Financial and Wealth Management (80+ New Financial Hacks 2019)

Financial and Wealth Management

Financial and Wealth Management with Financial Planning Process

Wealthy, as defined by Merriam-Webster’s Collegiate Dictionary, is the state of “having wealth” or becoming “extremely affluent.” There is no mention of actual money in this definition, but most people can’t become wealthy without also being rich.


In other words, the amount of dollars you have (either in your pocket or invest in financial or real assets) is equivalent to wealth.


This blog attempts to go beyond the standard definition of monetary accumulation (or what most people think of when they hear the word “rich”) to characterize wealth as a process of achievement involving not only financial independence but also an emotional and psychological state of looking forward to and being comfortable with the future.


Indeed, when we substitute the word “successful” for “wealthy,” we see that what most individuals want is a successful and fulfilling future that involves much more than purely monetary riches!


So how do you achieve wealth? There is both a hard (monetary) and a soft (psychological) answer to this question, but certainly, if your financial affairs are not in order, it complicates the summative belief that you’ve achieved a wealthy life. Thus, implementing a financial plan to manage the future is very important.


If you have not assembled such a plan, or even if you have not thought about how best to manage the future, don’t worry—you’re not alone! Americans are notoriously bad planners (and notoriously good procrastinators), but the important point to understand is that financial planning and wealth accumulation is a journey and not a destination.


You need to begin the financial planning process and then (hopefully) continue it as best as possible, with or without professional assistance.


This blog is designed to help you to do both—that is, as a do-it-yourself planner, as many individuals are inclined to be (either by conscious decision or by default of circumstances), or by becoming an educated consumer when seeking the help of a financial planner.


In addition, the blog introduces you to a simple way of thinking about the financial planning process: 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 (and for the benefit of your heirs after your death). Let’s begin!


The Steps in the Financial Planning Process

 Financial Planning

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. (We talk about budgets shortly.)


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!


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.

financial position

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.


In addition to preparing a statement of personal financial position, you need to track your ongoing expenses and sources of income.


A second reference document, the personal cash flow statement or worksheet, should be completed at least once a year (better done monthly, if possible). Here are the reasons why:

cash flow

The cash flow statement lets you see where you are actually spending your money (it will tell you whether you are living within or beyond your means).

  • It gives you an idea of your ability to save.
  • It pinpoints your financial strengths and weakness with respect to your current standard of living.
  • It can serve as a practice document before preparing a budget for future cash flow management (the cash flow statement reviews past financial performance or looks backward, whereas the budget looks forward).


Just as the statement of personal financial position has three general categories (cash equivalents, investments, and use assets), so does the personal cash flow statement.


On the cash flow statement, you should separately identify cash inflows (sources of income), cash outflows (ongoing expenses), and any resulting cash surplus or cash deficit. A cash surplus or deficit is merely the difference between your cash inflows and cash outflows.


Of course, what you want at the end of the year (or month) is a cash surplus, sometimes known as discretionary income, because that amount is available for saving.


A little mental trick to help you save: include a fixed savings amount or percentage of income on the first line of the Cash Outflows column. In other words, pay yourself first, and treat the savings amount the same as you would any other fixed expense.


An ongoing issue with respect to the preparation of the cash flow statement is whether to show income and social security taxes as a separate expense or cash outflow (alternatively, you would show the after-tax amount among your cash inflows because your paychecks reflect this).


The better practice is to list these taxes as a cash outflow, because (again) one of the purposes of the cash flow statement is to show you how you are spending your money.


If you include a separate line item for income and social security taxes among the cash outflows, it forces you to account for what may be an otherwise invisible expense. The following is an example of a properly prepared personal cash flow statement.





  • Salaries $
  • Bonuses $
  • Self-Employment Income $
  • Interest Received $
  • Dividends Received $
  • Capital Gains (from sale of assets) $
  • Rents and Royalties $
  • Pension and Annuities $
  • Social Security $
  • Other Income $
  • Total Cash Inflows $


  • Savings $
  • Rent/Mortgage Payments $
  • Repairs, Maintenance, $
  • Improvements
  • Utilities $
  • Auto Loan Payments $
  • Credit Card Payments $
  • Food $
  • Clothing $


Insurance Premiums:


  • Life $
  • Health $
  • Long-Term Care $
  • Disability $
  • Auto $
  • Homeowner (if not included in $ mortgage payment)
  • Umbrella Liability $
  • Total Insurance Premiums $
  • Medical Expenses $
  • Property Taxes (if not included in mortgage payment) $
  • Income Taxes $
  • Social Security and Medicare Taxes $
  • Child-Care Expenses $
  • Recreation and Entertainment $
  • Other Expenses $
  • Total Cash Outflows $

You may be wondering how both statements (the statement of personal financial position and the personal cash flow statement) tie together.


A cash surplus from the cash flow statement at the end of the year (or for whatever period you choose to list your income and expenses) increases your net worth, as reflected on the statement of personal financial position.


Conversely, a cash deficit decreases your net worth. Increasing net worth is a financial strength, whereas decreasing net worth (particularly if the decrease continues over a long period of time) is a financial weakness.


In other words, if a cash deficit continues (you are spending more than you are earning), you need to do something to reverse the situation. If you don’t, your financial goal of future wealth accumulation is impossible.




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 (hence the need for the emergency fund).


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.


Cash Flow and Debt Management

 Debt Management

As a matter of financial prudence, you should maintain an emergency or contingency fund for unanticipated expenses. This fund should be kept in liquid assets (those that may be converted quickly to cash without a significant loss in value) and equal in amount to three to six months of expenses.


(For example, if your monthly expenses average $5,000, you should have a contingency fund of at least $15,000—$5,000 times 3—in a checking, savings, or money market account or mutual fund.)


The size of this fund will vary depending on the nature of your employment and the constancy (or variability) of your income. A self-employed individual who has no employer to provide benefits to serve as a safety net (such as sick or personal days) should consider an even larger fund to compensate for lost income.


There is an investment trade-off, however, when establishing a contingency fund. This trade-off is a lower investment rate of return from money kept in more conservative cash equivalents.


For this reason, you may wish to consider establishing an unsecured line of credit with a bank or a home equity line of credit to substitute as emergency fund assets.


Be careful: if you do this, you must arrange for the credit line before the financial emergency occurs. For example, if you lose your job (for whatever reason), the bank is unlikely to extend you any credit.


Plus, if you are using a credit line as your emergency fund and you need to access the line once you have lost your job, you will incur even more debt—probably the last thing you need when you are no longer employed.


Let’s move on to a great tragedy or success story (depending on how you look at it)—the amount of debt carried by the average consumer. We read a great deal in the media about the negative savings rate of many Americans.


Is that bad? It depends. There is both good and bad debt. Good debt is generally any debt incurred for the purchase of an asset that is likely to appreciate—for example, your home or real estate in some parts of this country. 


More specifically, good debt is any interest rate assumed on an obligation where you are paying less than what you can make, in terms of investment return, on the asset for which you have borrowed the money.


Another example (in a rising stock market) is the margin interest incurred on the purchase of an individual stock or mutual fund from which you can potentially earn a far greater return than what you must pay the broker to make the purchase.

Bad debt

Bad debt is any debt incurred on an asset that is likely to depreciate in value, such as a new car or automobile. Another type of bad debt is credit card debt, which not only carries extremely high rates of interest (18 to 21 percent annually, on average), but also “revolves” from month to month so that it is very difficult to completely satisfy the obligation.


Both automobile and credit card debt share the income tax disadvantage that they are considered personal or consumer debt, which means that the interest paid generally is not deductible in reducing your annual income tax liability.


So how do you go about reducing bad debt? The obvious answer is not to incur it in the first place (by paying cash for a new car, for example), but often this is impractical. Here are some tried-and-true debt reduction techniques:


Focus on one type of bad debt to the exclusion of others. For instance, adopt a payment schedule and amount to pay off on your credit card debt—and stick to it!


Consider it another form of paying yourself: if the interest rate on the card is 18 percent annually, it is similar to earning 18 percent on an investment. (That does not mean, however, that credit cards are a good investment.)


Consolidate or restructure your debt. The most common example of this is a college or graduate student who consolidates several smaller loans into one larger loan. Although this does not eliminate the debt, it often reduces the total amount of debt service (interest).


Borrow from your cash-value life insurance or 401(k) plan. The advantage of these alternatives is that you are, in essence, borrowing from yourself. But be careful: you need to repay this money in a timely manner, or you will reduce the amount of your life insurance coverage and retirement plan benefits payable in the future.


If you die and still owe a balance on the life insurance policy loan, the insurance company will only pay the policy proceeds less the outstanding loan balance to your named beneficiary or beneficiaries. Similarly, if you leave your employer with an outstanding 401(k) loan balance, the company will likely pay only a net amount in your final paycheck or severance payment.

debit cards

Switch to debit cards. Debit cards work much like ATM machines because the money comes out of your checking account immediately. Although a debit card does not stop you from excessive spending, it does make you reckon with the cash-flow consequences much more quickly than would a traditional credit card.


Finally, it cannot be stressed enough that poor cash-flow and debt management can put you on the path to financial ruin. Fortunately, credit counselors and some financial planners can assist you in reducing your debt load.


If you think you have a problem with debt, you probably do! If you can’t solve the problem, the wealth-building techniques discussed in this blog will take much longer to work for you—if they work at all.


Monitor Your Progress and Life-Cycle Planning

 financial progress

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. (The question of whether you need a financial planner is addressed in the next blog.) 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.


Elements of Personal Financial Planning and the Wealth Management Process

Wealth Management Process

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.


Bottom line: you have to convince yourself of reasons to save, or you will probably not do it. One of the purposes of this blog is to provide you with those reasons.


Personal Financial Planning and Wealth Management

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)
  • Investments
  • Income tax planning and management
  • Planning for retirement
  • Estate planning


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.


The Need for an Investment Policy Statement

Investment Policy Statement

Many planners refer to the investment policy statement as the third mandatory personal financial statement. The investment policy statement helps the investor specify realistic investment goals while also forcing them to consider the risks and costs of investing.


For example, specifying that you wish to obtain an average 15 percent annual rate of return on an investment in an individual stock begs the question of whether you also expect the stock to increase in price by this same amount consistently every year.


If so, you need to engage in a reality check! Such thinking ignores the risk of stock investing because the market price of stocks can fluctuate dramatically from year to year. This is known as volatility, which you need to understand and accept as a risk prior to investing in the stock market.


Any well-developed investment policy statement has four basic sections. With allowances for the specific wording of any customized statement, these sections are:


Statement of the Investor’s Objectives: The formulation and statement of these objectives are your primary input to the statement and should explain your investment goals in terms of investment risk and return.


A careful analysis of your risk tolerance should precede any discussion of return objectives. As we have discussed, typically, you will not know how to adequately define your risk tolerance; accordingly, this is one of the benefits of using a financial planner, who will help assess and clearly specify the amount of risk you are willing to assume.


A person’s return objectives may be stated in terms of a percentage, but they may also be stated in words. For example, capital preservation means investors seek to maintain the purchasing power of their investment—therefore, the necessary return must be no less than the rate of annual inflation.


Alternatively, capital appreciation is an appropriate objective when the investor wants to achieve growth of their investment through capital gains (a return considerably more than annual inflation). A current income objective means the investor wants the manager to invest in dividend-paying stocks or interest-earning bonds to generate income.


Finally, a total return strategy implies that the investor seeks to increase the value of investments by taking advantage of both capital gains and reinvesting any current income back into the investment for future growth of principal.

Statement of Investment

Statement of Investment Constraints or Limitations: In this section of the statement, you need to specify your investment time horizon or the time period in which you intend to invest.


Concomitant to this time period is your need to access the money without a significant loss to principal (also known as liquidity).


Investors with longer investment horizons, such as an investor who is saving for retirement, generally require less liquidity and can thus tolerate more investment risk.


Investors with shorter time horizons, such as an investor already in retirement, generally seek greater liquidity and less risky investments because losses cannot be overcome nearly as quickly.


Additional factors or limitations that you will typically wish to consider when developing a policy statement are the current and expected state of the overall economy and sectors of the economy in which you may be considering investing (for example, technology). The current tax status of any previous investments should also be taken into account.


For example, an individual who is saving for retirement and is taking advantage of the tax-deferred nature of an individual retirement account (IRA) may engage in more frequent investment transactions than someone who holds these investments in a taxable portfolio where capital gains must be recognized at the date of sale.


A final, often-included limitation covers the unique circumstances or preferences of the investor. Here is where you should state any preference to invest only in socially responsible companies. Similarly, you should give some thought to your current or anticipated cash flow.


For example, if one of your goals is to purchase a vacation home during a shorter, specified time period, you will need to invest in relatively liquid assets. Alternatively, if you expect to receive a large inheritance during the time period (thus providing additional money for investment), you should discuss what you want to do with this money.


Meeting the Investor’s Objectives and Allocation of Investment Resources: Although the typical investment policy statement does not indicate specific stocks or bonds the investor should purchase or sell, it should provide guidelines with respect to which asset classes to include and the relative percentages of each.


In other words, the investment policy statement should provide an asset allocation strategy.


The assets you may wish to invest in may not be the same as the typical investor based on your risk-tolerance level, desired rate of return, and investment time horizon. However, most investment policy statements use only three categories or classes of investment assets:

  • Stocks
  • Bonds
  • Cash or cash equivalents (savings accounts, short-term certificates of deposit, money market funds, and an asset that is relatively liquid)


Investment percentages are assigned to each class. (Note: Sometimes a fourth category, referred to as alternative investments, is also used as an asset class. These are any assets other than stocks, bonds, and cash, such as gold or silver.)


Many methods are used to allocate the investment percentages, including some involving computer software. There are also a few rules of thumb. For example, one commonly cited rule is that you should subtract your age from 100 to determine the percentage amount that should be devoted to stock or stock mutual fund investments.


The rest should be split between bonds and cash or cash equivalents, with only a relatively small percentage allocated to cash given its lack of relative return. Here are four sample asset-allocation scenarios for a young, mid-life, pre-retiree, and retired investor of moderate risk tolerance:


  • Young investor (aged 25 to 44): 75 percent stocks; 20 percent bonds; 5 percent cash or cash equivalents
  • Mid-life investor (aged 45 to 55): 60 percent stocks; 30 percent bonds; 10 percent cash or cash equivalents
  • Pre-retiree investor (aged 55 to 64): 50 percent stocks; 35 percent bonds; 15 percent cash or cash equivalents
  • Retired investor (age 65 plus): 40 percent stocks; 40 percent bonds; 20 percent cash or cash equivalents


Once the asset-allocation process has been determined, you should consider a mix of assets that have the highest probability of meeting your financial goals at a level of risk with which you are comfortable. As you get closer to meeting your financial goal, you should adjust this asset mix.


For example, if you are several years away from meeting your goal, the safety of principal should become more important to you than the growth of that principle; accordingly, you should adjust the percentage of asset mix toward short-term bonds and cash equivalents and away from stocks.

Asset allocation

Asset allocation generates portfolio diversification, which is the key to reducing your investment risk. We will talk more about diversification later in this blog, but for now, you should understand that a well-thought-out asset-allocation strategy is the foundation of any effective investment policy statement.


Monitoring the Performance of the Investment Plan: The drafting of a policy statement will assist you in judging the performance of your investment manager. Typically, the statement should include a model or benchmark portfolio against which the performance of the manager may be judged.


For example, if you choose to invest in large-capitalization stocks (companies that have a large amount of outstanding public stock), you will likely want to compare the performance of the manager against the benchmark annual return of Standard & Poor’s Index of 500 stocks.


Alternatively, if you choose to invest in smaller-capitalization stocks, a benchmark portfolio of similar stocks, such as the Russell 2000 Index, should be used.


Because benchmark portfolios set an objective performance standard, the investment policy statement acts as a starting point for periodic portfolio review and assessment of investment manager performance.


The Basics of a Diversified Portfolio


A diversified portfolio should be diversified in two respects: between asset classes and within asset classes. Therefore, in addition to allocating your assets among stocks, bonds, and cash equivalents, you need to mix your investments within each of these three asset classes.


The key to doing this successfully is to identify investments that may perform differently under different market conditions. For example, you should locate a stock that does not go down (or does not go down much) in a declining or bear market.


The search for a stock that behaves in this manner, also known as correlation, is not easy; in essence, finding such a stock is how portfolio managers earn their money. Investment textbooks available at public libraries can tell you how this can be done.


A word of advice, however: leave this to the pros! If you choose to go about trying to select lower positively correlated or negatively correlated stocks on your own, you will quickly expend a lot of research time and possibly money and probably still not pick the stocks correctly.


Because achieving effective diversification is not easy, you may prefer to purchase a number of mutual funds. Mutual funds are a type of professionally managed asset, regulated by an investment company, that pools money from many investors and invests in stocks, bonds, and financial assets.


Such a fund makes it easy for the individual investor to own a small portion of a great number of investments. Be careful: a mutual fund investment does not necessarily guarantee instant diversification.

mutual fund

For example, the mutual fund may be investing only in stocks issued by companies involved in the same industry (called a sector fund). Thus, if you purchase a sector mutual fund, you have diversified between asset classes but not within asset classes.


A mutual fund investing only in the stocks of technology companies is not participating in the broader market, which includes the stocks of many more types of companies and industries.


There are also ways to purchase mutual funds that are automatically diversified based on your age and life stage. A life-cycle fund is a diversified mutual fund that automatically shifts toward a more conservative mix of investments (more bonds, fewer stocks) as it approaches a particular year in the future, known as its target date.


The Basics of Rebalancing


Rebalancing is a fundamental aspect of the initial asset-allocation decision and is necessary to bring your portfolio back to its original asset mix or percentages. Why is this required?


Over time, some of your investments and asset classes will grow more quickly (or decline more) than other classes, thus deviating from the original percentages you specified as a part of your investment policy statement.


Let’s say the stock market had a “good year” (a year in which the asset values of the majority of stocks increased in price). As a result, your initial stock allocation of 60 percent has now increased to 75 percent of your total portfolio. (This also means your percentage allocations to bonds and cash equivalents have decreased.)


You are faced with either selling off some of your stock investments or purchasing more investments from the bonds and cash or cash equivalents asset classes, assuming that you wish to remain true to the asset allocation you established when the investment policy statement was prepared.


This is not a bad thing. Portfolio rebalancing is an automatic trigger that will assist you in the practical accomplishment of this step.


How often should you rebalance your portfolio? Like many other questions in financial planning and wealth building, this one has no definitive answer.


If you have engaged the services of an investment advisor or professional financial planner, and a separate account has been established to hold your assets, the advisor will notify you when it is time to rebalance.


Alternatively, if you are proceeding on your own, this decision is yours to make, although an annual rebalancing is likely prudent. Whatever the time frame, before you rebalance your portfolio, consider any transaction fees or income tax consequences that may result from the rebalancing.


If you have invested in a taxable account and experienced a loss on the value of your stocks or bonds, consider selling those assets now and using the loss against your income taxes. By doing so, you also avoid one of the biggest mistakes of the average investor: refusing to let go.


Some securities will never return to their original value. Even if they do, think of what you could have made with your money in the meantime. The opportunity cost of what you could have done with your money—but did not—is rarely considered by the average investor.


Investment Strategies

Investment Strategies

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
  • Total: 258.80


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.


Averaging Down

Averaging Down

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.


Dividend Reinvestment Programs

Dividend Reinvestment

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.



income investments

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.


Buy and Hold

Buy and Hold

Another phrase that describes the buy-and-hold investment strategy is passive portfolio management. In other words, the investor does not intend to actively trade the stocks, bonds, or other assets in their portfolio and instead chooses to own those investments for a relatively long time.


Buy and hold, coupled with dollar-cost averaging, is a common strategy for building wealth to meet the average investor’s saving-for-retirement financial planning goal.


The buy-and-hold strategy has several advantages:

You can minimize your acquisition and trading costs in the trading of securities, leading to considerable savings over time.


It will assist you in managing your income tax obligations. For example, if you do not sell a security in a given year, you do not need to recognize a capital gain or loss on your income tax return.


Academic studies have shown that the most significant gains in the securities markets are made during several trading days throughout the year; a buy-and-hold strategy ensures that you will not be out of the market during those days.


A warning: many individuals say they are buy-and-hold investors when, in fact, they are not. Most of us allow changing market conditions to influence our buy-and-sell trading decisions. In other words, we let short-term emotions get in the way of our long-term investment decisions.


Mega-investor Warren Buffett has made his investors rich in part by not permitting emotions to dictate his investment philosophy. If you are a pure-buy-and-hold investor, you will remain in the market for a long time with little concern for market volatility.


Market Timing

Market timing is the behavioral opposite of the buy-and-hold strategy. It is an attempt to predict the overall direction of the securities market and to take advantage of the market’s volatility, whether that general direction is up (a bull market) or down (a bear market).


Market timing should not be confused with the rebalancing strategy discussed earlier in this blog. You should rebalance your portfolio to maintain consistent asset-allocation percentages over time.


However, when you rebalance, you are responding to rules and conditions that you have established: through an asset-allocation strategy, included in an investment policy statement, that is intended to culminate in the meeting of your financial goals.


Market timing responds to external market circumstances—rules and conditions that have been established by the market—over which you have no control. In actual practice, portfolio rebalancing is proactive, whereas market timing is reactive.


Does market timing work? Probably not, largely for the reason mentioned earlier—an investor needs to stay invested in the market all year long to experience the greatest gains. Nevertheless, if done properly, market timing can have some value.


For example, as an investor, you should pay attention to reports that indicate whether a large number of market timers are either buying or selling over a period of several weeks. This may give you some perspective with respect to overall market sentiment (and, accordingly, whether the market is likely to go up or down).


Value versus Growth Investing

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.


Investing in Real Estate

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.


Ensuring Yourself and Your Family

managing wealth

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.


Do I Need Life Insurance? How Much?

Life Insurance

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 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.


Types of Term Insurance

 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, 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

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 with 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), a 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.


Ensuring Your Earning Power

financial planner

Ask any financial planner or insurance agent what the most neglected or underinsured financial risk is, and they are likely to say the risk of losing your ability to earn a living. Most individuals simply do not give sufficient attention to this possibility and, if they do, believe that they are adequately covered.


In other words, they believe they will never lose their earning power. However, according to the Commissioner’s Individual Disability Table A, one in three working Americans will suffer some form of disability that lasts at least 90 days before they reach the age of 65. In addition, one in seven employees will be disabled for five or more years prior to their retirement.


You are two to three times more likely to become disabled during your working career than you are to die during this same period. These are impressive (and somewhat frightening) numbers.


Many individuals believe they are adequately insured against the loss of future earning power because they are covered by a group disability income policy at their place of employment. However, there are two major flaws in this thinking:


Most employer policies replace only 50–60 percent of your monthly income.


The replacement income provided by this benefit is likely income-taxable since the employer paid the cost of the insurance premium while you were working. In turn, this means you will receive less than the 50–60 percent of monthly income promised to you.


  • How can this often-forgotten risk be adequately covered? Most commonly through the purchase of an individual disability income policy.
  • Is the Loss of Your Earning Power Already Adequately Covered?


There are other forms of insurance that you may rely on to protect your earning power in the event that you are unable to work. Among these is supplemental income insurance, which is designed to pay your living expenses while you are disabled. The best known of these policies is issued by American Family Life Assurance Company—better known as AFLAC. Quack, quack!


In addition to supplemental policies, employee benefits from your employer are typically available, as mentioned previously. For short-term illness, your employer may provide sick leave, short-term disability income protection, or both.


Furthermore, all employers are mandated by the state to provide worker’s compensation benefits in the event of a serious injury while on the job. Keep in mind, however, that most employers only provide group long-term disability policies.


Benefits from these types of policies begin when short-term benefits if there are any, stop. Long-term benefits then generally continue until you reach age 65, until your full retirement age under Social Security, or until you return to work.


Group policies include a cap or limitation on the amount they will pay—usually no more than 60 percent of your monthly income.


Plus, as with most employee benefits, once you leave your current place of employment, the disability income coverage is terminated.


Social Security income protection, on the other hand, is a disability benefit provided under the Social Security system, but qualifying for it is not easy (some would say impossible—at least for a first-time application). Specifically, to qualify for a disability benefit under Social Security, you must


  • Have been disabled for at least five full calendar months
  • Have a disability expected to last at least 12 months or end in death
  • Be unable to engage in any substantially gainful occupation and not just your own occupation at the time your disability begins


Like funding for possible long-term care needs, many individuals (if they have given any thought to their chances of becoming disabled) attempt to self-fund for disability through investment.


To determine what you would need to self-fund for this possibility, review the basics of what we have discussed so far—most notably, how to prepare and analyze a personal cash- flow statement—and see what your monthly expenses are.


Then multiply this amount by 12 and determine the amount of your total annual expenses. Doing so gives you some idea of the funds needed to take you through one year of disability.


Most long-term disabilities last more than a year, so you should now be able to appreciate the actual amount of savings needed to cover the risk of loss to your earning power.


Most people cannot afford to self-fund for very long, which brings us back to considering the purchase of an individual disability income insurance policy.


Definitions of Disability

income insurance policy

The most important part of any disability income insurance policy (and the single most important consideration for you) is the language used by the policy to define disability. Fortunately, there are really only three definitions:


Own Occupation (Own Occ): This is the most favorable definition of disability from the point of view of the insured. The definition states that the insured is considered totally disabled (and therefore eligible for benefits payments) if they are unable to engage in the primary duties of their own occupation.


For example, a medical surgeon would be unable to engage in their own occupation if they suffered an injury to the hands. This would be the case even if the surgeon were still able to diagnose illnesses as a general practitioner of medicine.


Modified Any Occupation (Modified Any Occ): This definition is slightly less restrictive than the Any Occupation definition but not as liberal as the Own Occ definition. Modified Any Occ defines disability as the insured’s inability to engage in any occupation for which they are reasonably suited by education or experience and for which they could easily become qualified.


Applying this definition to the medical surgeon example, if the surgeon could become a general practitioner reasonably easily after the injury to their hands, the policy probably would not pay a benefit.


Any Occupation (Any Occ): This is the practical opposite of the Own Occ definition and requires the insured to be unable to perform the duties relating to any gainful occupation before they are considered to be totally disabled.


It is not unlike the Social Security definition of disability, except that there is no five-month waiting period and expected the length of disability.


The Any Occ definition is usually limited to blue-collar workers, although white-collar workers and professionals may also obtain a policy with this definition. The reason these individuals would want to do so is to achieve premium cost savings.


Group long-term disability policies usually use a combination of the Own Occ and Modified Any Occ definitions (called a split-definition policy). Such policies permit the insured to receive benefits for a period of months or years under the Own Occ criteria;


Then, after the insured has been retrained for another position, the policies apply the stricter Modified Any Occ definition. Why? By design, the split definition encourages the worker to return to work and remain with the company, even though it may be in a new position or occupation.


It is also possible to write an individual disability income policy with a loss-of-income definition. With this kind of policy, the type of disability is not defined; rather, if, as a result of injury or sickness, the insured suffers a loss of income, benefits based on that loss are payable regardless of whether the insured returns to work in the same or a related occupation.


Given that it does not usually provide as great a benefit, the loss-of-income policy is not as popular among professionals or other workers as the Own Occ definition.


But insurance companies like the loss-of-income standard because it establishes a simple benchmark from which to measure the number of benefits payable.


Additional Important Provisions in an Individual Disability Policy


Many of the same provisions that are included in a long-term care insurance policy are found in an individual disability income policy. For example, like long-term care policies, disability insurance includes an elimination or waiting period, a benefit period, and a benefit amount.


The elimination period in disability insurance essentially works the same way as that included in a long-term care policy. In other words, an elimination period is the period of time after the insured has met the qualifying conditions to collect under the policy but before any benefit payments are actually made.


In the case of disability insurance, an elimination period of 90 days is probably optimal when considering the trade-off between covering the required payments from personal funds for a number of days and the need for as low an insurance premium as possible.


Longer elimination periods naturally reduce policy premiums, but the longer this period, the greater the need for personal savings or other alternatives to cover the insured’s ongoing living expenses.


A somewhat novel and increasingly popular alternative that insurance agents are recommending to cover the elimination period is the separate purchase of a critical illness insurance policy.


Critical illness insurance is an insurance policy that makes a lump sum cash payment if the insured is diagnosed with one of the critical illnesses listed in the policy and survives a minimum number of days (typically 30) from the date of diagnosis.


Such a policy may be underwritten to require payment for the same illness or condition that prompts the insured to make a claim under their disability policy—and to make payment immediately rather than some 90 days later.


The maximum number of months or years that a disability income policy will pay a benefit is referred to as the benefit period. Most disability policies written today provide benefits until the insured becomes eligible for Medicare or reaches age 65. Nonetheless, some insurance companies will write a policy that ensures disability payments are made throughout the life of the insured.


The longer the benefit payment period, the higher the insurance policy premium. As such, you should think very carefully about whether this trade-off is financially worth it.


During retirement, if you are looking for a financial product to make lifetime payments, some form of annuity policy is likely a less expensive way to ensure an income stream, rather than an extremely long disability insurance benefit period.


Finally, what most people are interested in when purchasing a disability income policy is the benefit amount that is payable.


The general approach in the underwriting of all disability income policies is to pay individuals slightly less than their net after-tax income if they were able to work, thus encouraging them to return to work as soon as possible.


This typically works out to a benefit payable of somewhere between 50 and 60 percent of an employee’s previous monthly gross pay. If you are covered at work by a group long-term disability policy at the time you apply for individual coverage, the amount of new disability insurance that you can obtain will probably be limited because of underwriting restrictions.


If this is the case, ask your insurance agent if the company will sell you a rider—an addition to the insurance policy with specified benefits or conditions—that allows you to increase the benefit amount without having to undergo a qualifying medical exam.


Or, better yet, purchase and implement an individual disability policy before you participate in the group policy; then you can receive both benefits in the event that you leave the company.


You should also consider whether and how much of your disability insurance income may be taxable. In other words, how much of this income do you actually get to keep? Fortunately, unless you are self-employed, the answer is relatively simple.


If the employer pays the disability income insurance premiums on your behalf, the disability income payments are taxable. Alternatively, if you pay the disability insurance premiums yourself, the disability income payments are income-tax-free.


Therefore, when coupling a group policy with individual disability coverage, the group payments are taxable, whereas those payments made from an individual policy are not. In summary, you are now in the same position you would be in if you had been able to continue working and were receiving a steady paycheck.


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.


Policy Continuation Provisions

Policy Continuation Provisions

The first question you should ask with respect to policy continuation is whether the policy can ever be canceled. In contrast to group policies, individual disability income policies may be underwritten as non-cancelable.


This is a guarantee that not only can the insurance company not cancel the policy, but it also cannot increase the policy premiums unless otherwise provided for in your contract. This kind of guarantee does not come cheap, particularly in today’s inflationary society, but you want the cash-flow protection if you can get it.


The second question to ask with respect to policy continuation is whether the company can raise your premiums. Certainly, if you have been fortunate enough to secure a non-cancelable policy, the answer is no.


However, what if you cannot or do not want to incur the additional cost of a non-cancelable policy? In that case, you have another option: you can purchase a guaranteed renewable policy.


A guaranteed renewable policy allows the insurance company to increase the premiums but not to change the terms of the policy once written.


The company also guarantees that you can renew the policy at the date of expiration as long as you have paid the premiums on a timely basis. In addition, the company cannot single you out for any rate increase; it may only increase the premiums for an entire class of similarly rated insureds.


Guaranteed renewable policies generally have lower premiums than non-cancelable policies. Once issued, insurance companies are loath to increase the premiums on guaranteed renewable policies for fear of creating disgruntled policyholders.


As such, it may be possible for you to get essentially the same level of protection with a guaranteed renewable policy as with a non-cancelable policy but at a much lower cost.


Additional Policy Benefits to Consider

Policy Benefits

Many individual disability policies offer additional benefits, usually in the form of a policy rider. Here are some of the more important possible additional benefits:


Cost of living adjustment (COLA) rider: The most common form of this rider increases the disability benefit paid after you start to collect benefits, thus protecting you against inflation.


Another form increases the policy benefits by a specified percentage (usually five percent) each year before you become disabled, thus ensuring your constant purchasing power once you begin to draw benefits.


Return of premium: This benefit requires the insurance company to refund a portion of your premium if no claims are made for a specified period of time.


Waiver of premium: This benefit allows you to stop paying the premium on the policy if you are disabled for a period of time, usually 90 days.


Partial disability rider: This benefit is triggered when you are unable to perform some important duties of your own occupation but are able to perform enough other duties to allow you to return to work part-time. In this event, the policy pays a partial benefit, such as 50 percent, of the total that would otherwise be payable.


Residual disability rider: This rider provides that if you are able to return to work full-time but at lesser pay than before due to a disability, the policy will pay the difference between your former pay and the current pay for the benefit period.


Guaranteed insurability rider (also known as an increase-in-benefits rider): This rider guarantees you the opportunity to increase the benefit amount payable under the policy at specified time periods, regardless of your physical or mental health at the time.


A usual requirement to obtain this rider is that you must have initially purchased a disability policy that is at least 80 percent of the maximum benefit amount that the insurance company would approve.


Policy Exclusions

Policy Exclusions

Just as with other insurance contracts, it is important to know what is not covered under a disability income policy. These are known as policy exclusions and, with respect to disability income policies, refer to particular injuries or illnesses that may result in the insured not being able to work.


Those that are most frequently encountered are disabilities resulting from War or an act of war

  • Pregnancy or complications from childbirth
  • The insured committing or attempting to commit a crime
  • A period when the insured was incarcerated
  • An injury or disease that was self-inflicted, including those related to or caused by drinking alcoholic beverages or the illegal use of drugs
  • Remember, if your disability results from any one of these exclusions, the policy will likely not pay benefits.


Questions to Ask Before Purchasing an Individual Disability Income Policy

  • What is the definition of disability in my policy?
  • What is the amount of benefit payable from my policy?
  • Do I have to pay taxes on that benefit?
  • How long are my benefits payable?
  • Is my benefit adjusted for inflation (and if so, in what amount)?
  • Is there an elimination or waiting period before I can begin to receive my benefit (and if so, how long is it)?
  • Is there a way I can ensure that payments are made during this waiting period?
  • Can I renew my policy without undergoing a medical examination?
  • Can the company increase my policy premiums?
  • What are the policy exclusions and do they affect me?


This blog concludes our look at personal risk exposures. Now, let’s consider a risk exposure that most of us also have: the risk of loss or damage to our property, such as a home or automobile. Business insurance for self-employed individuals is also addressed in the next blog.


Investing in Real Assets

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).


Vacation Homes

Vacation Homes

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 rent-ing 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.


Rental Homes

Rental Homes

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.


Commercial Real Estate

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.


Raw or Unimproved Land

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.


Indirect Investments in Real Estate

There are two basic ways to indirectly invest in real estate: as a limited partner owning an interest in a RELP or as a shareholder in a REIT. Let’s look at the REIT first, because it is generally the more marketable of the two investments.


Real Estate Investment Trusts (REITs)

Real Estate Investment

A REIT is like a mutual fund, except that its shares are not always valued at net asset value (NAV). Instead, they are traded at a premium or discount to NAV on a publicly traded exchange.


In most cases, the REIT invests in income-producing real-estate properties, such as apartment buildings, shopping centers, office parks, hotels, and, increasingly, retirement communities. Some REITs, known as mortgage REITs, also invest in the financing of real estate properties.


The REIT entity is not subject to federal income tax as long as it distributes at least 90 percent of its annual income to shareholders each year. As a result, many REITs distribute 100 percent of their annual income to shareholders. Taxes are then paid by the shareholders on dividends received (like stocks or stock mutual funds) and any passed-through capital gains, but be careful:


unless the REIT tells you the dividend is a qualifying dividend for federal income tax purposes, you cannot claim the favorable 0 or 20 percent tax rate that otherwise applies to stock or mutual-fund dividends. Further, unlike RELPs, REITs cannot pass through any losses experienced in the sale of their underlying properties.


There is a relatively low correlation between the price movement of REIT shares and that of a typical stock or stock mutual fund. A primary advantage to you, as a potential investor, then, is the opportunity to further diversify your portfolio with the purchase of a REIT. Other advantages of REITs include


  • Relatively stable dividend income
  • High dividend yields
  • The possibility of significant capital appreciation
  • Liquidity


Access to professional management of the property


The long-term total return (defined as dividend income plus a capital appreciation of the underlying real-estate investment) of a REIT is likely less than a high-performing, higher-risk growth stock, but more than the return of a lower-risk investment-grade bond.


Before you invest in a REIT versus, for example, a mutual fund, you must first decide that you want to invest in real-estate properties. Then you must decide in what manner you wish to invest in those properties—directly or indirectly.


If you decide that you want to invest indirectly in the form of a REIT, you must decide whether you wish to invest in a publicly traded or non-publicly traded REIT. Finally, in what type of REIT should you invest? There are three types:


  • Equity REIT: Generally acquires income-producing real properties
  • Mortgage REIT: Makes construction loans and otherwise invests in the financing of real-estate ventures
  • Hybrid REIT: Both owns properties and makes financing loans


As a general rule, a mortgage REIT is a bit riskier than an equity REIT, because the mortgage REIT does not have established properties from which to generate an income stream to the investor. However, your ultimate rate of return from a mortgage REIT may be greater than from an equity REIT.


Real Estate Limited Partnerships (RELPs)

If you want a high-risk real-estate investment and the possibility of a high return, purchasing an interest in a RELP may be for you. A RELP is most commonly structured as a real-estate syndication with one or more general partners or real-estate developers and many investors as limited partners.


The limited partners have no say in the management or control of the real property investments or in when the underlying properties may be sold.


Unlike a REIT, a RELP is permitted to pass on losses to its limited partner investors. However, because of a series of income-tax rules known as the passive activity rules, it is doubtful that you, as a limited partner investor, can claim this loss on your annual income tax return.


Typically, you cannot claim this loss until the general partner or syndicator sells the partnership property that has generated the loss—and remember, as a limited partner, you cannot legally force them to do so.


A RELP usually is not a publicly traded entity, so cashing in your interest at something close to what you paid for it is difficult, if not impossible. Some RELPs are organized and publicly traded in the form of master limited partnerships (MLPs), but the trading is very thin, and tax rules generally restrict the claiming of any losses on your income tax return. Thus, an interest held in a RELP is generally both illiquid and relatively unmarketable.


So why invest in a RELP? You would do so almost always because you believe in the ability of the syndicator to develop and sell the underlying real properties for a significant profit.


In addition, you are able to invest in commercial and residential real estate properties for a relatively small amount and are limited in your potential liability as a creditor only to the extent of your investment.


The Use of Leverage in Real-Estate Investing


The financial concept of leverage is the use of borrowed money to increase your profit on a real-estate investment.


The concept may also be used with financial assets, most notably through the use of margin (borrowing money from your broker to purchase stock), but one of the oft-cited advantages of real assets is the ability to employ leverage effectively.


For example, assume that you have directly invested $100,000 in a residential real estate property. Further, assume that this real estate is in a good location and appreciates at a rate of 10 percent annually.


At the end of year one, your investment has grown to $110,000, and at the end of year two, the property is worth $121,000. You have earned a $21,000 profit in the property.


Now let’s assume that you have put down $100,000 on a $500,000 tract of residential real property and have borrowed the remaining $400,000 from a bank at a low-interest rate.


Again, the property appreciates at the rate of 10 percent annually. Now, however, at the end of year one, your investment has grown to $550,000, and at the end of year two, the property is worth $605,000.


Thus you have increased your dollar profit from $21,000 to $84,000 ($105,000 less $21,000). That is four times your original profit, or a total percentage return of 400 percent before figuring in dollars and percentage rate you have to pay to the bank for borrowing the money.


How do you put the concept of leveraging into practice as a real-estate investor? You do this by putting the minimum down on real property that has a strong likelihood of appreciating in future years. Generally, on any real-estate purchase other than primary home purchases, the bank will ask you to put down at least 20 percent on the initial investment.


If you can find a bank that will let you put down less, and you are relatively sure that the property you are interested in will go up in value, you should be able to understand the benefits of using someone else’s money to accumulate wealth. That is leverage!


However, be aware that leveraging also compounds your dollar loss if the property goes down in value. Using the previous two examples, if leverage is not used, you end up with a $19,000 loss after two years.


Because you are dealing with residential rental property, you may or may not be able to claim all of that loss on your tax return, depending on your AGI at the end of year two.


If you used leverage, on the other hand, your loss is $95,000, a difference of $76,000 ($95,000 less $19,000). Regardless of your AGI, you definitely cannot take all of that loss for income-tax purposes, because you are limited to no more than $25,000 in any given year. In addition, you still have to pay the bank for any interest incurred on the loan during the two years.



In the financial world, correlation measures the direction and extent of a relationship between two investment assets. However, you can also use this concept to diversify your portfolio and accumulate wealth.


How does correlation work? A correlation of +1.0 means two assets move exactly together in one direction, whereas a correlation of -1.0 means the two assets move in the exact opposite direction of each other—that is, when one goes up, the other goes down.


Meanwhile, a correlation of 0.0 means there is no relationship whatsoever between the two assets—that is, they move independently of each other.


Financial or Real Assets: Which Are Better?

Financial or Real Assets

A great amount of wealth has been created (the accumulation part of the PADD process) by individuals investing in financial and real assets. Nevertheless, this process is not a zero-sum game. The wealth-accumulation techniques involved with each type of asset are not mutually exclusive.


Many investors prefer to invest in either financial assets or real assets, but not both. The general reason is that those investors are investing in assets they understand (or someone has convinced them they understand), or they are comfortable with only one of the two general categories of assets.


If you understand your ability to assume differing amounts of risk, however, you may wish to invest in both financial and real assets. History has shown that adding real assets to a predominantly financial portfolio improves diversification and reduces overall risk.


Remember: the goal of wealth accumulation is not only to achieve as great an annual percentage of return as possible but also to do so with as little risk as possible.


As such, you might consider investing in real-estate investments that look more like financial investments (for example, a REIT is a mutual fund that invests in real estate and real-estate properties). Alternatively, you can invest in securities issued by real-estate development companies and home builders.


Regardless of whether you decide to invest solely in financial assets, solely in real assets, or in both, do not forget this fundamental rule of investing: if you do not understand a potential investment, you should not be investing your hard-earned money in it!


Prior to the most recent recession that began in December 2007, some investors ignored this basic rule and piled money into exotic derivative investments, such as credit-default swaps, whose underlying risk they did not appreciate and whose complexities they did not understand.


Now let’s move on to a topic of great interest to investors and non-investors alike: how to buy a home and take the best advantage of use assets in accumulating wealth.


The effective management of use assets is the focus of the next blog and concludes our look at the second step in the PADD process: techniques to accumulate wealth. After that, we take up the defense of that hard-earned wealth using effective tax management.


Investing in Use Assets

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

Your home likely means a lot of things to you, not the least of which is an adequate and enjoyable shelter. Further, owning your own home is an integral part of the American Dream.


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

 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.




Cost of Buying

  • 1. Annual mortgage payments (12 times monthly mortgage payment)
  • 2. Property taxes
  • 3. Homeowner’s insurance
  • 4. Maintenance
  • 5. 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.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.


Selling Your Home

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).


Tangible Personal Property and Collectibles

Tangible Personal Property

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.


Planning for Your Child’s Higher Education

We now move to the last step in the PADD process of wealth accumulation and management: distributing your wealth. Toward that end, this section of the blog focuses on the distribution of wealth during your lifetime and considers the common financial goals of saving and planning for your child’s higher education and your own retirement.


It also discusses how to save and plan for other lifetime financial goals you may have, such as starting your own business. Then, the last section of the blog takes up the process of distributing your wealth at death.


If you are married and have children, one of your first goals when evaluating how to distribute wealth during your lifetime is probably to afford your family members the best opportunity to pursue a profitable career—and that requires, at a minimum these days, a college degree.


There are many colleges and universities, public and private, that they may attend, and the costs of attendance will vary dramatically based on their eventual choice.


The common thread to whatever choice they make is that college is expensive—and getting more expensive by the year.


According to the College Board, over the ten-year period ending 2017–2018, tuition at public four-year institutions increased by an average of 5.2 percent per year nationally (tuition increases at private four-year institutions averaged 4.9 percent per year nationally over the same period). This compared to an average annual inflation rate of only 2.5 percent over the same period.


For the 2017–2018 school year, the total annual cost of attending a four-year public college or university for an in-state student was approximately $18,000 ($31,000 for an out-of-state student) and close to $40,000 at a private institution. It is closer to $50,000 annually at an Ivy League institution.


Fortunately, the availability of financial aid increased during this same ten-year period, although most of this aid is based on financial need, with the amount necessary to qualify decided by the school and other factors beyond the control of the average middle-class parent. The key thing to keep in mind, then, is that it is very important to plan for your child’s higher education as early as possible.


How Much Will I Need?

As with any financial planning goal that may be quantified, the first question to answer with respect to planning for your child’s higher education is how much money you will need.


The answer to that question depends on several factors, including how many children you have and whether you wish for them to attend public or private colleges or universities.


In 2018, private-college Ivy League institutions (elite institutions), such as Harvard and Yale, are among the most expensive to attend, with tuition, fees, and room and board costs averaging at least $50,000 per year.


Meanwhile, private liberal arts schools throughout the country are not far behind in cost. Finally, the cost of attendance at public schools varies greatly, but for planning purposes, using half of the current cost of attending an elite private school—or $25,000 annually—is not unreasonable.


The first step in computing the cost of your child’s education is to inflate or calculate in today’s dollars, what the current cost of attendance—say, $25,000 annually—will be when your child is ready to attend college.


To do this, you need to assume an annual increase in costs of a certain amount—say, 7 per-cent annually (this is higher than the current ten-year average increase, but not unrealistic when considering the financial pressure that the 2007–2009 recession placed on many state budgets). You can input these numbers into a web-based calculator (at Yahoo!, for example), or you can enter them on a financial function calculator.


In Whose Name Do I Save?

Before you begin to save for higher education, you need to consider whether your child is likely to qualify for federal financial aid. As you ponder this issue, ask yourself the following questions:


What do you expect your income to be at the time that the child enters college—or, more precisely, when you complete the Free Application for Student Aid (FAFSA) form in the second semester of your child’s junior year of high school? Most federal financial aid is need-based; and if the child’s parent makes too much money, the child is unlikely to qualify for the aid.


Do you believe it is your responsibility or financial obligation to provide the child with a college education? Do you expect the child to assist financially or cover the complete cost of attendance?


Do you anticipate that your child will receive an academic or athletic scholarship to cover the cost of college attendance? Be realistic: although we all believe our children are uniquely talented, more realistically, this is probably not the case.


Do you have relatives or family members such as grandparents who have offered—or expect to offer—financial assistance when the child goes to college?


Fundamentally, you may be somewhat ambivalent about whether your child attends college or pursues higher education, but remember this: studies have shown that over the course of a lifetime, a college graduate will earn in excess of a million dollars more than an individual who only receives a high school diploma.


Let’s return to the question of in whose name you should save for college, which is a critical concern if you anticipate that your child will need financial assistance to cover the cost of college attendance. As you complete the mandatory FAFSA form, you are asked to list your assets and income as well as those of the child.


This is necessary so the federal government can determine an amount of expected family contribution (EFC) toward the cost of college attendance. If your child needs financial aid, you want to achieve an EFC determination that is as low as possible. Accordingly, you should know the formula the federal government uses to compute the amount that the family is expected to contribute.


The most critical component of this formula is the fair market value of the assets held in the name of the child versus those that are held in the name of the parent. In other words, what percentage of these assets is expected to be contributed to the cost of a college education and should, therefore, be counted against the family in the formula?


The answer is 35 percent for the child and less than 6 percent (5.64 percent, to be exact) for the parent. Just from this entry into the formula alone, it is generally much more advantageous to save for college in the name of the parent rather than in the name of the child.


If you decide to save for your child’s college education in your own name, you should probably embark on Section 529 private savings plan. Meanwhile, if you have decided to save for your child’s college education under their name, you should open a custodial account, such as a Uniform Gifts to Minors or Uniform Transfers to Minors account.


Other savings strategies may also reap dividends when you are saving for college. They are as follows:

Spend down the student’s assets first. This may easily be understood when recognizing the disparity in count-able children’s assets (35 percent) versus parental assets (approximately 6 percent).


Maximize contributions to your retirement fund. Whereas annual contributions to your 401(k) (or other) retirement plan are included in the computation of countable parental income, the vested account balance in a retirement plan is not counted among available parental assets that may be used to help pay for college costs.


If you are going to borrow to help fund the cost of your child’s college attendance, do so through a home equity loan or line of credit.

Pay off as much as possible of your credit card and other unsecured debt before filing the FAFSA. This will reduce the amount of cash or other assets that you must list and that is counted against you when applying for federal financial aid on behalf of your child.


Try to pay down your original mortgage as much as possible before applying. This yields two benefits: it can free up cash flow that you may need to fund your child’s college education, and the amount of equity in your home is not included among parental assets when computing the expected family contribution.


To determine the amount of assistance required, most publicly funded college financial aid offices use a formula determined by the federal government known as the federal methodology.


This formula does not consider the value of a family’s home in arriving at the EFC. Meanwhile, some private colleges and universities use a formula known as the institutional methodology when computing the EFC.


In this formula, the amount of equity in your home is added back (and is thus counted against you). You know that a school is using the institutional methodology if it asks you to file the CSS/Financial Aid PROFILE along with the more exhaustive FAFSA form.


Unlike the information requested on the FAFSA, the PROFILE form requires the parent’s expected income during the child’s college years and not just your current or past year’s income.


As a parent, be aware of a bait-and-switch tactic used by some colleges or universities in enticing your child to attend their institution. Although this practice is not as prevalent as it once was, some schools may offer an extremely lucrative financial aid package to a student whom they want to attend the institution, only to reduce the amount of financial aid given to that student after their first year of attendance.


If the student is not comfortable at the school, they are then forced to consider transferring to another school (often with the disadvantage of not being able to transfer credit hours) or continuing studies at the same school and trying to resolve acclimation problems.


As a result, once your child has obtained a financial aid package from a school, be sure to ask the financial aid officer how long the current aid package will be offered or, absent that, whether your child can easily transfer credit hours to another school if they become uncomfortable at the institution.


Types of Financial Aid

The two most common federal need-based loans are the Perkins and Stafford loans. Unlike grants or scholarships that do not need to be repaid, both Perkins and Stafford loans require repayment by the student after graduation.


The federal Perkins loan is a campus-based loan, meaning the school disburses the loan proceeds to the student through its financial aid office. The loan may be taken out by both undergraduate and graduate students, although the annual limit is slightly higher for graduate students than it is for undergraduates.


Financial need must be demonstrated to qualify for a Perkins loan, but repayment is not required to begin until nine months after the student graduates from graduate or undergraduate school. Interest on the loan does not accrue on the loan principal until repayment is required.


The federal Stafford loan (also known as a direct loan ) may be subsidized or unsubsidized. A subsidized Stafford loan means the US Department of Education pays the interest on the loan while the student is in undergraduate or graduate school, as well as during grace and deferment periods.


An unsubsidized Stafford loan, on the other hand, means the student is responsible for the repayment of interest during the life of the loan and should repay the loan interest while they are still in school.


If the student does not repay the interest as it is due, it is simply added to the principal of the loan for repayment at a later date. For both subsidized and unsubsidized Stafford loans, financial need by the student must be demonstrated.


The third type of federal loan is made available to the parent of a student in the parent's name: the Parent Loan for Undergraduate Students (PLUS). This is the only type of loan available on behalf of a student for whom financial need is not determined under the FAFSA formula.


As a parent who makes too much money or has a significant net worth such that the child cannot qualify for federal financial aid, a PLUS loan is the only recourse offered by the federal government to assist with the child’s college education.


Good financial planning dictates that you have already planned for the cost of your child’s college attendance; but if you have not, the PLUS loan will be offered to you. Interest begins to accrue immediately on the loan, and repayment begins 60 days after you receive the money.


There are also need-based government grants, which do not need to be repaid, that may help you pay for your child’s college education. The most prevalent grant is the federal Pell Grant, for which the student is eligible if the family’s EFC does not exceed a specified amount as determined annually.


Scholarship awards do not affect student eligibility for the Pell Grant, although there is a limit on the amount of grant money that any student may receive annually (the maximum is $5,550 for the school year 2018–2019).


The student must be eligible for the Pell Grant on the basis of need before they can also qualify to receive federal Perkins or Stafford loans. Furthermore, the Pell Grant is available to undergraduate students only.

How Do I Save?


Section 529 Savings Plans

Two types of savings plans are described in Internal Revenue Code Section 529 (from which the savings plans get their popular name).


The first is a qualified prepaid tuition plan (QTP) that may have been established by your state to assist your child financially while they attend college. A QTP allows the contributor (typically the parent) to prepay tuition at a particular school using today’s tuition price.


As such, the parent is protected from future increases in the annual cost of the child attending college. In addition, the earnings made on the prepaid tuition grow income-tax deferred.


If the parent withdraws the accumulated contributions and earnings in a QTP (or a private-savings type of Section 529 plan, which we discuss shortly) only for payment of higher-education expenses, the entire distribution is free of income tax.


The problem with the QTP plan, however, is that the child is restricted in choosing where they will attend college. For example, the state of Florida may dictate that the prepaid tuition feature is valid only if your child attends a publicly funded institution in that state.


If your child attends a private school in Florida or another state, or a public college or university outside of Florida, you may not be able to use the money accumulated in the QTP.


This is also the result if your child is unfortunate enough to be denied entrance to the qualifying public school under the provisions of the state plan. Another problem associated with a QTP is that most plans only cover tuition, fees, and books at the qualifying institution and not room and board.


As a result of the disadvantages associated with the QTP, in 2001 Congress adopted the second type of Section 529 plan: the private savings plan. This plan is very similar to a private investment account, but unlike the QTP, a private savings plan does not lock in future college tuition payment at today’s prices.


Rather, the private savings plan affords the contributor the opportunity to earn a rate of return on funds invested that hopefully exceeds the annual increase in college tuition (currently averaging 5 to 6 percent annually).


Earnings in the account grow income-tax-free as long as distributions are used to pay college education expenses, including room and board.


In addition, although contributions to a private savings plan are not federal-income-tax deductible, some states permit a state income-tax deduction for contributions offered by their state for state residents. Generally, however, Section 529 private savings plans are open to investors from any state.


So, what should you look for when selecting among the many choices offered in Section 529 private savings plans? Here are among the most important factors:


Look for a plan that offers a variety of good choices— typically, mutual funds. Ask the same questions you would ask before investing in any mutual fund, such as what its investment objective is, how much investment risk you will assume, and what the fund’s longer-term, risk-adjusted investment performance has been.


Try to choose a plan with relatively low expenses. Some of this total amount depends on the mutual-fund manager in charge of the assets, but the higher the fund expenses, the more the manager must beat the market. And remember, the market in this instance is the ever-increasing annual cost of attending college.


Consider the possible availability of a state income-tax deduction for contributions made to the plan. A top-performing fund of another state plan may offset the loss of the deduction from not investing in your own state’s plan, but you should at least consider the advantage of the possible state income-tax deduction.


Approach an investment in a private savings plan as you would an investment in any mutual fund. If you like the manager and the funds in the fund family, you may wish to invest in the plan of the state where the fund company is responsible for managing the plan investments. If not, consider another state’s plan.


Other Methods of Saving for the Cost of College

There are several other methods of saving for your child’s higher education, including establishing a trust on their behalf. All trusts that may be used for this purpose are irrevocable, meaning you cannot get the money back, and ultimately the trust principal must be distributed to the minor.


Perhaps the most popular trust used in planning for the college education of a child is the Section 2503(c) trust, also known as a minor’s trust. This trust must be drafted by an attorney, with the trust principal (and any unexpended income) made available to the child once they reach age 21.


The age of distribution may be extended at your discretion by adopting an alternative trust, referred to as a Section 2503(b) trust, but the income from the Section 2503(b) trust must be distributed annually to the child, thus resulting in additional Kiddie Tax concerns.


You can also purchase Series EE and inflation-adjusted Series I US Savings Bonds and dedicate them to the purpose of paying for your child’s college education.


With both of these alternatives, the bond must be purchased in your name or in the name of an adult who is at least 24. Furthermore, AGI limits apply at the time of redeeming the bonds.


For example, if you purchase the bond in your name with the intent to use it to pay for the college expenses of your child, and your AGI is too high (a specified amount under law) when the child attends college, you will have to pay income tax on the bond interest at the time that you redeem the bond.


However, if your AGI is below the prescribed amount, you will not be taxed on the interest as long as the bond is used in payment of qualified higher-education expenses.


Tax Deductions and Credits Available for Paying for the Cost of College

Tax Deductions

This section addresses the benefits provided by the income-tax law to help you or your child pay for costs incurred while in college or pursuing some other type of higher education. The deductions available are a deduction for interest paid on student loans and a qualified higher-education tuition deduction.


Important credits include the American Opportunity Tax Credit and the Lifetime Learning Credit. But since 2001, these deductions and credits cannot be taken together in payment of the same expense.


As such, the use of each must be planned for carefully so as to take maximum advantage of every benefit available to you.


Deduction for Student Loan Interest


Under current law, the interest paid (never the principal paid) by any individual who is obligated to make repayment on a student loan is deductible regardless of whether the taxpayer itemizes their deductions.


However, the deductible amount is limited to a maximum of $2,500 per year, and an income phase-out range applies based on the taxpayer’s AGI level.


Although these phaseout ranges are very high, particularly for a student borrower, they can operate to deny the deduction for high-income taxpayer borrowers, such as parents who opt to take out a PLUS loan to pay for their child’s education.


For this deduction to be taken, any debt incurred by the borrower must be used solely to pay for qualified higher-education expenses, including tuition, fees, books, and room and board.


There is no restriction with respect to whether this debt is incurred for study toward an undergraduate or a graduate degree, but as part of the definition of a qualified higher-education expense, the debt must be taken out for study at a qualified educational institution.


Qualified Higher-Education Tuition and Fees Deduction


Unlike the student loan interest deduction, which may be taken by a parent or child, the deduction for qualified higher-education tuition is almost always taken by the parent.


Also, unlike the loan interest deduction, the qualified higher-education tuition deduction is not limited to a specified maximum amount but rather is tiered based on the taxpayer’s AGI.


For example, in 2018 a higher-tier $4,000 annual deduction is permitted for single taxpayers whose AGI does not exceed $65,000 and for married taxpayers filing jointly whose AGI does not exceed $130,000.


Meanwhile, a lower-tier maximum annual deduction of $2,000 is permitted for single taxpayers whose AGI is between $65,000 and $80,000 and joint taxpayers whose AGI is between $130,000 and $160,000.


Above $80,000 AGI for a single taxpayer or $160,000 AGI for a joint taxpayer, no deduction is permitted for higher-education tuition and fees.


How does the parent determine how much they have paid in qualified tuition? You need to obtain assistance. The educational institution your child attends during any part of the academic year must report those qualifying expenses to you on an IRS Form 1098-T. Then, in order for you to deduct those expenses, you must be able to claim the child as a taxable dependent.


Although this is typically not a problem if you are the parent of a child who has not yet completed an undergraduate degree, it is an issue if you are attempting to claim the deduction for graduate school expenses.


In part, this is because one of the tests for dependency dictates an age limit—the child must not have reached age 24 by the end of the calendar year. It also occurs because most children are financially independent by the time they attend graduate school.


As we discuss shortly, a parent may also potentially claim a tax credit, such as the American Opportunity Tax Credit (AOTC) or Lifetime Learning Credit, for higher-education tuition expenses.


But if they do so, the tuition deduction is not permitted for the same expense for the same student. This presents an interesting dilemma if you are a parent with two children in college at the same time.


You should give some thought as to how to best maximize any tax credit that is allowable for one child and any deduction of up to the maximum limit of tuition for the other.


In essence, although a two-student parent may mix and match tax credits and the tuition deduction, you cannot double-dip when trying to take advantage of both tax breaks for the same student.


Higher-Education Tax Credits

a tax credit (or a dollar-for-dollar reduction in tax due) is a very valuable tax-avoidance technique. In most cases, if a taxpayer can qualify to take advantage of any tax credit, they should structure their financial affairs to do so.


When a tax benefit is sought in paying for the considerable cost of pursuing higher education, three credits are permitted: the Hope Scholarship Credit, the American Opportunity Tax (modified Hope) Credit, and the Lifetime Learning Credit.