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Fundamentals of Financial Planning

What Is It? Financial planning is the process of solving financial problems and achieving financial goals by developing and implementing a personalized "game plan." In order to be effective this "plan" must take into consideration an individuals overall picture. It must be:

coordinated comprehensive continuous

Financial planning is like all other phases of life; it involves choices Spend now or save for later? Pay off existing bills or increase retirement savings? Focus savings rupees on short term or long term goals? A true financial plan does not focus one aspect or product but instead seeks to take all areas of planning into consideration !hen making financial decisions.

What is Included?

Cash Flow Management "his aspect of planning deals !ith the day to day allocation of income; and its effective use in paying for current living e#penses and in accumulating assets !hich !ill be used in meeting financial goals.

ax Planning and Management "his area focuses on the understanding of and application of federal and state income ta# la! estate and inheritance ta#es; and !hen possible minimizing these ta#es.

!is" Planning and Management "his area of planning deals !ith the risk of losing life income or property. It includes the use of insurance products and strategies.

Investment Planning and Management Almost everyone has accumulation goals for !hich investments must be made and managed. "hese could include buying a home; planning for college; or providing for retirement.

!etirement Planning and Management $y far the most common accumulation goal is the ability to become financially independent. %etirement strategies encompass the understanding of the &ocial &ecurity system; employer'sponsored retirement plans; and personal savings accumulation plans.

(e !ill e#amine each of these areas in more detail.

Why Plan? Anyone !ho has financial challenges to solve or financial goals to achieve needs financial planning. Financial )lanning can help to achieve both greater !ealth and financial security. Inade*uate or improper planning can be financially disastrous. An uninsured loss can !ipe out accumulated !ealth; insufficient savings for retirement can force a reduced lifestyle and+or postponement of retirement; and improper ta# planning can result in higher than necessary ta#es causing dollars to be lost to an accumulation plan or to ones heirs. Why #o People Fail to Plan?

"hey may feel they do not have enough income or financial assets to consider planning. "hey may believe that they are too young+old to begin planning. "hey may be reluctant to consider some of the less pleasant aspects of planning such as thinking about death disability illness etc. "hey may believe that financial planning is too e#pensive ",-. /A. )%01%A&"I2A"-3 4"he 2umber 0ne %eason For Failure5

he Steps in Financial Planning Identify 6oals and 0b7ectives: 6ather the necessary data Analyze present situation and consider alternatives 8evelop strategies to achieve goals. Implement the strategies %evie! and %evise periodically

Cash Management and $udgeting

1ash /anagement involves ho! you handle your cash resources on an ongoing basis. "here are a number of financial products and services !hich can assist you in this.

Managing Cash % Savings

95 Financial Institutions

"raditional financial institutions include banks savings and loan associations savings banks and credit unions. /any different accounts are available from these institutions:
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#emand #eposit &ccounts : (ithdra!als may be made !henever demanded by the accountholder 4checking accounts5 ime #eposit &ccounts : 8eposits in these accounts are intended for longer accumulation. An Accountholder may be re*uired to give a specific notice prior to !ithdra!al 4)assbook or %egular &avings Accounts5 MM#& &ccounts : /oney /arket 8emand Accounts are similar to MMMF &ccounts : /oney /arket /utual Funds pool funds from many investors and use these funds to purchase short term securities such as commercial paper etc. "hey also offer a rate of return and easy access to funds through !ithdra!als or checking.

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8eposits in banks savings and loan associations or credit unions are insured against the failure of the institution up to %s.9;; ;;; per account.

<5 8eveloping &avings ,abits

A portion of your financial assets should be kept li*uid and readily accessible for day'to' day needs and emergencies. /ost planners believe that you should maintain such an account in an amount e*ual to at least three to si# months living e#penses. 5

0nce this fund is established you may then begin to consider the funding of more long' term savings goals. "he most appropriate savings vehicle for these savings goals !ill vary depending on time horizon of the savings goal; risk tolerance; etc. ,o!ever as a rule of thumb a savings goal of '() of gross income is a good target although you may not be able to achieve this goal all at once. &ome savings vehicles available through traditional financial institutions or through brokers are:

=5 "he )o!er of 1ompound Interest

,o! much you earn on your accumulated investment funds !ill be determined by several factors:

.our initial Investment and subse*uent additional investments "he amount of time the money is left on deposit "he rate of interest being paid "he method of interest calculation

"he future value of your investment can be determined by the use of a simple calculation: Future *alue is the amount to !hich todays investment !ill gro! over a given period of time at a specific rate of interest. "his process is referred to as "compounding+" ,xample Assume that you !ere to make a %s.<;;; deposit into a 1ertificate of 8eposit earning >? interest per year. At the end of <; years total deposits !ould have been %s.@; ;;; 4<; years # %s.<;;; per year5. ,o!ever the total account value !ould be %s.AA 9=< due to the compounding of interest over that period of time. "o apply this to a goal'setting problem if you !ere to identify a savings goal of %s.<; ;;; as do!n payment for a home in five years 4!ith %s.>;;; already saved5 you could not simply divide the %s.9> ;;; remaining accumulation goal by > to find out ho! 6

much you !ould have to save per year to reach your goal. "his process !ould ignore the interest factor for !hich !e !ill use 9;?. FB"B%- CADB- E A/0B2" I2C-&"-8 F FB"B%- CADB- FA1"0% "his future value factor may be arrived at by using a financial calculator or by using a Future Calue "able. "o use this "able locate the factor 49.A9;>5 !hich lies at the intersection of > on the vertical a#is 4for > years5; and locate 9; on the horizontal a#is 4for 9;? interest5. "he factor 49.A9;>5 is then inserted into the formula: FC E %s.> ;;; # 9.A9;> E %s.G ;><.>; "hus your %s.> ;;; !ill be !orth %s.G ;><.>; in > years. &ubtracted from our total goal of %s.<; ;;; there is still %s.99 H@I.>; needed. "he second step of our problem involves using the future value formula again to determine ho! much savings per year !ill be necessary 4still at the 9;?5 for the > year period in order to reach the %s.99 H@I.>; goal. A second time value formula involving a cash flo! 4sometimes called an annuity5 can be used: .-A%D. &ACI26& E A/0B2" 8-&I%-8 8ICI8-8 $. FB"B%- CADBA22BI". FA1"0% "his computation uses a Future Calue of an Annuity "able. .ou again locate the intersection of > years and 9; percent interest !ith a factor of A.9;>9. )lugged into the formula the computation becomes: .& E %s.99 H@I.>; 8ICI8-8 $. A.9;>9 E %s.9 H>A.HI &o you !ould have to save %s.9 H>A.HI per year for five years invested at 9;? interest to reach your goal of %s.99 H@I.>;.

@5 )resent value calculation

)resent Calue is the value today of an amount to be received in the future; or the amount you !ould have to invest today at a given interest rate over the specified time period to accumulate the future amount. "his process is kno!n as "discounting-. and is the inverse of compounding. ,xample )resent Calue calculations are fre*uently used in retirement pro7ection calculations. For e#ample if you are => years old and !ish to accumulate a %s.=;; ;;; retirement fund by age A; 4<> years from no!5 you !ould use a )resent Calue "able .

)%-&-2" CADB- E FB"B%- CADB- F )%-&-2" CADB- FA1"0% If !e assume a <>'year investment at I? the solution !ould look like this: )C E %s.=;; ;;; # .9G@< E %s.>> <A; "his is the lump sum you !ould have to deposit today to reach your goal !ith no further contributions. Another e#ample involving present value deals !ith regular payments. ,xample

&uppose you this is in the fall of your son or daughterJs senior year in high school and you !ant to kno! ho! much money you need to have today in order to make tuition and fee payments of %s.9G ;;; at the beginning of each of the four years of your childJs college education. .ou believe you can achieve a 9<? yield on your funds during this time. "o do this use a )resent Calue of an Annuity "able. 8

)%-&. CADB- E A22BI". CAD. F )%-&. CAD. 0F A2 A22BI". FA1"0% -nter the )resent Calue of an Annuity "able at four years and 9<? interest and obtain the factor of =.;=I=. "herefore if you have %s.>@ AI9.@; invested today at 9<? interest you !ill be able to !ithdra! %s.9G ;;; one year from today and for each of the follo!ing three years.

Preparation of Personal Financial Statements

"he preparation of certain personal financial statements !ill clarify the current status of your financial situation and provide the"starting point" for any future action. "hese statements are very helpful in assisting you in evaluating your o!n situation or in gathering the information needed to !ork !ith a financial planner. "he t!o forms !e !ill be !orking !ith are the Personal Financial Statement; the Personal Budget.

",- )-%&02AD $B86-"

Why Prepare a Personal $udgetK A $udget can be used as a tool in identifying ho! and !hen money is being spent. It can help to identify cash flo! problems and can also identify dollars !hich may be redirected to!ard achieving financial goals. Steps in $udgeting 9. "he first step is to record historical information as to income. "his information !ill come from pay stubs or statements or ta# returns.

<. "he ne#t step is to record historical information concerning your personal e#penses. "his information !ill be found in your cancelled checks; checkbook registers; paid receipts 4cash5; credit card statements and+or ta# returns. =. .ou may !ish to segregate your e#penses by type. 4"Fi#ed" e#penses refer to payments !hich are e*ual and non'varying each payment period and "variable" e#penses involve payments that vary in amount from one time period to the ne#t.5 @. 0nce e#isting patterns are identified you can identify those areas !hich you may !ish to target for change. >. "he ne#t step in the budgeting process involves preparing pro7ected income and e#penses for the ne#t budgeting period 4usually one year5. .ou should include any targeted changes you have identified in &tep =. A. 2e#t you !ill maintain %ecords of income and e#penses as they occur. I. )eriodically compare actual results to desired target. /ake changes as needed. G. A budget !ill only help you achieve your goals if is honest; if it is used; and if ad/ustments are made as needed. It also makes sense to get into the habit of "paying yourself first" by making the first check you !rite once you get paid to yourself to be deposited to you savings and investment program. If you !ait to see !hat is left over it is usually nothing! )ersonal $udgeting (orksheet 4)eriod covering LLLLLLLLLLLLLLLto LLLLLLLLLLLLLLLL5 Item ,ousehold -#penses Food 1lothing "ransportation )ersonal Insurance )rofessional 8ebt %epayment /iscellaneous &avings and Investment Grand Total 0istorical arget &ctual #ifference

",- )-%&02AD FI2A21IAD &"A"-/-2"

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Why Prepare a Personal Financial Statement? "he Financial &tatement is like a snapshot of your financial condition as of a certain date. "he categories on a balance are assets liabilities and net !orth. Financial statements should be prepared at least once per year. "he )ersonal Financial &tatement !ill include the follo!ing information: &ssets Assets are the things that you own. "hey are often grouped into broad categories:

1i2uid &ssets ' 1ash or other financial assets !hich can be easily and *uickly converted into cash !ith little or no loss in value. 41hecking Accounts /oney /arket Accounts &avings Accounts5

Investment &ssets : Assets !hich are held for their financial return rather than for personal use. &tocks $onds /utual Funds etc.5 "hese assets generally appreciate 4increase5 in value.

!eal Property : Dand and things attached to it 4house garage etc.5 Personal Property : /ovable property usually held for personal use 4automobile furniture clothing etc. "hese assets generally depreciate 4decrease5 in value.

1iabilities Diabilities are the things that you owe. "hey are also grouped into broad categories:

1urrent Diabilities : $ills that are currently due and !ill be paid off !ithin one year 4%ent 1urrent /onths unpaid utility bills; medical bills; credit card balances etc.5

Dong "erm Diabilities : Diabilities on !hich the payment stream !ill continue for more than one year 4long term loans for auto home education etc.5

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3et Worth 2et (orth is the net amount of !ealth or e*uity you o!n based on your assets and liabilities. It is calculated by subtracting liabilities from assets. 2et !orth is increased !hen assets are added or debts are reduced or eliminated.

4tili5ing and &naly5ing the Information on your Personal Financial Statement Important areas to e#amine are:

2et (orth : If your familys net !orth is less than zero than you are insolvent. A familys net !orth should increase over time. &olvency %atio : "his calculation sho!s ho! much of a financial cushion you have in relation to your financial obligations. Di*uidity %atio : "his calculation sho!s ho! long you could pay your current bills from your assets.

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4nderstanding the 4se of Credit

Appropriate Bse of 1redit
"he use of credit 4posting payments until a future time5 can be a useful tool for individuals businesses and governments. "here are numerous valid reasons for the use of credit such as

&afety+1onvenience : 1onsumer does not need to carry large amounts of cash !hich could be lost or stolen . Also recourse is provided for unsatisfactory purchases and returns can be re'credited to the account.

-mergencies : 1onsumer can deal !ith short term une#pected situations 4auto repairs medical e#penses etc.5 !hen cash is not available. %ecord'Meeping : 1redit borro!ing provides an itemized record of all transactions. 0pportunity : 1onsumer can make unanticipated purchases !hen cash resources are not available Facilitation of "ransaction : 1onsumer can make certain purchases indirectly by telephone or Internet or directly such as automobile rental; airplane tickets etc. !hen other payment forms are not practical.

Identification : 1redit cards are often used as a form of identification for other transactions such as cashing a check; applying for credit etc.

Inappropriate Bse of 1redit

"here e#ists ho!ever the potential for abuse of credit !hich leads to over'indebtedness and financial problems and may ultimately impede or prevent the achievement of financial goals..

"he biggest problem !ith credit is the tendency to overspend. 1redit should not be used for routine basic living e#penses or impulse purchases

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1redit should also not be used for the purchase of short'lived goods and services. 4Rule of thumb: an item purchased by credit should not be used up sooner than the bill is paid off!

Monthly debt repayment should not exceed 20% of monthly take-home pay. ,igh interest costs on unpaid balances can accumulate rapidly.

1omputation of Finance 1harges on 1redit Accounts

Carious charges fees and interest computations may all affect the cost of credit !hen using a credit card. $e sure to compare3

1alculation of Interest rate on Bnpaid $alances : /ay be fi#ed or variable. Issuers must disclose the "A)%" 4Annual )ercentage %ate5 and the ")I%" 4)eriodic Interest %ate5 for each billing cycle.

1omputation of Bnpaid $alance : "he method by !hich a card issuer calculates the unpaid balance on an account. "his balance multiplied by the periodic interest rate determines the finance charge so it is very important3 9. &verage #aily $alance Method 6 -ach day the issuer subtracts any payments and adds ne! purchases to the account balance. "hese balances are they added together for the billing period and divided by the number of days in that cycle. <. Previous $alance Method 6 "he issuer charges interest on the balance outstanding at the end of the previous billing cycle. "his is the most e!pensi"e method for the consumer since interest is charged on the outstanding balance at the beginning of the billing period. =. &d/usted $alance Method 6 "he issuer starts !ith the previous balance subtracts any payments or credits and charges interest on any remaining unpaid amount. @. Past #ue $alance Method 6 (ith this method the issuer does not charge any interest for cardholders !ho pay the account in full before a specific 14

period of time; other!ise the finance charge is imposed under one of the three preceding methods.

Fees : &ome card issuers charge an annual fee 7ust to have access to the card. &eparate fees may be charged for cash advances late payments e#ceeding the credit limit and other services such as lost card replacement.

6race )eriod : "he amount of time during !hich no interest is charged if the entire amount is paid . 0ther $enefits : A card may provide other benefits such as cash advances flight insurance replacement of broken items discounts on merchandise or purchasing clubs.

Acceptance : &ome cards are more !idely accepted than other cards

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Income ax Planning
W0& IS I ?? As the old saying goes N2othing is certain but death and ta#es.O Financial )lanning cannot postpone or prevent the first inevitable 4death5 but in some instances planning can postpone reduce or even eliminate the impact of the second 4ta#es5. Income ta# planning encompasses several areas to include: Bnderstanding the structure and operation of our ta# la!s 1alculation and filing of federal income ta# returns )lanning to minimize ta#es 0ther forms of personal ta#ation

C&1C41& I73 &3# FI1I38 7F I3C7M, &9 !, 4!3S

"here are several factors !hich !ill determine the amount of income ta# you !ill pay: Filing status "a#able Income 46ross5 Allo!able ad7ustments to income Allo!able deductions to income -#emptions

FI1I38 S & 4S
"he ma7or categories are: An individual A hindu undivided family 16

 A company A firm An association of )ersons or a body of individuals !hether incorporated or not A local authority -very artificial Puridical )erson not falling !ithin any of the preceding categories

8!7SS I3C7M, #,FI3,#

"he definition of income under the Income "a# Act is of an inclusive nature i.e. Apart from the items listed in the definition any receipt !hich satisfies the basic condition of being income is also to be treated as income and charged to income ta# accordingly. Income includes:' )rofits or gains from business or profession including any benefit allo!ance amenity or per*uisite obtained in the course of such business or profession. &alary Income including any benefit allo!ance amenity or per*uisite obtained in addition to or in lieu of salary. 8ividend income (innings from lotteries cross!ord puzzles races games gambling or betting. 1apital gains on sale of capital assets. Amounts received under a Mey/an Insurance )olicy i.e. a life insurance policy taken by a person on the life of another person !ho is or !as the employee of the first mentioned person or is or !as connected in any manner !hatsoever !ith the business of the first mentioned person. Coluntary contributions received by a religious or charitable trust or scientific research association or a sports promotion association.

S74!C,S 7F I3C7M, ,9C14#&$1, F!7M &9& I73

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&ection 9; of the Income "a# Act 9HA9 specifies those incomes !hich are e#empt from income ta# i.e. incomes on !hich no income ta# is payable. Det us understand such incomes:' &+ &gricultural Income Bnder the constitution of India ta#ation of agricultural income eis the right of the state governments. "he 1entral 6overnment cannot levy ta# on such income. &ection <49A5 gives a detailed definition of agricultural income. Income derived from agricultural operation from land !hich is situated in India !ill be e#empt agricultural income. Income form agriculture up to and e#clusive of the processing state !ill be agricultural income. Income from processing stage and on!ards !ill be ta#able income. &imilarly Income from a farmhouse used for agricultural purposes !ill be treated as agricultural income. "hus income form basic operations on land like cultivation gro!ing crops etc. and secondary operations like removal digging etc. can be classified as agricultural income and is e#empt from ta#. ,o!ever income from sale of trees breeding livestock fishing activities poultry farming cannot be classified as agricultural income and is not e#empt from income ta#. $+ !eceipt by a member out of a 04F income Any sum received by a member of a ,indu Bndivided Family from out of the income of the family as !ell as the income received by an individual member from out of the income of the impartial estate is e#empt. Impartible estate means property !hich cannot be disposed off or divided by the holder of the property. An ,BF is separately ta#ed on its income. "he rate of ta# levied on a ,indu Bndivided Family is *uite high. "herefore in order to avoid the same income from being ta#ed t!ice distribution of ,BF income amongst members is e#empt from Income "a#. 18

C+ Share of income of a partner from a firm Any sum received by a partner from a firm as his share in the total income of the firm is e#empt from ta#. "he logic of such e#emption is similar to that for granting e#emption to income as share from ,BF. #+ Casual or non:recurring receipts Any receipts !hich are of casual or non' recurring nature are e#empt up to a sum of rs.>;;; 4rs. <>;; in case of !innings from races5 in each previous year. 1asual income is income !hich is accidental received !ithout stipulation or a receipt !hich is of a fortuitous nature and !hich cannot be foreseen. For e#ample )rize !on for taking part in a competition re!ard for finding a lost child etc. ,o!ever the follo!ing income !ill not be treated as casual or non' recurring:' ,+ 1apital gains %eceipts arising from business or from e#ercise of profession or occupation %eceipts by !ay of addition to the remuneration of an employee

&mount received under a life insurance policy: including the bonus allocated on such policy Any amount received under a life insurance policy including a bonus either on maturity of the policy or other!ise is e#empt from ta#. ,o!ever this e#emption is not available to receipts under a Meyman Insurance )olicy.

F+

Payments from Public Provident Fund Any payments received from "he )ublic )rovident Fund4))F5 are e#empt from ta#.

8+ &ny scholarship granted to meet the cost of education is exempt

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0+ Income of a minor upto rs+'(;; Any income !hich arises to a minor child of an assessee is added or clubbed to the parents income under &ection A@4IA5 of the Act. &ection 9;4=<5 ho!ever gives e#emption from such clubbing up to a ma#imum of rs.9>;; annually per child. I+ #ividend received by a shareholder Any income received by !ay of dividend from a domestic company or from B"I or from a recognized mutual fund by a shareholder+unit holder is fully e#empt from ta#. <+ &wards and !ewards Any a!ard or re!ard !hether in cash or kind from 1entral or any state government or any other approved body in public interest is e#empt from income ta#. =+ Pensions received form gallantry award winners+ Family pension received by individual !ho has been in the service of the 1entral or &tate 6overnment and has been a!arded N)aram Cir 1hakraO or N/aha Cir 1hakraO or NCir 1hakraO or other notified gallantry a!ard or by members of his family is e#empt from income ta#. 1+ Interest incomes of certain types "he follo!ing interest income is e#empt from income ta#:' Interest on notified securities bonds certificates deposits etc. Interest on notified 1apital Investment $onds Interest on %elief $onds Interest on notified $onds in the hands of non'residents Interest on notified savings certificate Interest on 6old deposit bonds 9HHH

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#,#4C I73S F!7M &#<4S ,# 8!7SS I3C7M,

&+ An individual assessee can claim a deduction 4u+s G; 1115 for any amount paid or deposited by him in any annuity plan of the Dife Insurance 1ompanies for receiving pension from a fund set up by the said corporation. "he deduction is restricted to a ma#imum of rs.9;;;;. $+ An assessee 4u+s G; 85 is entitled to a deduction up to rs.9;;;; a year in respect of the premium paid by him+her by che*ue for insurance: a> 0n his health or on the health of his spouse or dependent parents or children and b> In case of a ,indu Bndivided Family on the health of any member of such family (here any of the aforesaid persons is a senior citizen4i.e. one !ho has attained A> years of age at any time during the previous year5 the aforesaid limit has been increased upto rs.9>;;;. C+ &ection G;88$ has been inserted to specifically provide a separate deduction for e#penditure incurred for the medical treatment for the individual himself or to his dependent relative or any member of the ,indu undivided family in respect of diseases or ailments as maybe specified in the rules. "he amount of deduction shall be limited to a ma#imum of rs.@;;;;. /oreover assessee or any member is a senior citizen 4i.e. at least A> years of age at any time during the previous year5 then a fi#ed deduction of rs.A;;;; shall be available. "he amount of deduction available shall be further reduced by any amount received from an insurer for medical treatment. #+ Any ta#payer can claim a deduction 4u+s G; 6 Q u+s G; 66A5 in respect of donations made to certain funds charitable institutions. ,+ An assessee can claim a deduction for the interest received on the follo!ing &ecurities: Interest on any securities of the 1entral or any &tate 6overnment; 21

Interest on deposits under such 2ational 8eposit &cheme as may be framed by the 1entral 6overnment and notified by it in this behalf in the official gazette;

Interest on deposits under the )ost 0ffice4 /onthly Income Account5.

F+ An assessee shall be entitled to a deduction from the amount of income ta# 4&ection GG5 on his total income !ith !hich he is chargeable for any assessment year of an amount e*ual to <; per cent of the aggregate of the sum. It includes contributions to!ards Dife Insurance )remium )ost 0ffice &avings &cheme )ublic )rovident Funds etc.

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&9 C!,#I S
0nce the amount of ta#es due has been determined there may be ta# credits available to offset payment due. A ta# credit is a reduction in the actual ta# bill and as such is of more value than a deduction for an e*ual amount !hich simply reduces the amount of ta#able income. Dimitations and e#clusion apply to all of these credits and their use should be coordinated through your ta# advisor. &o no! !e complete our ta# calculation as follo!s:

6ross Income 1ess? 1ess 1ess Ad7ustments to 6ross Income Darger of Itemized or &tandard 8eductions -#emptions ,2uals? Ad7usted 6ross Income 4A6I5

,2uals "a#able Income imes? Applicable "a# %ate ,2uals "a# Diability 1ess "a# 1redits and )repayments ,2uals "a# or %efund 8ue

&9 P1&33I38 &3# I S !71, I3 0, FI3&3CI&1 P1&33I38 P!7C,SS

"a#payers are al!ays seeking !ays to eliminate or at least reduce their income ta# burden. "here are some strategies !hen used in con7unction !ith the overall financial plan !hich can accomplish these goals. 23

&ome popular ta#'savings strategies are:

95 "aking /a#imum Advantage of "a# Filing 0ptions

"his techni*ue involves the ma#imization of available ta# deductions e#emptions and credits 4thereby reducing the amount of ta#able income5. hese issues will vary by individual and should generally be discussed with a tax professional@ however. some of the more important considerations are?
o

Are you a!are of all available e#emptions deductions and credits to !hich you are entitledK Is your present ta#payer status 47oint return separate return ,ead of ,ousehold etc.5 best for youK (ill your A/" calculation e#ceed your regular ta# calculation; and if so !hat planning steps should you considerK If self'employed have you considered !hich form of business structure 4&ole )roprietorship )artnership etc5 is most advantageous from a ta# perspectiveK

<5 Acceleration and 8eferral "echni*ues

Income ta# liability can fre*uently be reduced though the techni*ues of deferral or acceleration.
o

Acceleration: Income may be accelerated 4taken early5 so as to include it for a ta#able period in !hich ta#able income is less than in the ne#t ta#able period; thereby reducing ta#es. -#penses may also be accelerated. 0ne reason this strategy !ould be used !ould be to take ma#imum advantage of deductions and e#emptions. For e#ample if a ta#payer has already had medical deductions of I.>? of A6I this !ould mean that any additional *ualifying medical e#penses incurred during that ta# year !ould be eligible for a deduction. Another instance in !hich this acceleration techni*ue !ould !ork !ould be if current year ta#able income !as considerably less than anticipated income for the upcoming

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ta# period; and thus deductions !ould be of more value in the future to offset the higher income.
o

8eferral: 8eferring or postponing income may also result in ta# savings. If ta#able income is anticipated to be less in the ne#t ta#able period deferring income into that period could result in lo!er ta#es. 1onversely deferring e#penses into the ne#t ta#able period !ould make sense if ta#able income !as anticipated to be higher than in the current income period.

=5 Btilization of 2on'"a#able -mployee $enefits

.ou may have access to certain employer'sponsored benefits through your 7ob !hich may provide great economic benefit to your family !ithout creating any ta#able income. "hese may be at no cost to you; or may re*uire that you share in the cost. &ome of the most popular benefits !hich result in no ta#able income are
o

6roup medical and dental insurance 4benefits received are not considered ta#able income.5 6roup term life insurance 4death benefits of up to %s.>; ;;; in most cases are e#empt from ta#ation.5 6roup accidental death and dismemberment travel accident and related plans

@5 Income+8eduction shifting
"he ta#payer shifts a portion of his+her income 4and therefore ta#es5 to a family member or entity !hich is in a lo!er ta# bracket. &ome useful techni*ues are:
o

/aking a gift of income:producing property 4such as stock savings bonds certain real estate etc.5 In this case all future income !ill be ta#ed to the recipient not the donor. It is important to note that this action may have 6ift "a# implications !hich should be discussed !ith your personal ta# advisor.

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Also the property itself must be given a!ay; since gifts of only the income !ill not shift the income ta# burden to the recipient. Also the "a# %eform Act of 9HGA limited the usefulness of this techni*ue bet!een parents and children by ta#ing unearned income over %s.9 @;; per year for children !ho are under age 9@ at their parents top ta# rate. "he opposite of income shifting is deduction shifting. "his is accomplished by shifting allo!able ta# deductions to a ta#payer !ho is in a higher bracket than the ta#payer !ho !ould other!ise be claiming this deduction.

>5 "a#'/anaging .our Investment )ortfolio

o

As an investor you may be able to time in"estment sales in order to ma#imize your ta# advantage. If you have capital gains on securities or other investment property these gains may be offset by selling another security you o!n for a loss. "his involves the planning in terms of the timing of the purchase and sale of these securities so that they fall !ithin the same ta# calculation period.

"Ta! e!changes" are available !hich !ill permit the sale of a security for a loss and yet maintain a similar investment position. 4For e#ample if you originally purchased a technology stock at %s.9; per share but the stock had no! declined to %s.> per share you could sell this stock taking advantage of the loss for income ta# purposes and immediately purchase a different technology stock; thereby keeping your position in a technology investment. A3ote? tax laws concerning this type transaction are somewhat complicated. so you should consult with your tax professional for personal advice before underta"ing this strategy+> "a# la!s permit a ta#payer to select !hich stock+fund shares they !ant to sell if they are selling only a part of their holdings. Example 26

Suppose, if over time, you had purchased shares of a particular stock as follo s! 9;; shares at %s.<; per share in 9HG> >; shares at %s.I; per share in 9HH; 9;; shares at %s.G; per share in 9HH> "he value of the stock is no! %s.I; per share. If you !ish to sell >; shares you may sell shares !hich !ould result in a gain 4those purchased in 9HG>5; no loss or gain 4those purchased in 9HH;5 or a loss 4those purchased in 9HH>5.
o

&ince capital gains la!s favor investments held for periods of at least 9< months 4&ee 1apital 6ains Above5 investment sales may be timed to take advantage of this lo!er ta# rate.

A5 /aking 1haritable 1ontributions

1haritable contributions are considered itemized deductions !hich reduce your ta#able income. "hese charitable gifts may take various forms:
o o

6ifts of cash 6ifts of appreciated property such as stock or real estate 4"hese gifts !ould generally be deductible at fair market value on the date of the gift !ith no capital gain conse*uences to the donor.5 "his may ho!ever trigger Alternative /inimum "a# conse*uences. "he establishment of 1haritable %emainder "rusts in !hich property is transferred to the trust !ith the donor receiving and income stream from the investment and the charity receiving the property. "he ta#payer receives a current ta# deduction for the value of the NremainderO interest that the charity is receiving.

I5 "a# &helters
&ome investments such as certain types of real estate oil and gas drilling historical rehabilitation etc. are structured to take advantage of certain ta# !rite'offs such as depreciation amortization or depletion. It should be noted that the effectiveness and 27

availability of these types of investments have been greatly diminished by the "a# %eform Act of 9HGA. "his !as intended to discourage ta#payers from investing in a particular activity strictly for ta# purposes.

G5 "a#'Free Investing
Interest paid on some investments is free from federal income ta#; and often from state and local ta#es as !ell. 0ne such investment category is public purpose municipal bonds 4that is bonds issued by some governmental entities5. ,o!ever you should be a!are that the interest from certain ta#'e#empt municipal securities might be sub7ect to the Alternative /inimum "a# computation.5 3ote? this strategy is generally of interest only to the higher tax brac"ets. due to the fact that at lower brac"ets. these bonds would not have as high a return as the taxable bonds even after the payment of taxes+ Another investment potentially e#cludable from ta#ation is &eries -- $onds !hen used for higher education purposes 41ertain limitations apply.5

H5 "a# 8eferred Investing

0ther investments do not eliminate ta# but simply postpone ta#ation until some future date. "his may be advantageous if the ta#payer anticipates being in a lo!er ta# bracket in the future. Another potential advantage of this techni*ue is that investment return during the deferral period is enhanced since the postponed amount of ta# remains invested earning interest as !ell. &ome of the most common vehicles for this deferral techni*ue are:
o o o o

Rualified employer'sponsored retirement plans -mployee &tock 0ptions )lans 2on'Rualified deferred compensation )lans )urchase of bonds 4bonds issued by the state or central government on a discounted basis5. $ond o!ners may elect !hen they !ant to be ta#ed on the increase in value of these funds; either yearly as interest accrues or upon maturity or !hen they are redeemed.

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Dife Insurance 1ash Calues and the interest+investment return they receive are not sub7ect to current income ta#ation. If values remain in the policy until the death of the insured they pass as a portion of the death benefit to the beneficiary !ith no income ta# conse*uences ever3 If values are !ithdra!n during the life of the insured any gain over and above the initial investment of premium is ta#ed as ordinary income. 4For more information see Insurance /odule.5 8eferred Annuity policies also feature the deferral of ta# on investment gro!th until the policyholder !ithdra!s these funds. 4For more information see Insurance and %etirement /odules.5

9;5 "a# )lanning (isdom

"a# planning is very important; ho!ever it should never be over'emphasized at the e#pense overall financial goals and ob7ectives. In some instances a strategy !hich results in ta#'savings also results in some loss of fle#ibility control or some other advantage. For e#ample ta#'favored retirement plans offer deferral of ta#es until retirement; ho!ever they impose strict regulations and penalties !hich prevent the use of these funds prior to retirement age 4>H S in most cases5. In general if a strategy to save ta#es does not make sense other than for ta# purposes it should not be implemented. Also a ta# adviser should generally be consulted concerning the overall implications of any ta#' savings strategies.

29

Insurance Planning and !is" Management

he $asics %isk /anagement is the cornerstone of any financial planning effort. It makes no difference ho! elaborate or effective the investment portfolio the retirement plan or the estate plan if you have not taken the necessary steps to eliminate risk all remaining planning efforts could be pointless. %isk management through the !ise use of insurance removes the concern for the unkno!n from a financial plan.

How Does One Manage Risk?

"here are four basic techni*ues for managing risk:

!is" &voidance ' "his techni*ue involves the avoidance of e#posure to loss; either by not o!ning specific property that could be e#posed to loss; or by not engaging in a specific activity !hich could create liability. ,xample "he ultimate avoidance of being killed in a plane crash is to refuse to fly. "he ultimate avoidance of being sued by someone being in7ured on your trampoline is not to o!n one.

!is" !eductionB1oss Management and Control ' "his techni*ue involves lo!ering the probability of a particular hazard occurring; and lessening the severity of the hazard by taking some positive action.

,xample A risk reduction strategy for a s!imming pool is to install !arning alarms on all doors leading to the pool; a risk reduction strategy to prevent home fires !ould be to refrain from leaving greasy or chemically saturated rags 30

near a gas hot !ater heater.

!is" &ssumptionB!etention ' "his techni*ue involves the acceptance of the risk. 6enerally this techni*ue should be used only !hen the potential e#posure is very small or has a lo! probability of occurrence. In other !ords you should only self' insure !hat you can afford to lose. Bnfortunately many people self'insure by default. "hey do not consciously decide to take'on the full risk; they merely fail to plan and provide for an ade*uate risk management program. ,xample 1hoosing not to insure a 9>'year'old car !ith a value of less than %s.9 ;;; for collision coverage is an e#ample of %isk Assumption.

&ometimes partial risk retention is used !herein the person at risk chooses to accept part of the potential liability for a certain hazard. ,xample "he selection of an insurance policy 4health auto or homeo!ners5 !ith a large deductible !ould involve partial retention.

!is" ransfer ' "his techni*ue almost al!ays involves some form of insurance. "he risk of a particular hazard is transferred to another entity 4usually an insurance company5 in e#change for a payment of premium. "his progress also involves the determination by the insurer of !hether or not the risk to be assumed is acceptable at the given premium. "his process is kno!n as the Nunder!ritingO process.

1ife Insurance
"he first application of %isk "ransfer through insurance that !e !ill address is the risk of death. 8eath al!ays involves a loss but in its financial sense a loss due to death is measured in terms of incomplete financial goals and ob7ectives.

31

0ow #o I #etermine My Potential Financial 1oss #ue to #eath? &ome of the financial needs that may be created by a death are as follo!s:

Final personal e#penses : final medical e#penses funeral burial etc. -state + death e#penses : estate settlement costs to include federal and state estate ta#es probate legal accounting appraisal fees etc. Family income : support for surviving spouse and dependent children Additional e#penses : necessary additional household services childcare etc. Di*uidation of debts : payoff of mortgage auto loan credit cards educational loans etc. &pecial financial needs : care of aging parents special needs child or other family member Di*uidity : emergency fund; necessary immediate cash flo! $e*uests : church school family members friends employees charities Funding of established financial goals : completing college funding; purchase of second home pay off the mortgage etc.

"here may also be additional financial needs of a business nature such as funding the transfer of an e#isting business through; or protecting a business from the loss of an o!ner+key'employee. 0ow Much 1ife Insurance Should I $uy? "here are many formulas used in the calculation of life insurance need. "he most meaningful methods consider both financial needs created at death and !hat available resources e#ist to address these financial needs. .ou should also remember that your needs !ill vary at different stages during your life. "he first step is to establish the rupee value of the needs+ &ome of these may be e#pressed as lump sums; others as cash flo!. "he ne#t step is to identify !hat available resources may be used to eliminate or reduce the financial shortfall. "hese resources !ill vary greatly from family to family but may include: 32

0ther sources of income from family members &urvivor benefits 4&ocial &ecurity employer'sponsored plans etc.5 Assets that may be easily li*uidated and used to meet the established needs

0nce available resources are applied against the identified needs the amount of life insurance needed can be calculated. 0nce the amount of life insurance needed is determined the ne#t decision is what kind to purchase.

Minds of Dife Insurance

What =ind of 1ife Insurance Should I Purchase? "here are several types of life insurance; each !ith numerous variations. "he type of coverage that is best for you depends on a number of factors. First a brief familiarity !ith the basic types !ill be helpful: '> erm Insurance erm is insurance that is purchased for a certain period of time 4its NtermO5. 8uring that term premiums are paid and a death benefit !ill be received if death occurs. "here is no cash value build'up. )remiums on term plans are considerably less expensive than !ith other plans. At the end of the term the insured !ill be faced !ith one of several choices depending on the type of term policy purchased. If the need for insurance still e#ists the insured !ill have to apply to purchase a ne! term policy; generally re*uiring evidence of insurability 4good health5; or may be allo!ed to continue !ith the e#isting plan but at a considerably higher premium. "erm plans are sometimes compared to renting a home. 8uring the time premiums is being paid 4NrentO5; the insured receives the benefit of coverage. 0nce the premium period has ceased the insured must NmoveO or pay higher NrentO. "here is no Ne*uityO 4cash value5. C> Whole 1ife "his is the oldest form of permanent+cash value life insurance. It features a guaranteed 33

premium; a guaranteed cash value; and a guaranteed death benefit. "he cash value earns a minimum guaranteed rate of return and may also receive dividends or additional interest.

D> ,ndowment policy -ndo!ment policies contain t!o components insurance costs 4!hich increase !ith the age of the insured5 and the cash value component. Interest is paid on the cash value !ith returns being similar to current money market returns.

0ow #o I #ecide Which Company o 4se? 0nce the amount of insurance needed and the type of policy desired is determined the ne#t decision is the selection of a company. Important considerations are:

#ost ' 1osts may vary greatly from company to company but cheapest is not always the best. #omparati"e Policy Benefits: ' "he policy provisions guarantees historical performance are but a fe! of the factors !hich may vary from company to company and should be considered.

Financial Strength of the $ssuing #ompany ' "he insurance companys financial strength and stability as !ell as its national and local reputation are e#tremely important. 1ertain rating services are available to assist in comparing the financial aspects of companies being considered. %"ailability of &ocal Professional Ser"ice Personnel: .ou !ill find the most able assistance !ith your insurance purchase through a local professional agent+adviser. "his individual can help you to analyze your personal situation and determine the amount coverage type and provisions that !ill best meet your needs. %emember there is no one policy that is right for all situations.

34

Dife Insurance Features

What other considerations are there in deciding on a life insurance purchase? Finally there are some uni*ue features of life insurance !hich make it a very valuable financial planning tool in some situations:

8eath proceeds are received income ta!'free 4as long as the policy has met statutory re*uirements5.

"he gro!th of cash value !ithin the life insurance contract gro!s on a ta!' deferred basis. &o no ta#es are currently due. "his is true so long as the policy remains in force 4as long as statutory re*uirements are met.5

If the cash value is ultimately !ithdra!n or the policy is surrendered prior to the death of the insured the !ithdra!al is income ta# free up to the total basis 4premiums paid5 of the policy. "hereafter the gain is ta#ed as ordinary income.

)olicy loans are a non'ta!able e"ent unless the policy is later surrendered !ith the loan still outstanding. 8ividends paid on (hole Dife policies are non'ta!able since they are considered a return of premium. 4,o!ever any interest paid on dividends left on deposit in the policy is ta#able.5

8eath proceeds payable to a named beneficiary do not become part of the estate and generally are not sub7ect to estate debts but may be sub7ect to estate ta#. In most states creditors are prevented from penetrating accumulated cash values in life insurance policies in the event of la!suit or bankruptcy.

35

0ealth Insurance
"he second application of %isk "ransfer through insurance is the risk of over!helming e#penses related to heath conditions. "hese e#penses can fall into several categories. What !is"s Should I Consider In the &rea of 0ealth Insurance? /edical -#pensesK Doss of Income 8ue to a 8isabilityK As !ith a loss due to death the financial cost of an uninsured loss relating to health can be catastrophic. ,o!ever !ith the ever'rising cost of all forms of health insurance this form of %isk "ransfer can encompass a large portion of the family budget.

95 /edical Insurance
What =inds of Medical Plans &re &vailable? /edical insurance may be available though your employer on a group basis. "hese plans are fre*uently more comprehensive in coverage and more cost'effective than the purchase of individual plans. ,o!ever both types of plans may very greatly in structure and cost. "hey are usually divided into t!o types:

/anaged 1are )lans Indemnity )lans

<5 8isability Income Insurance

"he odds of becoming disabled are greater at any age than are the odds of dying at that same age; yet many !orking adults have not made any provision to manage this risk. In many !ays disability is a more e#pensive risk to manage since income flo! !ould stop as in the event of death; but in addition to that there are usually e#tra medical and care' 36

giving costs !hich actually increase the cost of living. Pust as !ith medical insurance group disability plans may be available to you through your employer and if so they may be more cost'effective than purchasing your o!n individual policy. ,o!ever group plans often do not contain definitions and coverage provisions that are as favorable for the insured as are those available !ith an individual plan. What are he Chances hat I Will $e #isabled? Insurance industry studies indicate the follo!ing comparative odds of becoming disabled vs. dying at a given age: %t %ge () * (.) times greater %t %ge +( * ,.- times greater %t %ge -( * (.( times greater 0ow #o I =now 0ow Much #isability Insurance I 3eed o Purchase? 1alculating the amount of disability insurance that may need to be purchased is a process similar to the calculation performed in determining life insurance need. "he first step is to determine the amount of income that is re*uired for family support. .ou may !ant to inflate this number some!hat to make allo!ance for potentially higher living e#penses in the event of a disability such as e#tra help around home; additional medical services etc. "he second step is to offset this need !ith any income available from sources other than employment 4!ages of other family members rental or investment income etc.5. "his calculation !ill give you a good idea of ho! much disability insurance you !ill need to purchase. /ost carriers limit coverage to appro#imately A;? to A>? of pre'disability earnings. .our premiums !ill be based on your age se# occupation income and the policy provisions you select. Also keep in mind that if you are paying your disability premium from your personal resources !hen the benefits are paid to you they !ill not be ta#able. If ho!ever your employer is paying the premiums on your behalf benefits !ill be ta#able !hen received.

37

Property and 1iability Insurance

"he third and final application of %isk "ransfer through insurance that !e !ill address relates to the catastrophic losses of real and personal property caused by such hazards as fire theft vandalism storms and the liability of legal actions.

,omeo!ners Insurance
What =ind of Policy #o I 3eed o Carry 7n My 0ome? .our home is usually your biggest and most e#pensive asset and represents a significant risk of loss so it is very important that it be ade*uately insured. "here are four types of ,omeo!ners )olicies. ,0'9 ,0'< ,0'= and ,0'G are available to resident o!ners only. ,0'@ is for renters and ,0'A is for condominium o!ners. ,o'= is the most complete coverage and the most fre*uently'sold policy.

0ow &re hese Policies Structured All of these policies contain t!o sections and sometimes a rider:
o

&ection I : )roperty Doss -#posure !hich covers a loss of any of the follo!ing due to a peril stated in the policy: A. ' 8!elling $. ' 0ther &tructures 1. ' )ersonal )roperty 8. ' Doss of Bse

&ection II : Diability Doss -#posure 4-5 !hich covers personal liability 4la!suit protection5 and /edical )ayments to 0thers 4F5 38

"he )ersonal )roperty Floater 4))F5 is a rider !hich provides additional protection for items not ade*uately covered in a standard homeo!ners policy such as furs 7e!elry photography e*uipment silver!are art anti*ues musical instruments and collections

Who Is Covered 4nder his Policy?

o

)ersons named in the policy and members of their family !ho are residents of the household including students and their possessions a!ay at college.5

6uests of the insured for property losses occurring at the insured house 4if the insured !ants the coverage to apply.5

7n What Is Coverage $ased? 6enerally coverage on the d!elling includes the amount necessary to repair rebuild or replace an asset at todays prices is covered. if the homeo!ner keeps the home insured for at least G;? of the amount it !ould cost to rebuild currently e#cluding land value. In periods of inflation you should increase coverage annually to keep up !ith inflation or purchase an inflation rider !hich automatically ad7usts coverage for inflation. 1ontents may be covered on actual cash value basis or on a replacement cost basis 4also taking depreciation into account.5 Full re'imbursement may be available for a higher premium &re there 7ther hings I Should Consider In Structuring My Policy?
o

It is very important that you keep a complete and current inventory of items covered to include pictures 4video if possible5; and receipts to document cost. "his inventory should be kept in a safe place a!ay from the insured premises. .ou may !ish to consider purchasing an Inflation %ider that !ill increase the cost of your policy some!hat but !ill keep your coverage at current levels. 39

&ome covered items !ill re*uire an additional policy rider in order to be ade*uately covered such as your home computer; anti*ues or art; furs 7e!elry and some collectibles. -arth*uakes and floods are generally e#cluded from the basic policy. If you live in an area !here this occurrence is a possibility you should seek separate coverage for these perils.

Automobile Insurance
0ow &re &uto Policies Structured? &tate la! determines !hether auto coverage !ill be handled on a standard policy basis or the "no'fault" basis. What Factors &ffect My &uto Premium !ates? &ome of the factors affecting premium are:
o

6eographic Docation of 1overage 4"Rating Territory/ ' &ome geographic locations have !orse claims e#perience than others; therefore premiums are higher in these areas. Bse of the Insured Auto : %ates are higher for autos driven to !ork. "otal miles driven may also be considered a risk'increasing factor. )ersonal characteristics of 8rivers : Age se# marital status all affect premiums. .oung drivers are in higher classes than others. "ype of Auto to be Insured : An autos classification as "standard" "intermediate" or "high" performance affects premium. )remiums are also higher on sports vehicles and vehicles !ith rear engines. 8riving %ecord : A driver !ith traffic tickets accidents or arrests for 8BI !ill incur higher rates than safe drivers.

40

Investment Planning
"he $asics
)eople make investments for a number of reasons. /ost are accumulating funds to achieve some specific goal+ /ost financial goals involve investing capital so that it !ill gro! as much as possible over a period of time. For this reason it is very important to understand the basics of investment planning in order to invest !isely.

6et &tartedT
Ask yourself these *uestions:

What will be the source of my investment capital? 4(here !ill the money come from to investK5 "he most common source of capital is any e#cess of family income over family e#penses. 0ther sources may include inheritances gifts gro!th of investments or business interests or distributions from retirement plans etc. "hese investment sources may include lump sums or periodic investing or both.

What is Aare> my investment goalAs>? "here may be one or more goals that you !ish to fund. %emember for a goal to be meaningful it must be specific and have a time horizon. &ome common financial goals include creating a current income stream; saving for a do!n payment on a residence or vacation home; saving for childrens college education; accumulating sufficient capital to start a business; or funding ma7or home improvements. $ut the most fre*uently mentioned reason for investing among Americans surveyed is saving for retirement+

What is my time hori5on? Are you investing for a fe! months; a fe! years; or for the distant futureK "he 41

ans!er to this *uestion !ill have an impact on the appropriate investment selections.

0ow much will be needed to fund my goalAs>? Future Calue methods may be used to determine ho! much is needed.

0nce these *uestions are ans!ered the ne#t step !ill be to determine !hich investment vehicles !ill best achieve these goals.

&electing an Investment
Although there are numerous factors that may be considered some of the most important are:

%isk %ate of %eturn Impact of "a#es on %eturn /arketability and Di*uidity 8iversification

'> !is" "here are many kinds of risk in investing. &ome forms of risk may be more important to you as an investor than others. If you learn to identify each of these types of risk you can then determine !hich of these have importance as you structure your investment portfolio.

!is" of Principal : If the investment selected performs poorly the amount of money !hich !as invested can be lost in part or in !hole.

Mar"etB*olatility !is" 6 "he value of the investment selected may move up or do!n due to changes in the particular financial market your investment is participating in.

42

Purchasing Power !is" : "his is uncertainty over the future purchasing po!er of the income and principal from a selected investment. "his is created by changes in the general price level of the economy.

Interest !ate !is" : Investments !hich are providing fi#ed income 4such as bonds 18s etc5. !ill e#perience changes in price as interest rates increase and decrease. In general a rise in market interest rates tends to cause a decline in market prices for e#isting securities and conversely a decline in interest rates tends to cause an increase in market prices for e#isting securities thus creating an inverse relationship !ith the general level of interest rates. ,xample .ou have purchased a bond paying >? !ith a >'year maturity. It is no! year three of the five'year period and you !ish to sell your bond. ,o!ever interest rates are no! at I?. ,o! easy !ill it be for you to find a purchaser for your >? bond !hen there are many I? bonds available on the marketK 2ot very easy3 .ou !ould probably have to "discount" your >? bond 4that is sell it for less than you purchased it5 in order to attract any buyers; therefore the value of your bond has decreased in an inverse relationship to interest rates !hich have increased over that same time period.

ax !is" : "his involves the potential ta# conse*uences involved !ith a particular investment to include federal and state income estate inheritance and gift ta#es.

C> !ate of !eturn ,xpected future return is !hat causes an investor to select an investment. And since the purpose of investing is to earn a return sufficient to fund your goal4s5 you should 43

understand ho! you !ould receive this return. It may take a variety of forms to include interest dividends rental income business profits and capital gains. he total amount of earnings on an investment is -total return". And this is generally broken do!n into t!o main components:

1urrent Income : income received regularly over the course of the investment 4dividends interest or rent5 1apital 6ains : the increase in the market value of the specific investment vehicle. "his return is generally not received or recognized until the asset is sold.

Another factor affecting %ate of %eturn is the potential effect of compounding 4earning interest on interest5. If interest dividends etc. are allo!ed to remain in the investment and in turn receive the benefit of future gro!th the result is compounding. "he interaction bet!een these first t!o factors creates the %isk+%eturn "rade 0ff. he amount of ris" associated with a given investment vehicle is directly related to its expected return+ "his is kno!n as the "0ni"ersal Rule of $n"esting/. &o theoretically the more risk you are !illing to take the higher return you should e#pect to receive. "o give you some perspective a "risk'free" rate of return !ould be an investment that provides a positive return !ith zero risk 4i.e. a H;'day B& "reasury bill5. "his is often used as a benchmark against !hich other investments are measured. As risk is increased so should return potential. D> Impact of axes on !eturn It has been said that it doesnEt matter what you get@ only what you get to "eep3 For this reason it is very important to differentiate bet!een the %eturn received from an investment and its "after'ta#" %eturn. "here are several considerations here:

An investment may yield income that is currently ta#able as ordinary income such as interest on 1ertificates of 8eposit corporate bonds etc. In this case the 44

&fter: ax Field is going to be less than its Current Field 4interest rate5. "his can be determined by multiplying the current yield by "9" minus the investors income ta# rate.

,xample If /r. Fletcher !ho is in the <G? ta# bracket invested in a 1ertificate of 8eposit !hich !as paying A? interest his After'"a# .ield !ould look like this: After'"a# .ield E 1urrent .ield 49 : "a# %ate5 E .;A 49 ' .<G5 E .;A 4.I<5 E .;@=< or @.=<? &o /r. Fletcher really didnt make A? on his investment; he made @.=<? because the rest !ent to pay ta#es.

An investment may yield income that is ta# e#empt such as interest from some municipal bonds. &o the after'ta# yield for a fully ta#'e#empt investment e*uals the 1urrent .ield.

,xample &o this time if /r. Fletcher !ho is still in the <G? ta# bracket invested in a municipal bond paying >? his After'"a# .ield !ould still be >? since there is no ta# implication.

An investment may yield returns that are ta#able only !hen realized and recognized as capital gains. "his time /r. Fletcher purchased shares common stock of A$1 )harmaceutical 1ompany. "he stock has paid no dividends but it 45

has increased in price from U9; per share to U<; per share during the past year. In this situation /r. Fletcher !ill not have a ta#able event until he sells his shares since he has not "realized" his capital gain of U9; per share yet. Further due to favorable capital gains treatment !hen the shares of stock are finally sold the ta# rate !ill be lo!er than the ta# rate !ould have been had the shares produced dividends !hich !ould have been ta#ed as ordinary income. "hese !ere very simple e#amples !hen in fact the implications of ta# treatment of investment income can be very comple#. .our professional ta# and investment adviser !ill assist you in determining the impact of your investment positioning on your personal ta# situation.

G> Mar"etability and 1i2uidity "hese terms are sometimes used synonymously but they are not the same thing.

Mar"etability refers to the degree to !hich there is an active market in !hich an investment can be readily traded. 1i2uidity refers to the ability to readily convert an investment into cash !ithout losing any of the principal invested. An investment !ith li*uidity has a highly stable price. &ome investments are neither marketable nor li*uid; others are marketable but not li*uid; or li*uid but not marketable; !hile others are both marketable and li*uid.

,xample 1hecking and savings accounts do not have a market !here they can be

46

readily bought and sold; therefore they have limited marketability; but they are very li*uid. &tocks !hich are traded on one of the e#changes have high marketability since they can generally be sold !ith little or not difficulty or !aiting; ho!ever a sale may result in loss of principal !hich !ould not create pure "li*uidity". %eal estate has neither li*uidity nor marketability because it generally takes a significant amount of time to sell real estate and it cannot necessarily be sold at its original purchase value. Although marketability and li*uidity are desirable it is often necessary to have a "trade' off" since highly marketable or li*uid assets usually yield less than less marketable or illi*uid investments. &o an important *uestion for you to consider is "Is marketability or li*uidity important enough to give up some yieldK" "his of course depends on your overall situation. (> #iversification #iversification is an important investment policy to consider in constructing a portfolio. It refers to the defensive strategy of spreading investment dollars into several different investments in order to minimize risk. "here are numerous types of diversification. .ou might diversify bet!een stocks and bonds 4e*uity and debt5; bet!een li*uid and non' li*uid investments; bet!een one investment ob7ective and another; etc. "he principal of diversification is that the prices or values of all differing investment opportunities do not go up or do!n at the same time or in the same magnitude so an investor can protect at least a portion of his+her investment assets by diversifying.

=inds of Investments
"here are many investment vehicles available. $ut in general all forms of investments may be divided into -#ebt- and -,2uity- investments. Anytime you allo! someone to 47

use your money to make money it is considered a "debt" investment. "his category !ould include bank certificates of deposit; bonds 4of all types5; fi#ed annuities; cash value of !hole or universal life insurance; notes receivable; etc. "-*uity" investments actually allo! you to take an o!nership position and include stocks real estate tangible assets such as gold; and collectibles such as art anti*ues etc. 8ebt investments usually involve little if any risk of principal and lo! to moderate returns. "hese returns are derived from interest and+or dividends. -*uity investments e#pose all of your investment capital to the risk of losing your principal and generally derive most of their investment return from appreciation of the value of the underlying asset 4capital gains5.

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'> #ebt Investments

(hat kinds of debt investments 4fi#ed income securities5 should you consider for your portfolio and ho! !ill they impact your investment returnK Fi#ed income securities promise the investor a stated amount of income periodically. "he most common fi#ed income investments include: 6overnment &ecurities "reasury $ills 1ommercial )apers )ublic &ector Bnit $onds

"o#ds
What &re the Investment Characteristics of $onds? A bond is a fi#ed income security that provides investors !ith secure and regular sources of current income. It is a negotiable long'term debt instrument of the issuer that carries certain obligations. "here is no o!nership position in bonds. Interest is usually paid semi' annually. $onds can also generate a capital gain if the bond is sold prior to its maturity for more than its original par value 4the value !hich !ill be paid in full at maturity.5

What ypes of $onds are there? $onds may also be classified as -callable" or "non-callable". 1allable bonds contain a provision allo!ing its issuer to retire the bond earlier than its maturity date. "his right must be specified in the original bond offering and most callable bonds prohibit recall during a specified period of time. "he issuing corporation can usually e#ercise the call provision at any time after a specified date. A "call premium" 4such as one years interest5 is generally payable to the investor if the bond is called. &ome of the different types of bonds issued in the Indian /arket are as follo!s:

49

95 %$I %elief $onds: "hese are bonds issued by the %eserve $ank 0f India and are fully backed by the faith and credit of the Indian 6overnment. they are sold in %s. 9;;; denominations and all issues are non'callable. "he interests earned on these bonds are e#empt from income ta#. <5 Infrastructure $onds+ "a# &aving $onds: "his bond is issues specifically for infrastructure development on the country. "he individuals investing in such types of bonds get rebate under &ection GG. "he 6overnment has given permission only to I8$I and I1I1I to issue such bonds. "he interest received from these bonds is sub7ect to ta#. =5 -ncash $onds: "his bond is designed to give instant li*uidity anytime after one year across the counter to the investors in case of need. 2%Is are not eligible to invest in this bond. @5 %egular Income bonds: "his bond is designed in such a !ay that an individual !ill get the interest payment regularly till the maturity of the bond. "he payment options generally are monthly *uarterly half'yearly or yearly. >5 Floating %ate $ond: "his bond is designed to provide returns to the investors linked to the yields on 6overnment of India securities.

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C> ,2uity Investments

(hat kinds of e*uity investments should you consider for your portfolio and ho! !ill they impact your investment return as !ell as your risk e#posureK In order to assist you !ith your understanding of these e*uity vehicles !e !ill no! take a closer look at several of these.

1ommon &tocks %eal -state )uts and 1alls+0ptions 1ommodities

1ommon &tocks
What &re the Investment Characteristics of Common Stoc"? (hen you purchase a "share" of stock you become a fractional o!ner interest in that company. As a common stockholder you !ill actually have an o!nership position in the company. .ou may receive dividend income but only after all other debt obligations have been met by the company. Also if the value of your share of stock increases over the time you hold it you !ill e#perience a capital gain at the time you sell your share of stock. $ut in the event the company does not meet its financial ob7ectives there may be no dividends paid and the value of your share of stock may stay the same or even decrease. here is no guarantee that there will be a return on your investment+ As a shareholder you !ill have the right to vote on company decisions. Why Should I Consider Investing In Stoc"s? /ost investors !ho purchase common stock do so based on their potential for relatively high returns. but there are other factors to consider.

An investment may yield income that is ta# e#empt such as interest from some municipal bonds. &o the after'ta# yield for a fully ta#'e#empt investment e*uals the 1urrent .ield. 51

&re here #ifferent =inds of Stoc"s? &tocks may be categorized in many !ays. 1lassification by type is probably the most common method of categorizing.
o

lue !hip "tocks : "hese are stocks of high *uality !ith long and stable records of earnings and dividends. "hey are !ell'established and hold strong financial credentials 4i.e. 6eneral -lectric 1oca 1ola (al/art5 #rowth "tocks : "hese are stocks !hich e#perience high rates of gro!th in operations and earnings. $ncome "tocks : "hese are stocks that are selected primarily for the dividends they pay. "hey have been able to demonstrate a stable stream of earnings. "peculative "tocks : "hese are stocks of companies !hich may be e#pected to have significant immediate gro!th such as a company !hich may have recently developed a ne! patent etc. "here is usually no proven record of earnings and these are considered high'risk companies. !yclical and %efensive "tocks ' 1yclical stocks are those !hose movement tends to follo! the business cycle of the economy as a !hole. (hen the economy as a !hole is e#panding the prices of these stocks are increasing. "hese are industries such as automotive lumber steel etc. 8efensive or "counter'cyclical" stocks on the other hand can be e#pected to remain stable throughout the periods of contraction in the business cycle. "hey are usually dividend stocks and their earnings tend to keep market prices up during periods of economic decline.

Another method of categorizing stocks is by "Mar"et Capitali5ation" or Si5e. "his uses the stocks market price multiplied by the number of shares outstanding resulting in the placement of the stock !ithin one of three categories by size:

52

Small Cap : &tocks !ith market caps of less than UI>; million. 4"hese stocks may provide an above'average return but not !ithout more significant risk.5 Mid Cap : &tocks !ith market caps of from UI>; million to U= to U@ billion. 4"hese stocks are generally considered to offer good returns !ithout significant price volatility.5 1arge Cap : stocks !ith market caps of more than U= ' U@ billion

0ow is Stoc" Performance Measured? Although there are many theories dealing !ith stock selection and timing of purchases and sales you must remember that investing is not a science. "here are many helpful tools available in designing a portfolio but there is no !ay of predicting !ith any certainty !hat !ill happen in the stock market especially over short periods of time. 0istorical rate of return cannot predict future returnH "here is some terminology you !ill need to understand in evaluating and selecting corporations for stock purchases for your portfolio.
o

,arnings Per Share ' &ince both present and future dividends are dependent upon earnings a stocks market price tends to keep pace !ith the gro!th 4or decline of its earnings per share5. "his is computed by taking net corporate profits after ta#es subtracting any preferred dividends and dividing the remainder by the number of common shares outstanding. 3et &sset *alue Per Share : "his is also kno!n as "$ook Calue per &hare" and attempts to measure the amount of assets a corporation has !orking for each share of common stock. It is computed by subtracting the companys liabilities and preferred stock from the value of its assets. and then dividing by the number of shares outstanding. Price:,arnings !atio A-PB,-> : "his is the market price of the stock divided by the current per share earnings of the corporation. Field ' "his generally refers to the percentage that the annual cash dividend bears to the current market price of the stock.

53

$eta : "his indicates the price volatility in relation to the /arket as a !hole 4usually measured against the &tandard and )oors >;;5 !hich has a $eta of 9.;. Do! $eta stocks 4less than 9.;5 are less volatile than the /arket as a !hole; and high $etas 4over 9.;5 are more volatile. $etas may also be positive or negative. )ositives more in the same direction as the /arket; !hile negatives move in the opposite direction.

0ther -*uity Investments

Although 1ommon &tocks are by far the most fre*uently used e*uity investment in portfolios and there are numerous other e*uity investments !hich may !arrant consideration for your portfolio.

What ,2uity Investments 7ther han Common Stoc"s Should I Consider for my Investment Portfolio? !eal ,state : %eal estate has historically been useful in a portfolio for both income and capital gains. ,ome o!nership in itself is a form of e*uity investment as is the o!nership of a second or vacation home since these properties generally appreciate in value. 0ther types of real estate such as residential and commercial rental property can create income streams as !ell as potential long'term capital gains. "here are numerous additional e*uity investments; ho!ever the ma7ority are highly speculative and re*uire specialized kno!ledge and e#pertise and generally should not be undertaken by an ine#perienced investor !ithout appropriate *ualified professional advice and assistance. Put and Call 7ptions 6 A "call" is an option allo!ing the investor to purchase a certain stock at a set price at any time !ithin a specified period. A "put" on the other hand is an option allo!ing the investor to sell a certain stock to someone at a set price at any time !ithin the specified period. "hese are usually bought !hen the investor !ants to 54

speculate on !hether a particular stock is going to go up or do!n. "hese are also considered high'risk investments. Commodity Futures rading 6 A futures contract is an agreement to buy or sell a commodity 4!heat corn oats soybeans copper silver lumber etc.5 at a price stated in the agreement on a specified future date.

D> Mutual Funds Investments

What &re Mutual Funds? /utual funds are large professionally managed portfolios that are formed by many individual investors !ho collectively pool their resources in order to achieve a high level of diversification. /ore investors by far invest in mutual funds than in any other type of investment product. "here are t!o types of mutual funds: 7pen:,nd Investment Companies : In these funds investors buy and sell shares from the fund itself. "here is no limit to the number of shares a fund can sell and buy and sell transactions are carried out at prices based on the current value of all the securities in the funds portfolio. &et 'sset (alue )&'(* is based on the current value of all securities held in the funds portfolio and represents the price at !hich the investor can sell his+her shares. Closed:,nd Investment Companies 6 1losed end companies operate !ith a fi#ed number of shares outstanding and do not regularly issue ne! shares. "hese shares are listed and traded on an organized securities e#change and trades may be at a discount or premium.

55

Why Should I Consider Investing in Mutual Funds? "hrough mutual funds small investors are able to en7oy a much higher degree of diversification than they !ould be able to attain though individual stock or bond purchases on their o!n. /ost mutual fund accounts can be opened !ith small initial investments 4some as lo! as U<>;5. In addition e#perienced professional managers select the securities to be purchased and make timing decisions concerning buying and selling on the most advantageous basis. In addition funds are highly marketable and mutual funds offer numerous services to meet individual investor needs. Funds are easy to ac*uire or sell and there is very little paper!ork or record'keeping re*uired of the investor. Finally the return on many funds has e#ceeded the average return of many other comparable investments.

0ow #o I Ma"e Money In a Mutual Fund? /utual funds have three potential sources of return: '+ %ividend $ncome : "he underlying stocks in the fund may pay a dividend and the mutual fund investor receives his+her proportionate share of those dividends. 4"his is considered ta#able income.5 C+ !apital #ains %istributions : "he fund may sell one of its stock holdings at a profit and the individual fund investors !ill again receive a proportionate share of this capital gain. 4"his is also a ta#able event and may or may not *ualify for favorable ta#able gains treatment.5. D+ $ncrease in "hare (alue 'bove +urchase +rice : "he share of the mutual fund itself may increase in value over the purchase price. "his gain is not realized until the share of the fund is ultimately

56

sold at !hich time it !ill receive capital gains treatment for ta# purposes. "he overall return 4gain or loss5 of the fund is based on these three sources.

What ypes of Investments are &vailable hrough Mutual Funds? Almost any type of investment is available through mutual funds. A funds investment ob7ective must be disclosed in its prospectus. "he most common fund ob7ectives are: 8rowth Funds : "he ob7ective is capital appreciation achieved through long term gro!th and capital gains. $alanced Funds : "hese funds hold a balanced portfolio of both stocks and bonds in order to generate a !ell'balanced return of current income and long term capital gains. Money Mar"et Funds : "hese funds include a portfolio of short'term money market instruments and have high li*uidity but limited investment return. Sector Funds : "hese funds concentrate in one ore more specific industries that make up the targeted sector such as technology health energy etc.

What Services &re 7ffered $y Mutual Funds? 2umerous services are offered by mutual funds to include: 95 Automatic Investment )lans : Investors may direct specific amounts of money from paychecks or bank accounts into the mutual fund on a regular basis 4usually monthly5. <5 Automatic %e'Investment )lans : 8ividends and other distributions are automatically used to buy additional shares in the fund. =5 %egular Income : For shareholders !ishing to receive monthly income a pre' determined amount can be !ithdra!n on a regular basis !ith a check mailed to the 57

investor. "his may be a fi#ed amount or tied to interest and dividend earnings. @5 1onversion )rivileges : Investors investing in a "family" of funds may s!itch from one fund to another if their investment ob7ective should change or if they feel the change !ould enhance their investment performance. "hese s!itches are usually made !ithout additional sales charge. 4"his s!itch !ould ho!ever trigger capital gains ta#ation if applicable.5

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!etirement Planning

he $asics %isk /anagement )lanning can help you to address many of the possible risks you !ill encounter on your !ay to achieving your financial goals. ,o!ever there is one risk !hich must be dealt !ith aside from your %isk /anagement planning. "his is the risk of living too long or outliving your income. As !e have previously discovered the planning and accumulation for retirement is generally the most important accumulation goal !hich you !ill address in your personal financial planning. "he biggest pitfalls to sound retirement planning are generally considered to be:

Starting too late AP!7C!&S I3& I735 Failing to commit sufficient resources to this goal Investing too conservatively

%etirements planning 7ust like the other areas of planning begin !ith a thorough self' assessment !hich !ill help you determine your course of action.

&etting %etirement 6oalsK . . . . . (here Am I 6oingK

First you must ask yourself -What will my financial needs be during retirement?&ome financial planners use as a target rule'of'thumb of I;? ' I>? of pre'retirement income. "his of course assumes that your financial needs !ill decrease in retirement. And sometimes this is true. -#penses may be lo!er for e#ample for those !ho plan to pay off their e#isting mortgage and+or other debt obligations prior to retirement. Also it is assumed that at retirement costs relating to dependent children are gone.

59

"hese assumptions may or may not be applicable to your situation. &ome planning candidates actually !ant to increase their income at retirement so that they !ill have funds for travel hobbies etc. A revie! of your current budget keeping in mind !hat changes 4up or do!n5 you think may be applicable to your situation should give you a good idea of your financial needs 4in todays dollars5.

. . . .(hen Am I 6oing "o 6et "hereK

"he ne#t *uestion should be "When do I plan to retireK" .our ans!er may be at age >H S 4the earliest normal date that *ualified retirement funds I%As etc. can be !ithdra!n !ithout penalty5; or it may be at age A> 4fre*uently considered the "standard" retirement age5; or something earlier or later. 0ne important point to keep in mind the earlier you plan to retire the more ambitious your accumulation program must be no!3

. . . .(here Am I 2o!K
0nce you have determined your financial needs in todays dollars and your target retirement date you are ready to calculate the amount of "future" dollars you !ill need to accumulate in order to retire. "he first step is to determine !hat available sources you have at present to contribute to the funding of this goal. "hese resources may be in form of a future income stream 4&ocial &ecurity or a pension benefit from your employer5 or in the form of accumulations such as savings accounts or other personal investments. "hese amounts are also converted to "future values" and applied against your needs. "he remaining balance or shortfall is the amount you !ill need to save bet!een no! and your desired retirement date.

60

,o! Am I 6oing "o 6et "hereK

.ou may be having a difficult time trying to grasp the concept of future dollars. .ou are not alone. /any people have a difficult time understanding future impact; both in terms of ho! inflation !ill affect your future needs; and ho! the compounding of interest over long periods of time can help you to accomplish a financial goal. Inflation is the rate at !hich the general level of prices of goods and services is increasing. -ven pro7ecting a meager level of =? per year if you are planning on retiring in <; years; and you have estimated your needs in todays dollars at %s.>; ;;; this means that by retirement that inflation'ad7usted need !ill be %s.H; ;;;3 "aking this a step further t!enty years into your retirement that %s.H; ;;; !ill have become %s.9A; ;;;3 "his inflation factor must be taken into account in all or your planning efforts or you !ill find your resources seriously lacking. 0n your side ho!ever is the po!er of the compounding of interest. "o give you a rule of thumb !hich does not re*uire a complicated financial calculation the !ule of IC can provide a *uick !ay to estimate the future value of your present assets. "his method tells you ho! long it !ill take for a sum to double in value at various compound rates. .ou simply divide the number "I<" by the applicable interest rate 4rounded to the nearest !hole number5. "he result is the number of years it !ill take your original sum to double. ,xample

If your current investment account is earning an annual rate of return of A? you divide I< by A and get "9<." It !ill take your account 9< years at this rate to double. If ho!ever you are receiving an annual return of 9<? on your money you divide the I< by 9< and the result is that your money !ill double in A years3

61

1an I 6et "here From ,ereK

&adly many planning candidates '' upon consideration of the amount of savings necessary to provide their retirement goal '' discover that "they cant get there from here." If the savings and+or investment return goal is beyond your reasonable capabilities several options e#ist.

.ou may need to re'evaluate your income needs in retirement and make an appropriate reduction. "his of course results in a lo!ering of future living standards. 0%

.ou may need to ad7ust your current standards of living do!n!ard in order to free up additional dollars !hich can then be committed to your savings program thus increasing your accumulation potential. 0%

.ou may need to ad7ust your time horizon to reflect a later date of retirement than originally planned. 0% .ou may re'assess and re'allocate your current retirement investments in order to increase the return available to you !hile could improve your ultimate funding balance.

At any rate this !hole process must be updated and verified periodically as you proceed to!ard retirement in order to make sure that there have been no material changes in your planning assumptions.

(hat Are "he /ost 1ommon %oadblocks to a &uccessful %etirementK &ome

of the most common roadbloc"s to financial success are:

"he tendency to spend all that 1e ma2e !ithout making any dollars available for saving Prioriti3ation of other sa"ings goals abo"e retirement 4-ven if you are saving you may be savings funds first as a do!n payment on a ne! home; for the college education of your children etc.5 62

0ne!pected e!penses such as medical; ma7or home repairs; etc. 4&ome of these issues can be dealt !ith through appropriate %isk /anagement strategies; others cannot.5 4isruption of family status through divorce death etc. 4Again an ade*uate %isk /anagement program can anticipate and prevent loss for some of these circumstances; but no all5.

%epeated changes of employment 4"hese changes can prevent you from becoming vested@ that is having the right to complete access to your benefits if you should leave your employment.5

+,-!,'".$&'.$-& Al!ays having a "good reason" not to begin your savings plan 4"Im afraid of the stock market right no!"; "I cant afford to start participating in the retirement plan until I get my credit cards paid off" etc.5

(hat Are /y )otential &ources of %etirement IncomeK

&ources of income for retirement are often compared to a three'legged stool. -ach of the legs helps to hold up or support your retirement funding. "hese three legs are &ocial &ecurity employer sponsored pension and retirement plan4s5 and your personal savings. 2o! for a closer look at each of these:

Pension Plans and !etirement Programs

In recent years employer'sponsored plans 4especially those that are totally funded by the employer5 have diminished partly due to the rapidly rising cost of employee benefits and partly due to the ever'increasing and changing reporting and plan re*uirements imposed by the federal government.

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If your employer is currently sponsoring a retirement plan it is important to be a!are of !hat your benefits !ill be and ho! they are structured. Again this information !ill be needed to accurately complete your %etirement )lanning 1alculations 4above5. "here are t!o basic types of Rualified %etirement )lans !hich may be offered by your employer.

#efined $enefit #efined Contribution

& #efined $enefit Plan specifies the amount of benefit !hich you !ill receive at retirement It may be stated as a specific dollar amount 4i.e. %s.I;; monthly beginning at age A>5; or it may be stated as a percentage or number of units based on your length of service salary and other criteria 4i.e. >;? of your average monthly salary during the last three years of employment5. If you are a participant in this type of plan it makes your retirement calculations easier since you kno! !ith some certainty !hat benefit you !ill be receiving from your plan. & #efined Contribution Plan specifies the amount of contribution that !ill be made over the accumulation period. $ut the amount of benefit that !ill be available is unkno!n since it !ill be affected by time the investment return and the amount of future contributions. For e#ample an employers plan may specify that it !ill contribute =? of your annual salary each year to the plan on your behalf. $ut the amount available to you at your retirement !ill be based on !hen you retire ho! !ell the plans investments have done over the years and your actual earnings history !hich establish the =? contribution. $oth of these plans are considered "Jualified Plans- under Federal "a# Da!s. As such they provide several benefits to encourage participation. "he first is that any contributions made to the plan are considered ta#'deductible to your employer and not considered taxable income for you... "he second and most important is that all of the gro!th !ithin this Rualified )lan !ill be tax:deferred until such time as you !ithdra!

64

the money for retirement use. 0f course at that time all !ithdra!als 4both principal and interest5 !ill be fully ta#ed as ordinary income. 6enerally both of these Rualified )lans are completely funded by your employer. ,o!ever the trend in recent years has been to replace or supplement these traditional types of pension plans !ith plans in !hich the employees share in the cost. In addition to these plans there are also numerous other versions of the Rualified )lan that may be sponsored by your employer. "hese include &traight )rofit &haring )lans &imple )lans and "arget $enefit )lans. All of these plans !ork similarly to the other Rualified )lans and may or may not allo! employee contributions. "here may also be other plans such as &tock 0ptions or payroll deduction savings plans.

&nnuities
"here are numerous !ays to save for retirement. 0ne commonly used vehicle is the #eferred &nnuity. An annuity is an investment contract issued by a life insurance company in !hich an investor invests a sum of money in the annuity contract !ith the sum plus investment earnings to be returned to the investor at a later time as a lump sum or as a guaranteed income stream. 8uring the deferred or accumulation phase funds deposited in this annuity gro! on a ta!'deferred basis 7ust like in the Rualified %etirement )lans. Annuities may be:

Single Premium or by installment payment 4usually monthly5 Fixed or *ariable in investment nature 4fi#ed guaranteeing the return of principal and a flat rate minimum rate of interest; !ith variable like variable life offering the investor the opportunity to select investments from among a number of investment options.5 65

An annuity is like other ta#'*ualified savings vehicles in that there is a 9;? penalty if funds are !ithdra!n prior to age >H S. (hen you are ready to begin the !ithdra!al phase of an annuity you !ill have several choices. "hese options parallel those that are usually available in the !ithdra!al phase of your employers Rualified )lan. Selecting & !etirement Income B &nnuity Pay:7ut /ost Rualified %etirement )lans offer a number of pay'out options upon retirement. 0ne option may be a lump sum. representing your entire retirement account balance. (hen this option is selected income ta#es !ill be due in the year of receipt on the entire amount. &ome retirees find this option attractive if they are going to be in a very lo! ta# bracket for that year and their personal retirement goals re*uire a large lump sum of available cash. In addition to the lump sum or rollover option most plans offer one or more structured pay'outs !hich offer income streams for life or for specific periods of time. It is very important to understand these options since the option you select may greatly affect your cash flo! in retirement. And in almost all cases once you have selected and have begun to receive a payout under one of these options you !ill not be allo!ed to change your option. &ome of the most commonly offered payout streams are as follo!s:

Straight 1ife &nnuity Payment : payment stream is guaranteed over the lifetime of the annuitant !hether that is one month or >; years. -ven if the annuitant dies early in the payment stream there is no residual benefit. his option provides the highest payout of all the annuitized options. ,xample

/rs. $ro!n age A> has accumulated %s.>;; ;;; in her deferred annuity and is no! ready to select a pay'out. &he selects the &traight' 66

Dife 0ption because it !ill pay her %s.@>;; per month. Bnfortunately /rs. $ro!n dies at age AG having only received three years of payout. &ince she selected the &traight Dife payout the payments !ill cease upon her death !ithout any residual value being available for her heirs.

&nnuity Certain : "his annuity pays for on the period selected. It has no connection to the life span of the annuitant. ,xample

,ad /rs. $ro!n selected a 9;'.ear'1ertain payout her monthly income !ould have been %s.>>;;. If she died at age AG the result !ould have been the same as !ith the Dife Annuity !ith 9;'.ears'1ertain. "he payout !ould have continued for the remainder of the 9;'year period. ,o!ever had she lived beyond the 9; years she !ould have had no further income after the 9;'year period.

!efund &nnuity : "his annuity guarantees payment for lifetime of the annuitant and beyond that guarantees payment until an amount at least as large as the purchase payment is reached. In essence this creates a full "refund" of premium. ,xample "his option !ould have paid /rs. $ro!n %s. =>;; per month and it !ould have continued as long as she lived regardless ho! long that might be; ho!ever if she did indeed die at age AG the payments !ould have stopped and the purchase price of the annuity have been paid to the nominee+beneficiary of /rs. $ro!n. "his amount received by the nominee is ta# free. 67

<oint and Survivor &nnuity : )ayments under this option are based on the lives of more than 7ust the annuitant; usually it is the annuitant and a spouse. )ayments !ill continue on a full or partial basis as long as either annuitant is living. "his option is fre*uently used in pension plan to insure that surviving spouses !ill continue to receive all or part of the retirement income flo! of his+her spouse.

,xample

In this case if /rs. $ro!n had a husband 4age A>5 and had selected the Point and 9;;? &urvivor option her payout !ould have been %s. =;;; . "his amount !ould have been paid for as long as either /rs. or /r. $ro!n !as living. As you can see there is a difference bet!een the payment levels of these various options. "he more contingencies an insurance company is asked to accommodate the lo!er the income flo!. For e#ample the simplest form of payout is the straight life annuity. "he only contingency here is ho! long one person 4the annuitant5 !ill live. "his option provides the highest payout of any life'contingent option. (ith the addition of an additional annuitant; a time period that is guaranteed; or especially if the company has to guarantee a full refund the payment flo!s shrink accordingly. "he ten year only option offered a higher payout ho!ever there !ould have been no benefits beyond the ten year period; and at age A> /rs. $ro!n 4under normal circumstances5 !ould have had a life e#pectancy considerably beyond this 9; year period. If you !ill be selecting a retirement payout from among these options your o!n personal circumstances !ill dictate !hich choice is best for you. $ut there is sometimes a !ay to "have your cake and eat it too".

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0ow &re #istributions from !etirement Savings axed? "he ta# treatment depends on ho! the distribution is paid; that is as a lump sum distribution an "annuitized" 4structured and guaranteed5 monthly payment; or as fle#ible !ithdra!als. Dump sum distributions are non ta#able. )eriodic payments received from an -mployers )ension or %etirement )lan is also considered ordinary income as they are received. $ut annuity payments !ill be treated as part principal and part interest !ith only the interest portion being ta#able.

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Case
1omputation of income of /r. F before financial planning
)articulars I3C7M, F!7M S&1&!F &alary %eceived Dess: &tandard 8eduction u+s 9A 4i5 @I> ;;;.; ; =; ;;;.;; @@> ;;;.;; Amount "a#able Amount

I3C7M, F!7M 7 0,! S74!C,S $ank Interest 8!7SS 7 &1 I3C7M, Dess : #,#4C I73S 43#,! C0&P ,! *I: & 9< ;;;.;; @A9 I>;.;; @A9 I>;.;; 99< ><>.;; <G I>;.;; @I= I>;.;;

B+s G; ' D : $ank Interest 3, &9&$1, I3C7M, %0B28-8 0FF "AF 02 A$0CDess: "a# 8educted at source &alary Interest $alance )ayable H> >;;.;; < H@I.;;

HG @@I.;; 9@ ;IG. ;;

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