily meet with respect to their rental real estate activities.
An individual meets the active-participation standard if they participate in making management decisions with respect to the rental property or arrange for others (for example, a property manager) to provide rental property services.
If this lesser standard is met, you can deduct up to $25,000 of losses annually from your rental real-estate activities, provided your adjusted gross income (AGI) for that year does not exceed $100,000.
If you pass this threshold, the $25,000 maximum is then reduced by 50 percent of the amount by which your AGI exceeds $100,000, meaning that if your AGI (and your spouse’s income, if you file jointly) reaches $150,000, no loss deduction is permitted.
For example, assume that you own an apartment building that is managed by an on-site property manager. You meet frequently with the property manager and make all decisions with respect to improving the property. As such, you actively participate for purposes of the rental real-estate loss deduction.
Further, assume that your AGI for the year 2018 is $110,000 and the building generates $26,000 in losses during that year.
You are allowed to deduct only $20,000 of these losses on your 2018 income tax return, because of the maximum deduction is $25,000, and the maximum deduction is reduced by $5,000 (the portion of $110,000 in excess of $100,000—or $10,000—times 0.50 equals $5,000).
However, there is a favorable exclusion-of-gain provision in the tax code that applies to the sale of a personal residence previously converted into rental property.
The sale of a rental home is taxed in accordance with the normal capital-gain and -loss rules (remember, you have turned your home into an investment), but there is the additional tax benefit of the up-to-$25,000 annual loss provision if you qualify.
This may even be enough reward to compensate you for the daily hassles of putting up with tenants.
Financial Management Tip 15:
Commercial Real Estate
Typically, given the investment risk, only experienced investors purchase the commercial real estate. Accordingly, you may wish to avoid this investment opportunity entirely.
However, if you do wish to invest in commercial properties, you will probably do so for one of two reasons: to receive annual income or to hold such properties for capital appreciation before an eventual sale.
Most investors who participate in the commercial real- estate market do so to generate income because a primary reason to invest in raw land is capital appreciation. If you are after income from a commercial property, you first need to determine how much to pay for it.
For that, fortunately, you can use a relatively easy computation known as the net operating income (NOI) formula. The formula for NOI is as follows (if you hire an appraiser to help you with the investment decision, the appraiser will likely compute the NOI for you):
Gross rental receipts from the property
+ Nonrental or other additional income from the property
= Potential gross income
– Vacancy and collection of receipts losses
= Effective gross income
– Operating expenses (excluding interest and depreciation)
= Net operating income (NOI)
Because NOI is a cash-flow computation from the commercial property, any charges you have incurred to finance the purchase of the property (such as interest on a loan) and tax-related charges (such as depreciation) do not enter into the computation.
Once you or your appraiser have computed the commercial property’s NOI, you need to divide that by a prevailing capitalization rate (cap rate) to determine how much you should pay for the property. This cap rate is not easy to determine but think of it as the rate of annual compounded return you would like to receive from the property.
It is also the reciprocal of the number of years it will take for the property to pay for itself. For example, a standard cap rate is 12 percent, meaning you want your original investment back in slightly more than 8 years (100 divided by 12 = 8.33 years).
Similarly, to achieve a 20 percent return from the property, you want your original purchase price back in 5 years (100 divided by 20 = 5).
Of course, keep in mind that you are being more aggressive, and factor in higher risk regarding the initial investment with a 20 percent cap rate than with a 12 percent cap rate.
Financial Management Tip 16:
Raw or Unimproved Land
Mark Twain is famous for saying, “Buy land, they’re not making it anymore.” This is true, but it does not provide a great deal of guidance if you are an investor trying to decide where to buy land.
The most valuable land or unimproved real estate is probably land that is adjacent to already-developed or soon-to-be-developed residential or commercial property.
It is likely that, before long, the adjacent property will also be developed, given that its highest and best use is no longer as farmland, grassland, or other land lying fallow. As a result, you will probably enjoy significant capital appreciation from this land when you subsequently sell it.
Keep in mind, though, that certain significant investment risks are associated with the purchase of any undeveloped land. Among these risks are the following:
The land may be adversely rezoned. For example, property bought for residential development purposes may be rezoned by the city or county for commercial purposes.
You may not be able to obtain permits from the county, city, or township to build on the land in the manner that you (or the developer) intend.
Access to your land may be restricted by an adjacent landowner’s property or property rights.
The population growth that you anticipate in the area may not occur.
As a result, many investments in undeveloped land are extremely risky. If you have borrowed money to buy the land (known as leveraging your investment), you must find a way to service the debt from income or assets other than your original purchase. Otherwise, you will be forced into a position to sell the land well before you otherwise intended.
Financial Management Tip 17:
Investing in Use Assets
If you think back in the financial planning process to when you first prepared your personal financial statement, you will notice that your home and auto-mobile were properly listed as use assets and not as investments.
Although a profit motive may attach to some use assets (particularly luxury automobiles or antique collectibles), generally such assets are purchased so you can make efficient and enjoyable use of them.
Your Home as an Investment
One of the things your primary residence or home should not be, however, is an investment—or, as many baby boomers are relying on, a retirement planning vehicle.
The average annual real rate of return on the residential real estate is only 1.62 percent after considering the costs of maintenance and improvement.
Moreover, it is generally not good financial planning to have too much of your net worth tied up in any one asset, such as your home. the importance of diversification when investing in financial and real assets, yet millions of individuals now, and when they retire, will hold approximately 70 percent of their net worth in just one asset: the equity in their home.
According to the Wall Street Journal as a homeowner, you can easily spend up to three times the purchase price of your homes in additional costs, such as mortgage interest, property taxes, and major home improvements.
For example, today’s buyer of a $300,000 single-family dwelling who finances with a 30-year fixed rate mortgage will end up paying the price of the dwelling over again just in mortgage interest.
Then add 30 years of property taxes, ongoing maintenance of the home, and several major home repairs or improvements, and the total cost of buying the home could approach $1.0 million.
Let’s now address two other questions you should be sure to ask before purchasing an individual disability insurance policy. Each of these questions has to do with continuing policy coverage in the future and the price you must pay to obtain it.
Does this mean you should not buy a home and should instead rent? No, not at all! Since the nationwide collapse of the housing market that began in 2007, and the subsequent historic reduction in mortgage rates, it is now less expensive in many parts of the country to buy than to rent.
However, the cost of home ownership does argue for a new method of analyzing why you bought your home in the first place.
A house is one of the few assets that does not violate the basic rule of debt management: only go into debt for an asset that is likely to appreciate in value. Notwithstanding the current housing crisis in many cities, over the long term, depending on their location, houses generally do increase in value.
As mentioned, you may have already spent your initial purchase several times over; so, as the Wall Street Journal suggests, think of the sales proceeds from your home as a rebate of the money you spent on it.
In other words, some of the thousands of dollars you spent on upkeep and improvements to your house are returned to you when you eventually sell it.
This speaks to the next major point we need to make with respect to home ownership: exercise as much financial discipline as possible over the controllable aspects of the purchase and ongoing ownership of your home.
Specifically, as a prospective home purchaser and owner, you have control over two significant home-owning costs: the amount of interest you pay and the extent of home improvements you make.
With respect to the interest payments on your home, even though some of this cost can be offset by income-tax deductions, you are doing nothing to pay down the principal on which the total interest amount of your home is computed if you simply submit your mortgage payments in accordance with your financing schedule.
Thus, accelerating your principal payments and paying off the mortgage as quickly as you can will result in considerable savings. Another option, if you can afford it, is to finance the purchase of the home with a 15-year fixed-rate mortgage rather than the standard 30-year note.
Limiting the number of home improvements you make is even more challenging, but the fact is that very few improvements will pay off for you at the time of sale.
Studies have shown that a new kitchen or bathroom returns the greatest rebate at the time of sale, but even those improvements do not often return all of the money expended.
In addition, beware the temptation to add a backyard swimming pool or dog run to your home. The next buyer of your house may not have children or a dog, so these additions can actually be disadvantageous at the time of sale, not advantageous.
Furthermore, a swimming pool can be an attractive nuisance to neighborhood kids, and if one of them falls in the pool and is injured, you will likely be sued, particularly if you did not enclose the pool.
In addition to accelerating your mortgage payments and limiting the extent of your home improvements, you can adopt several other planning strategies with respect to managing your home as a useful asset:
Adopt a different attitude. Treat your home like any other consumer purchase, and buy it at as low a price as possible. Monitor price trends in your local housing market closely, and when there is a dip in the market, consider houses to be on sale.
Buy them if you can. When tracking home values, websites such as Zillow: Real Estate, Apartments, Mortgages & Home Values can be very helpful.
Stay put as long as possible. Be a buy-and-hold home purchaser as long as possible. The average homeowner lives in their home only seven years before moving on, usually to a more expensive residence. Depending on your area and market conditions, this probably is not long enough to ensure a net profit when you eventually sell.
Pay as much cash as possible. If you can afford an all-cash purchase, doing so is preferable; but absent that, make as much of a down payment as you can. A large down payment limits the amount of principal you have to borrow and interest you have to pay.
Be careful about refinancing. Yes, if you refinance, you will lower your monthly payment, but you also extend the time of your loan and thus add to your total interest payments.
If you are going to refinance, consider going from a 30-year fixed-rate mortgage to a 15-year fixed-rate mortgage (especially as you grow closer to your planned retirement date).
Stay away from interest-only mortgages. This is not so much a cash-management tool as it is straightforward, practical advice.
Many individuals who finance their home purchases with interest-only mortgages buy more house than they can afford and thus probably pay too much. Interest-only mortgages contradict the first strategy of paying as little for the house as you can.
Diversify, diversify, diversify! After accelerating your mortgage payments, take whatever money you have left and make sure you are contributing as much as possible to your employer’s 401(k) retirement plan and any personal retirement savings vehicles, such as traditional or Roth IRAs.
But don’t go overboard: if you can pay off your house (or as much of it as possible) before you retire, you will increase your cash flow considerably and enjoy your retirement years that much more.
Buying versus Renting a Home
It can be argued that buying a home with a mortgage is just another form of renting. Instead of paying the rent to a landlord, however, as a homeowner paying interest, you are paying the mortgage lender.
Sure, you get a tax deduction for paying mortgage interest if you itemize your deductions; but until about the 20-year point in a standard 30-year mortgage, your interest payments are not doing much to reduce your principal.
As such, you are only compromising your financial well-being when you move soon after purchasing your home. As just discussed, this is why it is so important to accelerate the payment of your mortgage as quickly as possible. A sample home buy-versus-rent analysis worksheet is provided next.
HOME BUY-OR-RENT ANALYSIS
Cost of Buying
Annual mortgage payments (12 times monthly mortgage payment)
The after-tax cost of interest on down payment and closing costs ($ times % after-tax rate of return)
Total costs (sum of lines 1 to 5)
7. Principal reduction in mortgage loan balance (from amortization schedule)
8. Tax savings due to itemized mortgage-interest deduction (interest portion of mortgage payments times marginal income tax rate)
9. Tax savings due to itemized property-tax deduction (line 2 times marginal income tax rate)
Total reduction and deductions (sum of lines 7 to 9)
11.The annual after-tax cost of home ownership (line 6 less line 10)
12. Anticipated annual appreciation in fair market value of the home, if any (percentage of price of the home)
Equals: Total Cost of Buying (line 11 less line 12)
Cost of Renting
Annual rental costs (12 times monthly rental rate)
Renter’s or tenant’s insurance
Equals: Total Cost of Renting (line 1 plus line 2)
One important positive component of buying a home is not an issue for renters: the estimated annual appreciation in the value of the home. This underscores what was just discussed: it is critical that, as a prospective homeowner, you research the local market carefully and do not overpay for the property.
If you do overpay, you limit the amount of potential appreciation in your home’s value. If you happen to buy in the wrong area or at the wrong time, you may have been better off renting in the first place.
As for renting, an oft-overlooked protection strategy for the renter is the purchase of a tenant’s property insurance policy. Almost every lease includes exculpatory language whereby the landlord bears no liability for damage to or theft of the tenant’s personal property.
A tenant’s policy provides for this protection plus liability coverage for guests who may be injured while on the property. The policy also protects the tenant from the consequences of their own injurious acts, wherever they may occur.
In addition to securing a property insurance policy, a tenant should be sure to check on the status of any security deposit required by the landlord. Some landlords, in an attempt to attract tenants, invest this deposit for the tenant and pay them the interest at the end of a long-term lease.
However, more commonly this deposit is simply maintained in escrow by the landlord and refunded to the tenant at the expiration of the lease, provided the rental unit is left in good physical condition.
As a prospective tenant, you want as low a security deposit as possible and a return on your money in the form of protected premises and timely landlord maintenance.
Financial Management Tip 18:
Selling Your Home
Most of the issues involving the sale of your home are income-tax related, but you should not overlook practical questions, such as whether to sell the home yourself or use a real-estate broker.
With today’s Internet-savvy society, increasing numbers of individuals are opting to list and sell their homes themselves. However, as attractive as it might seem to avoid the cost of using a real-estate broker, consider the following if you choose to sell your home on your own:
You must establish a reasonable price for your home. Although this may appear easy given the widespread availability of comparable market data these days, you need to be as realistic as you can about what your home may be worth. As such, you must separate emotion and the natural tendency to ask for more money rather than less. Be as objective as possible.
You need to market your home. This involves much more than simply sticking a For Sale by Owner sign in the front yard. You need your house listed in your area’s multiple-listing service (MLS).
According to the National Association of Realtors, over 60 percent of home sales occur with the assistance of a buyer’s agent (in contrast, real-estate agents or brokers typically work only for the seller). Try to list your house with such an agent, who typically works as part of a network and represents any number of qualified buyers.
You need to separate the serious prospects from the merely curious. Neighbors are notorious for taking sales brochures or flyers simply because they want to see what you are asking for your house.
Instead, ask your neighbors to refer any friends or family who may be looking for a new home. You should then prequalify the serious buyers so as not to waste your time negotiating a price with someone the mortgage lender will not approve.
You have to close the deal! This is where many for-sale-by-owner sellers stumble. Many buyers are skilled in the art of negotiating for the absolute lowest price (or sometimes even a below-market price). Hence, as a seller, you have to know what price you will accept while recognizing that it is the most the market will bear at that particular time.
Assuming that you or your real estate agent have been successful in getting a fair price for your home, you now have to report the tax on any gain from that sale. Fortunately, the gain from the sale of any primary residence is considered again on the sale of a capital asset.
Depending on your income-tax bracket and whether you have owned the house for at least one year, the gain is generally taxed at either a 0 percent or a 20 percent rate.
More important, if you meet certain conditions, any gain on the sale of a home is taxable only to the extent that it exceeds $250,000 (or $500,000, if you file a joint return). This $250,000 or $500,000 exclusion may be used as often as once every two years.
To determine your taxable gain, you must subtract your basis in the home from its sales price minus all costs and commissions. This computation process underscores the importance of keeping good records because your basis in a home is generally equal to what you paid for it plus any improvements made while you owned it.
For example, assume that you paid $150,000 for your home ten years ago. While you owned it, you finished the basement at a cost of $30,000. Your adjusted basis in the home is now $180,000 ($150,000 plus the $30,000 in improvements).
Also, assume that you recently sold the home for $270,000 with the assistance of a real-estate broker. You must pay your broker a commission of 6 percent of the sales price.
Therefore, your sales price for determining any capital gains tax due is $253,800 ($270,000 less the $16,200 broker’s commission). Accordingly, your total, potentially taxable gain is $73,800 ($253,800 net sales price less $180,000 basis);
But if you qualify for the $250,000 exclusion, you do not have any recognized gain for tax purposes. In other words, you do not owe any income tax if you take advantage of the available exclusion.
To qualify for the $250,000 or $500,000 exclusion, you must meet both an ownership test and a useful test. Specifically, you must have Owned the residence for at least two out of the five years prior to when you sold it Used the home as your primary residence for this same period of time.
If you are married and file jointly at the time of sale, either you or your spouse can meet the ownership requirement, but you both must meet the use requirement. This may be a particularly difficult requirement for divorced or divorcing couples in which one partner vacates the home before sale.
If you fail to meet these tests due to a change in employment (for example, if your employer transfers you to a new location) or as a result of other unforeseen circumstances, you can exclude the fraction of the $250,000 or $500,000 exclusion that is equal to the fraction of the two-year period in which these tests were met.
For example, assume that you purchased a home on January 1, 2011, and on January 2, 2017, your employer transferred you to another city. You have owned your home for at least 12 months and, as a single taxpayer, are entitled to exclude up to $125,000 of any gain on the sale ($250,000 times 0.50 [or 12 divided by 24]).
Finally, as with any other personal asset, losses on the sale of a home used as a personal residence are not allowed for income-tax purposes.
Automobiles: Do You Really Need That New Lamborghini?
Unlike houses, which have historically appreciated in value, no other use assets depreciate in value more quickly than automobiles. From a debt-management perspective, you should think twice before borrowing to purchase a new luxury automobile.
Remember, it does not make financial sense to borrow to buy a depreciating asset. Nevertheless, in most places in America, an automobile is not a discretionary purchase, but a necessity for getting around. What are some tips for taking the most advantage of this necessary tool for daily living?
If you can suffer what is, for some, an indignity, purchase only a quality used automobile. An automobile broker can assist you in finding one. Then, as with a house, do not overpay for it.
Do some research before you buy. For example, if you have decided on a pre-owned car, consult the Kelley Blue Blog to determine what you should be paying as the retail price.
If you are purchasing a new car, there are online services you can consult to find out the dealer’s invoice cost. Start your negotiation with the dealer about 2 per-cent above that cost, and try to work down from there.
Before you buy, try to determine whether the car you are interested in is likely to become a classic model. For example, individuals who were fortunate enough to buy a 1957 Chevrolet or a 1965 Ford Mustang transformed a depreciating asset (a car) into a collector’s item (a classic automobile).
Buy only one quality automobile at a time, and keep it for at least ten years or 100,000 miles. Fortunately, automobiles are improving in quality all the time, so this should not be too difficult.
Keep your car in good repair and up to date on maintenance. It has been proven that well-tuned cars conserve gasoline and thus, in the longer term, save you money.
Another decision you may need to make with respect to an automobile is whether to buy or lease the car. Generally, when a high percentage of the car’s use is for business purposes, it may be more advantageous to lease instead of buy.
Not only can the business portion of the lease payments be deducted for income tax purposes, but the business portion of the interest on the loan may be deducted.
Further, depreciation of the leased vehicle, within certain limits, is also a tax deduction. Finally, if the vehicle you are purchasing is to be used for primarily personal purposes, buying and owning the car for a significant period of time is preferable.
This is particularly the case if the lease agreement does not provide for an option to purchase the car at its depreciated value at the lease’s expiration date (known as a closed-end automobile lease agreement).
Financial Management Tip 19:
Tangible Personal Property and Collectibles
The tangible personal property, such as art, stamps, and coins, may be transformed from a useful asset to an investment based on the rarity and quality of the property.
Likewise, a hobby, such as a stamp collecting, may turn into a business depending on whether there is intent on the part of the collector to earn a profit from the activity as determined by the IRS and the courts.
Examples of popular investment-quality collectibles include artwork, gem-stones, rare coins, antique dolls and furniture, and even baseball cards. All share certain attributes—notably, rarity and popularity within a sizeable market.
But collectibles generally do not provide any current income to the owner and are best held for capital appreciation. Once disposed of, the items are taxed at a special long-term capital gain rate of 28 percent.
Although there is a market for collectibles, in most cases it is not an organized market. As a result, both buyers and sellers are at a disadvantage, because unless they are very skilled, they are unlikely to know what constitutes a fair price for the item.
As with so many other consumer purchases, the Internet and a multiplicity of websites (particularly eBay) have improved access to reliable information about collectibles. Still, by and large, the market for collectibles is inefficient.