Pfin 6 Personal Finance 6Th Edition Randall S Billingsley All Chapter

PFIN 6: Personal Finance 6th Edition
Randall S. Billingsley
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PFIN
B I L L I N G S L E Y/G I T MA N/ J O E H N K
6 BRIEF CONTENTS
PART 1 FOUNDATIONS OF FINANCIAL

PLANNING
1 Understanding the Financial Planning Process 2
2 Using Financial Statements and Budgets 28
3 Preparing Your Taxes 54
PART 2 MANAGING BASIC ASSETS

4 Managing Your Cash and Savings 84
5 Making Automobile and Housing Decisions 110
PART 3 MANAGING CREDIT

6 Using Credit 144
7 Using Consumer Loans 170
PART 4 MANAGING INSURANCE NEEDS

8 Insuring Your Life 196
9 Insuring Your Health 224
10 Protecting Your Property 252
PART 5 MANAGING INVESTMENTS

11 Investment Planning 276
12 Investing in Stocks and Bonds 308
13 Investing in Mutual Funds, ETFs, and Real Estate 340
PART 6 RETIREMENT AND ESTATE PLANNING

14 Planning for Retirement 370
15 Preserving Your Estate 398
Appendix A 424
Appendix B 425
Appendix C 426
Appendix D 427
adventtr/E+/Getty Images
Appendix E 428
Index 430
Brief Contents iii
CONTENTS
Part 1 3 Preparing Your Taxes 54

FOUNDATIONS OF 3-1 Understanding Federal Income Tax Principles 55
FINANCIAL PLANNING
3-2 It’s Taxable Income that Matters 59
3-3 Calculating and Filing Your Taxes 63
3-4 Other Filing Considerations 73
3-5 Effective Tax Planning 77
Part 2
JGI/Jamie Grill/Getty Images
MANAGING BASIC
ASSETS
1 Understanding the Financial

Planning Process 2
11-1 The Rewards of Sound Financial Planning
rCarner/Shutterstock.com
3
1-2 The Personal Financial Planning Process 6
1-3 From Goals to Plans: A Lifetime of Planning 13
1-4 The Planning Environment 19
1-5 What Determines Your Personal Income? 23
2 Using Financial Statements 4 Managing Your Cash and

Savings 84
and Budgets 28 4-1 The Role of Cash Management in Personal Financial
2-1 Mapping Out Your Financial Future 29 Planning 85
2-2 The Balance Sheet: How Much Are You Worth 4-2 Today’s Financial Services Marketplace 87
Today? 30 4-3 A Full Menu of Cash Management Products 90
2-3 The Income and Expense Statement: What We Earn 4-4 Maintaining a Checking Account 95
and Where It Goes 35
4-5 Establishing a Savings Program 101
2-4 Using Your Personal Financial Statements 38
2-5 Cash In and Cash Out: Preparing and Using
Budgets 40 5 Making Automobile and
2-6 The Time Value of Money: Putting a Dollar Value on Housing Decisions 110
Financial Goals 44 5-1 Buying an Automobile 110
5-2 Leasing a Car 116
5-3 Meeting Housing Needs: Buy or Rent? 118
iv Contents
5-4 How Much Housing Can You Afford? 124
5-5 The Home-Buying Process 131 Part 4
5-6 Financing the Transaction 135
MANAGING
Part 3
INSURANCE NEEDS
MANAGING CREDIT
Rawpixel.com/Shutterstock.com
Mark Viker/Getty Images
8 Insuring Your Life 196

8-1 Basic Insurance Concepts 197
8-2 Why Buy Life Insurance? 198
6 Using Credit 144

8-3 How Much Life Insurance Is Right for You?
8-4 What Kind of Policy Is Right for You? 204
199
6-1 The Basic Concepts of Credit 144 8-5 Buying Life Insurance 213
6-2 Credit Cards and Other Types of Open Account 8-6 Key Features of Life Insurance Policies 216
Credit 150
6-3 Obtaining and Managing Open Forms of Credit 157
6-4 Using Credit Wisely 164
9 Insuring Your Health 224
9-1 The Importance of Health Insurance
7 Using Consumer Coverage 225

9-2 Health Insurance Plans 226
Loans 170 9-3 Health Insurance Decisions 232
7-1 Basic Features of Consumer Loans 170 9-4 Medical Expense Coverage and Policy
7-2 Managing Your Credit 177 Provisions 236
7-3 Single-Payment Loans 181 9-5 Long-Term-Care Insurance 241
7-4 Installment Loans 186 9-6 Disability Income Insurance 244
Contents v
10 Protecting Your Property 252
13-2 Types of Funds and Fund Services 350
13-3 Making Mutual Fund and ETF Investments 356
10-1 Basic Principles of Property Insurance 253 13-4 Investing in Real Estate 362
10-2 Homeowner’s Insurance 257
10-3 Automobile Insurance 263
10-4 Other Property and Liability Insurance 269
Part 6
10-5 Buying Insurance and Settling Claims 270
RETIREMENT AND
Part 5
ESTATE PLANNING
MANAGING
INVESTMENTS
Cathy Yeulet/123RF
Jan Stromme/Getty Images
14 Planning for Retirement 370

14-1 An Overview of Retirement Planning 371
14-2 Social Security 377
11 Investment Planning
14-3 Pension Plans and Retirement Programs 380
276 14-4 Annuities 389
15 Preserving Your Estate

11-1 The Objectives and Rewards of Investing 277
11-2 Securities Markets 283 398
11-3 Making Transactions in the Securities 15-1 Principles of Estate Planning 398
Markets 288
15-2 Thy Will Be Done . . . 403
11-4 Becoming an Informed Investor 294
15-3 Trusts 411
11-5 Online Investing 296
15-4 Federal Unified Transfer Taxes 414
11-6 Managing Your Investment Holdings 300
15-5 Calculating Estate Taxes 418
12 Investing in Stocks and 15-6 Estate Planning Techniques 420
Bonds 308 Appendix A 424

12-1 The Risks and Rewards of Investing 309 Appendix B 425
12-2 Investing in Common Stock 315 Appendix C 426
12-3 Investing in Bonds 326 Appendix D 427
Appendix E 428
13 Investing in Mutual Funds, Index 430
ETFs, and Real Estate 340

13-1 Mutual Funds and Exchange Traded Funds: Some
Basics 341
vi Contents
ABOUT THE AUTHORS
RANDALL S. BILLINGSLEY is a finance professor in Financial Management, The Financial Review, the
at Virginia Tech. He received his bachelor’s degree in Journal of Financial Planning, the Journal of Risk and
economics from Texas Tech University and received Insurance, the Financial Services Review, the Journal of
both an M.S. in economics and a Ph.D. in finance from Financial Research, Financial Practice and Education,
Texas A&M University. Professor Billingsley holds the the Journal of Financial Education, and other scholarly
Chartered Financial Analyst (CFA), Financial Risk publications.
Manager (FRM), and Certified Rate of Return Analyst His major textbooks include The Future of Business,
(CRRA) professional designations. An award-winning Sixth Edition, and The Future of Business: The Essen-
teacher at the undergraduate and graduate levels, his tials, Fourth Edition, both of which are co-authored with
research, consulting, and teaching focus on investment Carl McDaniel; and Fundamentals of Investing, Twelfth
analysis and issues relevant to practicing financial ad- Edition, which is co-authored with Michael D. Joehnk
visors. Formerly a vice-president at the Association and Scott B. Smart. Gitman and Joehnk also wrote Invest-
for Investment Management and Research (now the ment Fundamentals: A Guide to Becoming a Knowledge-
CFA Institute), Professor Billingsley’s published equity able Investor, which was selected as one of 1988’s 10 best
valuation case study of Merck & Company was assigned personal finance books by Money magazine; Principles of
reading in the CFA curriculum for several years. In 2006, Managerial Finance, Sixth Brief Edition, and Principles
the Wharton School published his book, Understanding of Managerial Finance, Thirteenth Edition, both co-
Arbitrage: An Intuitive Approach to Financial Analysis. authored with Chad J. Zutter; Foundations of Manageri-
In addition, his research has been published in refereed al Finance, Fourth Edition; and Introduction to Finance,
journals that include the Journal of Portfolio Manage- co-authored with Jeff Madura.
ment, the Journal of Banking and Finance, Financial An active member of numerous professional organi-
Management, the Journal of Financial Research, and zations, Professor Gitman is past president of the Acad-
the Journal of Futures Markets. Professor Billingsley emy of Financial Services, the San Diego Chapter of the
advises the Student-Managed Endowment for Educa- Financial Executives Institute, the Midwest Finance
tional Development (SEED) at Virginia Tech, which Association, and the FMA National Honor Society. In
manages an equity portfolio of about $5 million on be- addition, he is a Certified Financial Planner® (CFP®).
half of the Virginia Tech Foundation. Gitman formerly served as a director on the CFP®
Professor Billingsley’s consulting to date has focused Board of Governors, as vice-president–financial edu-
on two areas of expertise. First, he has acted extensively cation for the Financial Management Association, and
as an expert witness on financial issues. Second, he has as director of the San Diego MIT Enterprise Forum.
taught seminars and published materials that prepare in- Gitman has two grown children and lives with his wife
vestment professionals for the CFA examinations. This in La Jolla, California, where he is an avid bicyclist.
has afforded him the opportunity to explore and discuss
MICHAEL D. JOEHNK is an emeritus professor of
the relationships among diverse areas of investment anal-
finance at Arizona State University. In addition to his ac-
ysis. His consulting endeavors have taken him across the
ademic appointments at ASU, Professor Joehnk spent a
United States and to Canada, Europe, and Asia. A primary
year (1999) as a visiting professor of finance at the Univer
Univer-
goal of Professor Billingsley’s consulting is to apply the
sity of Otago in New Zealand. He received his bachelor’s
findings of academic financial research to practical invest-
and Ph.D. degrees from the University of Arizona and
ment decision making and personal financial planning.
his M.B.A. from Arizona State University. A Chartered
LAWRENCE J. GITMAN is an emeritus professor of fi- Financial Analyst (CFA), he has served as a member
nance at San Diego State University. He received his of the Candidate Curriculum Committee and of the
bachelor’s degree from Purdue University, his M.B.A. Council of Examiners of the Institute of Chartered
from the University of Dayton, and his Ph.D. from the Financial Analysts. He has also served as a director of the
University of Cincinnati. Professor Gitman is a prolific Phoenix Society of Financial Analysts and as secretary/
textbook author and has more than 50 articles appearing treasurer of the Western Finance Association, and he was
About the Authors vii
elected to two terms as a vice-president of the Financial successful paperback trade book, Investing for Safety’s
Management Association. Professor Joehnk is the author Sake. Dr. Joehnk was also the editor of Institutional
or co-author of some 50 articles, five books, and numer
numer- Asset Allocation, which was sponsored by the Institute
ous monographs. His articles have appeared in Finan- of Chartered Financial Analysts and published by Dow
cial Management, the Journal of Finance, the Journal of Jones-Irwin. He was a contributor to the Handbook
Bank Research, the Journal of Portfolio Management, for Fixed Income Securities and to Investing and Risk
the Journal of Consumer Affairs, the Journal of Financial Management, Volume 1 of the Library of Investment
and Quantitative Analysis, the AAII Journal, the Journal Banking. In addition, he served a six-year term as ex-
of Financial Research, the Bell Journal of Economics, ecutive co-editor of the Journal of Financial Research.
the Daily Bond Buyer, Financial Planner, and other He and his wife live in Flagstaff, Arizona, where they
publications. enjoy hiking and other activities in the nearby moun-
tains and canyons.
In addition to co-authoring several books with Lawrence
J. Gitman, Professor Joehnk was the author of a highly
viii About the Authors
ACKNOWLEDGEMENTS
In addition to the many individuals who made significant The editorial staff at Cengage Learning has been
contributions to the book by their expertise, classroom most helpful in our endeavors. We particularly wish
experience, guidance, general advice, and reassurance, to thank Steven E. Joos, the former Product Director,
we also appreciate the students and faculty who used the 4LTR Press; Laura Redden, Product Manager; Tricia
book and provided valuable feedback, confirming our Hempel, Content/Media Developer; Lauren Dame,
conviction that a truly teachable personal financial plan- Product Assistant, and Nadia Saloom, Content Project
ning text could be developed. Manager.
We are indebted to the academicians and practitio- Finally, our wives – Bonnie, Robin, and Charlene –
ners who have created the body of knowledge contained have provided needed support during the writing of this
in this text. We particularly wish to thank several people book. We are forever grateful to them.
who gave the most significant help in developing and revis-
ing it. They include Eric Johnson, ChFC, CLU, LTCP, of Randall S. Billingsley, FRM, CFA
StateFarm for his helpful insights on insurance products Virginia Tech
and planning; Professor Sam Hicks, CPA, of Virginia Tech, Lawrence J. Gitman, CFP®
for his thorough review of the entire book; Professor Hon- San Diego State University
gbok Lee, of Western Illinois University, for helpful obser
obser-
vations, and Thomas C. Via Jr., CLU, of Leonard L. Brown Michael D. Joehnk, CFA
Agency for his help on life and property insurance issues. Arizona State University
Acknowledgements ix
1 Understanding the
Financial Planning
Process
LEARNING OBJECTIVES
After studying this chapter, you will be able to…
LO1 Identify the benefits of using personal financial planning techniques to manage your finances.
LO2 Describe the personal financial planning process and define your goals. After finishing
this chapter go
LO3 Explain the life cycle of financial plans, their role in achieving your financial goals, how to deal
with special planning concerns, and the use of professional financial planners. to PAGE26 for

LO4 Examine the economic environment’s influence on personal financial planning. STUDY TOOLS
LO5 Evaluate the impact of age, education, and geographic location on personal income.
LO6 Understand the importance of career choices and their relationship to personal financial
planning.
How Will This Affect Me? The heart of financial planning is making sure your
values line up with how you spend and save. That means knowing where you are
financially and planning on how to get where you want to be in the future no
matter what life throws at you. For example, how should your plan handle the
projection that Social Security costs may exceed revenues by 2037? And what if the
government decides to raise marginal tax rates to help cover the federal deficit? An
informed financial plan should reflect such uncertainties and more.
This chapter describes the financial planning process and explains its context.
Topics include how financial plans change to accommodate your current stage
in life and the role that financial planners can play in helping you achieve your
objectives. After reading this chapter you will have a good perspective on how to
organize your overall personal financial plan.
2 PART ONE: Foundations of Financial Planning
1-1 THE REWARDS OF SOUND The best way to achieve financial objectives is
through personal financial planning, which helps de-
FINANCIAL PLANNING fine your financial goals and develop appropriate strat-
egies to reach them. And being financially self-aware
LO1 What does living “the good life” mean to you? Does provides more insight into the range of available fi-
it mean having the flexibility to pursue your dreams and nancial choices and their trade-offs. Your comfortable
goals in life? Is it owning a home in a certain part of retirement should not depend solely on employee or
town, starting a company, being debt free, driving a par
par- government benefits—such as steady salary increases
ticular type of car, taking luxury vacations, or having a or adequate funding from employer-paid pensions or
large investment portfolio? Today’s complex, fast-paced Social Security. Creating flexible plans and regularly
world offers a bewildering array of choices. Rapidly revising them is the key to building a sound financial
changing economic, political, technological, and social future.
environments make it increasingly difficult to develop Successful financial planning also brings rewards
solid financial strategies that will improve your lifestyle that include greater flexibility, an improved standard
consistently. Moreover, the financial crisis of 2008–2009 of living, wiser spending habits, and increased wealth.
dramatizes the need to plan for financial contingen- Of course, planning alone does not guarantee success;
cies. No matter how you define it, the good life requires but having an effective, consistent plan can help you
sound planning to turn financial goals into reality. use your resources wisely. Careful financial planning
CHAPTER 1: Understanding the Financial Planning Process 3
Exhibit 1.1
Organizational Planning Model
This text emphasizes making financial decisions regarding assets, credit, insurance, investments, and retirement and estates.
Financial Actions
Financial Basic asset decisions Financial

Plans Credit decisions Results
Insurance decisions
Investment decisions
Retirement and estate decisions
increases the chance that your financial goals will be income and thus to improve our standard of living—the
achieved and that you will have sufficient flexibility to necessities, comforts, and luxuries we have or desire.
handle such contingencies as illness, job loss, and even Our quality of life is closely tied to our standard
financial crises. of living. Although other factors—geographic location,
The goal of this book is to remove the mystery from public facilities, local cost of living, pollution, traffic,
the personal financial planning process and replace it and population density—also affect quality of life,
with the tools you need to take charge of your personal wealth is commonly viewed as a key determinant. Ma-
finances. To organize this process, the text is divided into terial items such as a house, car, and clothing as well as
six parts, as follows: money available for health care, education, art, music,
travel, and entertainment all contribute to our quality
▶ Part 1: Foundations of Financial Planning
of life. Of course, many so-called wealthy people live
▶ Part 2: Managing Basic Assets “plain” lives, choosing to save, invest, or support phil-
▶ Part 3: Managing Credit anthropic organizations with their money rather than
▶ Part 4: Managing Insurance Needs indulge in luxuries.
▶ Part 5: Managing Investments One trend profoundly affecting our standard of liv-
ing is the two-income family. What was relatively rare
▶ Part 6: Retirement and Estate Planning
in the early 1970s has become commonplace today, and
Each part explains a different aspect of personal fi- the incomes of millions of families have risen sharply as
nancial planning, as shown in Exhibit 1.1. This orga- a result. About 75 percent of married adults say that they
nizational scheme revolves around financial decision and their mate share all their money. Two incomes not
making that’s firmly based on an operational set of fi- only buy more, but they also require greater responsibil-
nancial plans. We believe that sound financial planning ity to manage the money wisely.
enables individuals to make decisions that will yield
their desired results.
1-1b Spending Money Wisely

1-1a Improving Your Standard
Using money wisely is a major benefit of financial plan-
of Living ning. Whatever your income, you can either spend it now
With personal financial planning we learn to acquire, use, or save some of it for the future. Determining your cur
cur-
and control our finan- rent and future spending patterns is an important part of
standard of living the necessities, cial resources more effi- personal money management. The goal, of course, is to
comforts, and luxuries enjoyed or
desired by an individual or family ciently. It allows us to gain spend your money so that you get the most satisfaction
more enjoyment from our from each dollar.
Current Needs Your current spending level is based Future Needs A carefully developed financial plan
on the necessities of life and your average propensity to should set aside a portion of current income for future
consume, which is the percentage of each dollar of in- spending. Placing these funds in various savings and in-
come, on average, that is spent for current needs rather vestment vehicles allows you to earn a return on your funds
than savings. A minimum level of spending would allow until you need them. For example, you may want to build
you to obtain only the necessities of life: food, clothing, and up a retirement fund to maintain a desirable standard of
shelter. Although the quantity and type of food, clothing, living in your later years. Instead of spending the money
and shelter purchased may differ among individuals de- now, you defer actual spending until the future when you
pending on their wealth, we all need these items to survive. retire. Nearly 35 percent of Americans say retirement
Some people with high average propensi-
propensi planning is their most press-
ties to consume earn low incomes ing financial concern. Other
and spend a large portion of it examples of deferred spending
on basic necessities. On the include saving for a child’s ed-
canbedone/Shutterstock.com
other hand, individuals earn- ucation, a primary residence
ing large amounts quite often or vacation home, a major
have low average propensi- acquisition (such as a car or
ties to consume, in part home entertainment cen-
because the cost of ne- ter), or even a vacation.
cessities represents only The portion of current
a small portion of their in- income we commit to future needs
come. depends on how much we earn and also on our av av-
Still, two people with signifi- erage propensity to consume. Many affluent Americans say
cantly different incomes could have the same average they need at least $5 million to feel rich. And more gener
gener-
propensity to consume because of differences in their ally, most people say that it would take about twice their
standard of living. The person making more money current net worth to feel wealthy. The more we earn and
may believe it is essential to buy better-quality items or the less we devote to current spending, the more we
more items and will thus, on average, spend the same can commit to meeting future needs. Regardless of in-
percentage of each dollar of income as the person mak- come or wealth, some portion of current income should
ing far less. be set aside regularly for future use. Doing so creates
good saving habits and provides for your future needs.
Financial Planning Tips 1-1c Accumulating Wealth

BE SMART IN PLANNING YOUR FINANCIAL GOALS
In addition to using current income to pay for everyday liv-
ing expenses, we often spend it to acquire assets such as cars,
Success is most likely if your goals are: a home, or stocks and bonds. Our assets largely determine
Specific: What do I want to achieve? What is how wealthy we are. Personal financial planning plays a
required of me, and what are my constraints? critical role in the accumulation of wealth by directing our
Measurable: How much money is needed? How financial resources to the most productive areas.
will I know if I am succeeding? One’s wealth is the
Attainable: How can I do this? Is this consistent net total value of all the
items that the individual average propensity to consume
with my other financial goals? the percentage of each dollar of income, on
owns. Wealth consists of
Realistic: Am I willing and able to do this? average, that a person spends for current
financial and tangible as- needs rather than savings
Timely: What is my target date? What short-term sets. Financial assets are
goals must be achieved along the way to achieve wealth the total value of all items owned
intangible, paper assets
by an individual, such as savings accounts,
my longer-term goals? such as savings accounts stocks, bonds, home, and automobiles
Inspired by Paul J. Meyers, Attitude Is Everything, The Meyer and securities (stocks,
Resource Group, 2003. financial assets intangible assets, such
bonds, mutual funds, as savings accounts and securities, that are
and so forth). They are acquired for some promised future return
earning assets that are
Exhibit 1.2
The Average
A American, Financially Speaking
This financial snapshot of the “average American” gives you an idea of where you stand in terms of income, net worth, and
other measures. It should help you set some goals for the future.
Income and Assets
What Do We Earn? (median)
All families $46,700
What Are We Worth? (median)
All families $81,200
Home Ownership (median)
Value of primary residence $170,000
Mortgage on primary residence 115,000
How Much Savings Do We Have? (median)
Pooled investment funds (excluding money market) $80,000
Stocks 27,000
Bonds 94,500
Bank accounts/CDs 20,100
Retirement accounts 59,000
Source: Adapted from Jesse Bricker, Lisa J. Dettling, Alice Henriques, Joanne W. Hsu, Kevin B. Moore, John Sabelhaus, Jeffrey Thompson, and Richard A.Windle, “Changes in U.S. Family Finances from 2010 to 2013:
Evidence from the Survey of Consumer Finances,” Board of Governors of the Federal Reserve System, Washington, D.C., October 24, 2014. Data is for 2013. http://www.federalreserve.gov/pubs/bulletin/2014/pdf
/scf14.pdf, Tables 1–4, accessed September 2016.
held for their expected future returns. enough, you need personal financial
Tangible assets, in contrast, are physical Everyone—including planning. If you have enough money,
assets such as real estate and automobiles. recent college graduates, planning can help you spend and in-
These assets can be held for either con- young married couples, vest it wisely. If your income seems
sumption (e.g., your home, car, artwork, and others—needs inadequate, taking steps to plan your
or jewelry) or investment purposes (e.g., a to develop a personal financial activities will lead to an im-
duplex purchased for rental income). The proved lifestyle. Personal financial
financial plan.
goal of most people is to accumulate as planning is a systematic process that
much wealth as possible while maintaining considers the important elements of
current consumption at a level that provides the desired stan- an individual’s financial affairs and is aimed at fulfilling
dard of living. To see how you compare with the typical Ameri- his or her financial goals.
can in financial terms, check out the statistics in Exhibit 1.2. Everyone—including recent college graduates,
young married couples, and others—needs to develop
1-2 THE PERSONAL FINANCIAL

a personal financial plan. Knowing what you need to ac-
complish financially, and how you intend to do it, gives
PLANNING PROCESS you an edge over someone who merely reacts to financial
events as they unfold. Just think of the example provided
by the financial crisis of 2008–2009. Do you think that
tangible assets physical assets, LO2 Many people mis-
a financial plan would have helped in weathering the
such as real estate and automobiles, that takenly assume that per
per-
can be held for either consumption or
financial storm?
sonal financial planning
investment purposes
is only for the wealthy. 1-2a Steps in the Financial
personal financial planning a However, nothing could
systematic process that considers important be further from the Planning Process
elements of an individual’s financial affairs
truth. Whether you have The financial planning process translates personal fi-
in order to fulfill financial goals
a lot of money or not nancial goals into specific financial plans, which then
Exhibit 1.3
The Six-Step Financial Planning Process
The financial planning process translates personal financial goals into specific financial plans and strategies, implements them,
and then uses budgets and financial statements to monitor, evaluate, and revise plans and strategies as needed. This process
typically involves the six steps shown in sequence here.
1. Define financial goals.
2. Develop financial plans and strategies to achieve goals.
3. Implement financial plans and strategies.
4. Periodically develop and implement budgets to monitor and control progress toward goals.
5. Use financial statements to evaluate results of plans and budgets, taking corrective action as required.
6. Redefine goals and revise plans and strategies as personal circumstances change.
help you implement those goals through financial

strategies. The financial planning process involves the
six steps shown in Exhibit 1.3.
You start with financial goals, formulate and im-
plement financial plans and strategies to reach them,
monitor and control progress toward goals through
budgets, and use financial statements to evaluate the
plan and budget results. This leads you back to rede-
fining your goals so that they better meet your current
needs, and to revising your financial plans and strate-
Patpitchaya/Shutterstock.com
gies accordingly.
Let’s now look at how goal setting fits into the plan-
ning process. In Chapters 2 and 3, we’ll consider other
information essential to creating your financial plans:
personal financial statements, budgets, and taxes.
1-2b Defining Your Financial Goals

Financial goals are the results that an individual wants effectively meet the major financial events in our lives.
to attain. Examples include buying a home, build- Your financial goals or preferences must be stated in mon-
ing a college fund, and achieving financial indepen- etary terms because
dence. What are your financial goals? Have you spelled money and the sat- financial goals results that an
them out? It’s impossible to effectively manage your individual wants to attain, such as
isfaction it can bring
buying a home, building a college fund,
financial resources without financial goals. We need are an integral part of or achieving financial independence
to know where we are going, in a financial sense, to financial planning.
BEHAVIOR MATTERS
Practicing Financial Self-Awareness

Are you aware of your financial behavior, its causes, Then ask yourself two critically important questions:
and its consequences? For example, are you routinely ● Is the way I spend money consistent with what I
relying too heavily on your credit card? Are you saving
believe? Financial planning that works taking the
enough to buy a new car or to fund your retirement?
time to develop a plan that purposely lines up your
And the bottom line: Are you continuing the same
values and your use of money.
financial behavior you have in the past and yet expect-
ing different results? ● Have I clearly stated the financial goals that are
The first decisive step in taking control of your life is important to me and, if so, what am I doing today
to be aware of what you’re thinking, feeling, and doing. to make sure I achieve them? The heart of financial
Be financially self-aware: observe your own thoughts, planning is determining where you are today and
feelings, and behavior concerning your finances. Take where you want to be in the future. This implies the
notes on things that affect how you feel, and what you need for a financial plan: limited resources sometimes
do about financial decisions. Watch yourself, and be bring painful trade-offs.
honest about your feelings concerning money and your Source: Adapted from Carl Richards, “Practicing Radical Self-Awareness,”
Behaviorgap.com, http://us2.campaign-archive1.com/?u=23ce2ac179e81
future. 58f7583c4e3f&id=86f42577bc&e=b50e826a9e, accessed September 2016.
The Role of Money About 75 percent of Americans cost when evaluating alternative qualities of life, spend-
believe that money is freedom. Money is the medium ing patterns, and forms of wealth accumulation.
of exchange used to measure value in financial trans-
actions. It would be difficult to set specific personal
financial goals and to measure progress toward achiev- Go to Smart Sites
ing them without the standard unit of exchange pro-
vided by the dollar. Money, as we know it today, is the Is getting the lowest price important to you? Where can
key consideration in establishing financial goals. Yet you search for the best prices? A highlight box in each
it’s not money, as such, that most people want. Rather, chapter of PFIN Online includes “Smart Sites,” a list of
we want the utility, which is the amount of satisfaction resources and sites that offer additional information on
received from buying quantities of goods and services topics in the PFIN text. Log in at www.cengagebrain.com.
of a given quality, that money makes possible.
People may choose one item over another because
of a special feature that provides additional utility. For
example, some people will pay more for a car with satel-
lite radio than one with only an audio player. The added
utility may result from the actual usefulness of the spe-
cial feature, from the “status” it’s expected to provide, or
from both. Regardless,
people receive varying
money the medium of exchange levels of satisfaction from
used as a measure of value in
similar items, and their The Psychology of Money Money and its utility
financial transactions
satisfaction isn’t neces- are not only economic concepts; they’re also closely
utility the amount of satisfaction sarily directly related to linked to the psychological concepts of values, emo-
received from purchasing certain
the cost of the items. We, tion, and personality. Your personal value system—the
types or quantities of goods and
services therefore, need to con- important ideals and beliefs that guide your life—will
sider utility along with also shape your attitude toward money and wealth
accumulation. If you place a high value
on family life, you may choose a career
that offers regular hours and less stress
or choose an employer who offers flex-
time rather than a higher-paying po-
sition that requires travel and lots of
overtime.
You may have plenty of money but
choose to live frugally and do things your
your-
self rather than hire someone to do them
for you. Or you may spend a high propor
propor-
tion of your current income on acquiring
zimmytws/Shutterstock.com
luxuries. Financial goals and decisions
should be consistent with your personal
values. You can formulate financial plans
that provide the greatest personal satis-
faction and quality of life by identifying
your values.
Money is an important motivator of personal be- in any relationship, including that with a partner,
havior because it has a strong effect on self-image. parents, or children. Most people are uncomfortable
Each person’s unique personality and emotional talking about money matters and avoid such discus-
makeup determine the importance and role of money sions, even with their partners. However, differing
in his or her life. You should become aware of your opinions on how to spend money may threaten the
own attitudes toward money because they are the ba- stability of a marriage or cause arguments between
sis of your “money personality” and money manage- parents and children. Learning to communicate with
ment style. your partner about money is a critical step in develop-
Some questions to ask yourself include: How im- ing effective financial plans.
portant is money to me? Why? What types of spend- The best way to resolve money disputes is to be
ing give me satisfaction? Am I a risk taker? Do I need aware of your partner’s financial style, consistently com-
large financial reserves to feel secure? Knowing the municate openly, and be willing to compromise. It’s
answers to these questions is a prerequisite for devel- highly unlikely that you can change your partner’s style,
oping realistic and effective financial goals and plans. but you can work out your differences. Financial plan-
Trade-offs between current and future benefits are ning is an especially important part of the conflict resolu-
strongly affected by values, emotions, and personality. tion process. You need to work together to develop your
Effective financial plans are both economically and financial goals.
psychologically sound. They must not only consider
your wants, needs, and financial resources but must
also realistically reflect your personality and emo- 1-2d Types of Financial Goals
tional reactions to money.
Financial goals cover a wide range of financial as-
pirations: controlling living expenses, meeting re-
tirement needs, setting up a savings and investment
1-2c Money and Relationships
program, and minimizing your taxes. Other impor-
The average couple spends between 250 and 700 tant financial goals include having enough money to
hours planning their wedding. While most couples live as well as possible, being financially indepen-
spend less than $10,000 on the big day, the average dent, sending children to college, and providing for
cost has risen to more than $32,000, depending on retirement.
where they live. But with all the hoopla surrounding Financial goals should be defined as specifically
the wedding day, many couples overlook one of the as possible. Saying that you want to save money next
most important aspects of marriage: financial compat- year is not a specific goal. How much do you want
ibility. Money can be one of the most emotional issues to save, and for what purpose? A goal such as “save
Financial Planning Tips
COMMON MISCONCEPTIONS ABOUT FINANCIAL PLANNING
● A professional financial planner is an unneces- tendency to overspend because expenses are easy
sary expense. The answer depends on you. A lot of to underestimate without a formal budget. And if
good financial planning can be done on your own. you spend first and only save what’s left over, the
But honestly ask yourself: Do I have the discipline, probability of achieving your financial goals is much
time, and financial experience to manage these lower. Sticking to a budget is the key.
complicated tasks effectively and confidently? If the ● Retirement is a lifetime away. While that may be
answer is no, see a financial planner to get a realistic true, that doesn’t justify focusing only on short-
idea of the planning process. term goals like coming up with the down pay-
● A little credit card debt is just fine. Define “a little.” ment on a house. When retirement is a “lifetime
A modest amount of credit card debt is OK. The prob- away,” that’s the time to exploit the compounding
lem is that for all too many people, “a little” leads to of returns over a long period of time by taking full
a lot. As discussed in Part 3 of this book, “Managing advantage of retirement investments in your em-
Credit,” credit card debt is often one of the biggest ployer’s 401(k) plan and in IRAs. An early start can
problems in managing your personal finances. Just put you well ahead.
consider the high interest rates of credit cards and
how easy it is to build up a big balance. Source: Adapted from Kimberly J. Howard, CFP®, CRPC, “Financial
Fiascos Every Young Couple with Debts Should Avoid,” NAPFA
● I don’t need a budget because I have a general Planning Perspectives, volume 6, issue 5, Sept/Oct 2011, www
idea of what I earn and spend. There is a natural .NAPFA.org, accessed September 2016.
10 percent of my take-home pay each month to start budgets. Finally, you should assign priorities and a
an investment program” states clearly what you want time frame to financial goals. Are they short-term
to do and why. goals for the next year, or are they intermediate or
Because they are the basis of your financial plans, long-term goals that will not be achieved for many
your goals should be realistic and attainable. If you set more years? For example, saving for a vacation might
a savings goal too high—for example, 25 percent of be a medium-priority, short-term goal, whereas buy-
your take-home pay when your basic living expenses ing a larger home may be a high-priority, intermediate
already account for 85 percent of it—then your goal goal and purchasing a vacation home a low-priority,
is unattainable and there’s no way to meet it. But if long-term goal. Normally, long-term financial goals
savings goals are set too low, you may not accumulate are set first, followed by a series of corresponding
enough for a meaningful investment program. If your short-term and intermediate goals.
goals are unrealistic, they’ll put the integrity of your
financial plan at risk and be a source of ongoing finan-
cial frustration.
It’s important to involve your immediate family in 1-2e Putting Target Dates
the goal-setting process. When family members “buy
on Financial Goals
into” the goals, it reduces the likelihood of future
conflicts and improves Financial goals are most effective when they are set with
the family’s chances for goal dates. Goal dates are target points in the future
goal dates target dates in financial success. After when you expect to have achieved or completed certain
the future when certain financial
objectives are expected to be
defining and approving financial objectives. They may serve as progress check-
completed your goals, you can pre- points toward some longer-term financial goals and/or as
pare appropriate cash deadlines for others.
EXAMPLE: Target Dates for Financial Goals
Austin and Clara Martin are both 28 and have been
married for one year. They have set financial goals of
buying a boat for $3,000 in 2019, accumulate a net
worth of $10,000 by 2023, and accumulate a net worth
of $50,000 by 2031.
Long-Term Goals Long-term financial goals should

indicate wants and desires for a period covering about
RomanR/Shutterstock.com
6 years out to the next 30 or 40 years. Although it’s dif
dif-
ficult to pinpoint exactly what you will want 30 years
from now, it’s useful to establish some tentative long-
term financial goals. However, you should recognize
that long-term goals will change over time and that
you’ll need to revise them accordingly. If the goals
long-term goals. Short-term planning should also include
seem too ambitious, you’ll want to make them more
establishing an emergency fund with at least six months’
realistic. If they’re too conservative, you’ll want to
worth of income. This special savings account serves as a
adjust them to a level that encourages you to make
safety reserve in case of financial emergencies such as a
financially responsible decisions rather than squander
temporary loss of income.
surplus funds.
Unless you attain your short-term goals, you proba-
Short-Term and Intermediate Goals Short-term fi- bly won’t achieve your intermediate or long-term goals.
nancial goals are set each year and cover a 12-month It’s tempting to let the desire to spend now take prior
prior-
period. They include making substantial, regular con- ity over the need to save for the future. But by making
tributions to savings or investments in order to accumu- some short-term sacrifices now, you’re more likely to
late your desired net worth. Intermediate goals bridge have a comfortable future. Worksheet 1.1 is a conve-
the gap between short- and long-term goals. And of nient way to summarize your personal financial goals. It
course, both intermediate and short-term goals should groups them by time frame (short term, intermediate,
be consistent with your long-term goals. or long term) and lists a priority for each goal (high,
Short-term goals become the key input for the cash medium, or low), a target date to reach the goal, and an
budget, a tool used to plan for short-term income and estimated cost.
expenses. To define your short-term goals, consider We have filled out the form showing the goals that
your immediate goals, expected income for the year, and Silas and Emily Nelson set in December 2017. The
Nelsons were married in 2013, own a condominium in
a Midwestern suburb, and have no children. Because
Silas and Emily are 28 and 26 years old, respectively,
DO IT NOW: Start a List of Your Financial Goals they have set their longest-term financial goal 33 years
Yogi Berra summed it up: “If you don’t know where from now, when they want to retire. Silas has just com-
you’re going, you might not get there.” And so it is pleted his fifth year as a marketing representative for
with your financial goals. Pick up some paper now and a large pharmaceutical company. Emily, a former el-
start a list of your financial goals. Maybe it’s as simple ementary school teacher, finished her MBA in May
as saving $25 by the end of the month or as lofty as 2016 and began working at a local advertising agency.
saving $200,000 for retirement by the time you’re 50. Silas and Emily love to travel and ski. They plan to
You’ll never achieve your goals if you don’t know what start a family in a few years, but for now they want
they are, much less know whether they’re realistic. Go to develop some degree of financial stability and in-
ahead and dream. List your goals (short-term, interme- dependence. Their short-term goals include purchas-
diate, and long-term) and start laying out how you’ll ing assets (clothes, furniture, and car), reducing debt,
get there. You can do it now. reviewing insurance, increasing savings, and planning
for retirement.
WORKSHEET 1.1 SUMMARY OF PERSONAL FINANCIAL GOALS
Set financial goals carefully and realistically, because they form the basis for your personal
financial plans. Each goal should be clearly defined and have a priority, time frame, and
cost estimate.
Personal Financial Goals
Name(s)
Silas and Emily Nelson Date
December 27, 2017
Short-Term Goals (1 year or less)
Goal Priority Target Date Cost Estimate

Buy new tires and brakes for Honda High Feb. 2018 $ 500
Take Colorado ski trip Medium Mar. 2018 1,800
Buy career clothes for Emily High May 2018 1,200
Buy new work clothes for Silas Medium June 2018 750
Replace stereo components Low Sept. 2018 1,100
Intermediate Goals (2 to 5 years)

Start family High 2019 -
Take 2-week European Vacation Medium 2019–20 5,000
Repay all loans except mortgage High 2020 $ 7,500
Trade Focus and buy larger car High 2020 10,500
Review insurance needs High 2020 -
Buy new bedroom furniture Low 2022 4,000
Accumulate $100,000 net worth High 2022 -
Long-Term Goals (6 1 years)
Begin college fund for children High 2023 ? /year

Diversify/increase investment portfolio High 2024 Varies
Take Hawaiian vacation Low 2025 $ 10,000
Increase college fund contributions High 2025 -
Buy larger home High 2027 $ 250,000
Retire from jobs High 2050 ?
1-3 FROM GOALS TO PLANS: 45, or 65. Some changes—a new job, marriage, children,
moving to a new area—may be part of your original plan.
A LIFETIME OF PLANNING More often than not, you’ll face unexpected “financial
shocks” during your life: loss of a job, a car accident, di-
LO3 How will you achieve the financial goals you set vorce or death of a spouse, a long illness, or the need to
for yourself? The answer, of course, lies in the financial support adult children or aging parents. With careful plan-
plans you establish. Financial plans provide the road ning, you can get through tough times and prosper in good
map for achieving your financial goals. The six-step fi- times. You need to plan ahead and take steps to weather
nancial planning process (introduced in Exhibit 1.3) re- life’s financial storms successfully. For example, setting up
sults in separate yet interrelated components covering an emergency fund or reducing monthly expenses will help
all the important financial elements in your life. protect you and your family financially if a setback occurs.
Some elements deal with the more imme- As we move from childhood to retirement age, we
diate aspects of money management, go through different life stages. Ex Ex-
such as preparing a budget to hibit 1.4 illustrates the various
help manage spending. Oth- components of a typical per- per
ers focus on acquiring major sonal financial planning life
assets, controlling borrowing, re- re cycle as they relate to these different
ducing financial risk, providing for life stages. While the exhibit shows
emergency funds and future wealth more detail, the life cycle involves
accumulation, taking advantage of three general stages: 1) wealth accu
accu-
and managing employer-sponsored mulation, 2) wealth preservation, and
benefits, deferring and minimizing 3) wealth transfer. This exhibit pres-
pres
taxes, providing for financial security ents the organizing framework of
the entire financial planning pro pro-
when you stop working, and ensuring
cess. We will refer to it throughout
an orderly and cost-effective transfer
the book—and we suggest you do
of assets to your heirs.
so for the rest of your life.
In addition to discussing your
As we pass from one stage of Mega Pixel/Shutterstock.com
financial goals and attitudes toward
maturation to the next, our patterns
money with your partner, you must al- al
of income, home ownership, and
locate responsibility for money man-man
debt also change. From early child child-
agement tasks and decisions. Many
hood, when we rely on our parents
couples make major decisions jointly
for support, to early adulthood,
and divide routine financial decision
when we hold our first jobs and start
making on the basis of expertise and interest.
our families, we can see a noticeable change in income
Others believe it is important for their entire family to
patterns. For example, those in the pre-retirement 45–64
work together as a team to manage the family finances.
age group tend to have higher income than those younger
They hold family financial meetings once every few
than age 45. Thus, as our emphasis in life changes, so do
months to help their children understand how the house- the kinds of financial plans we need to pursue.
hold money is spent. New career strategies—planned and unplanned job
changes—may require that financial plans be revised.
1-3a The Life Cycle Many young people focus on their careers and building a
financial base before marrying and having children. The
of Financial Plans families of women who interrupt their careers to stay
Financial planning is a dynamic process. As you move home with their children, whether for six months or six
through different stages of your life, years, will experience periods of reduced
your needs and goals will change. Yet income. A divorce, a spouse’s death, or
certain financial goals are important You need to plan ahead remarriage can also drastically change
regardless of age. Having extra re- and take steps to your financial circumstances. Many peo-
sources to fall back on in an economic weather life’s financial ple in their 30s, 40s, and 50s find them-
downturn or period of unemployment storms successfully. selves in the “sandwich generation”:
should be a priority whether you are 25, supporting their elderly parents while
Exhibit 1.4
The Personal Financial Planning Life Cycle
As you move through life and your income and living cost patterns change, you’ll typically have to pursue a variety of financial
plans. For instance, after graduating from college, your focus likely will be on buying a car and a house, and you’ll be concerned
about health and automobile insurance to protect against loss.
Wealth Wealth
Wealth accumulation
preservation transfer
Early High Pre- Family Pre- Retirement
childhood school family formation/ retirement
and inde- career
college pendence development Income
Retirement and estate planning
Tax planning
$
Employee benefit planning
Savings and investment planning
Liability and insurance planning
Asset acquisition planning
0
10 20 30 40 50 60 70 80 90
Age
still raising their own children and paying for college. And as a house). Chapters 4 and 5 focus on important con-
some people must cope with reduced income due to jobs siderations for managing liquid assets and other major
lost because of corporate downsizing or early retirement. assets such as automobiles and housing.
Liability and Insurance Planning Another category

1-3b Plans to Achieve Your of financial planning is liability planning. A liability is
Financial Goals something we owe, which is measured by the amount
of debt we incur. We create liabilities by borrowing
Financial goals can range from short-term goals, such
money. By the time most of us graduate from college,
as saving for a car, to long-term goals, such as saving
we have debts of some sort or another—examples in-
enough to start your own business. Reaching your partic-
ular goals requires different types of financial planning. clude education loans, car loans, credit card balances,
and so on. Our borrowing needs typically increase as
Asset Acquisition Planning One of the first catego- we acquire assets like a home, furnishings, and appli-
ries of financial planning we typically encounter is asset ances. Whatever the source of credit, such transactions
acquisition. We accumulate assets—things we own— have one thing in common: the debt must be repaid at
throughout our lives. These include liquid assets (cash, some future time. How we manage our debt burden is
savings accounts, and money market funds) used to pay just as important as how we manage our assets. Manag-
everyday expenses, investments (stocks, bonds, and mu- ing credit effectively requires careful planning, which
tual funds) acquired to earn a return on our money, per-
per is covered in Chapters 6 and 7.
sonal property (movable property such as automobiles, Obtaining adequate insurance coverage is also essen-
household furnishings, appliances, clothing, jewelry, tial. Like borrowing money, obtaining insurance is often
home electronics, and similar items), and real property introduced relatively early in our life cycle (usually early in
(immovable property; land and anything fixed to it, such the family formation stage). Insurance is a way to reduce
investment planning. Initially, people save to establish
an emergency fund for meeting unexpected expenses.
Eventually, however, they devote greater attention to
investing excess income as a means of accumulating
wealth, either for major expenditures, such as a child’s
college education, or for retirement. Individuals build
wealth through savings and subsequently making various
investments: common or preferred stocks, government
Shutter_M/Shutterstock.com
or corporate bonds, mutual funds, real estate, and so
on. The higher the returns on the investment of excess
funds, the greater the wealth they accumulate.
Exhibit 1.5 shows the impact of two different rates
of return on accumulated wealth. The graph shows that
if you had $1,000 today and could keep it invested at
4 percent, then you would accumulate a considerable
financial risk and protect both income (life, health, and
sum of money over time. For example, at the end of
disability insurance) and assets (property and liability in-
40 years, you’d have $4,801 from your original $1,000.
surance). Most consumers regard insurance as absolutely
Earning a higher rate of return provides even greater
essential—and for good reason. One serious illness or
rewards. Some might assume that earning, say, only
accident can wipe out everything you have accumulated
2 percentage points more (e.g., 6 percent rather than
over many years of hard work. But having more insurance
4 percent) would not matter much. But it certainly
than necessary can be costly too. We’ll examine how to
would! Observe that if you could earn 6 percent over
manage your insurance needs in Chapters 8, 9, and 10.
the 40 years, then you’d accumulate $10,286, which
Savings and Investment Planning As your income is more than twice as much as you’d accumulate at
begins to increase, so does the importance of saving and 4 percent. This powerful observation is important to
Exhibit 1.5
How a $1,000 Investment Grows over Time
Four or 6 percent: How big a deal is a 2-percent difference? The deal is more than twice the money over a 40-year period!
Through the power of compound interest, a higher return means dramatically more money as time goes on.
15,000
$10,286
10,000
Investment Value ($)
8,000 6% rate of return
6,000 $5,743
$4,801
4,000
$3,207 4% rate
$3,243 of return
$1,791 $2,191
1,000 $1,480
0 10 20 30 40
Years
keep in mind when comparing competing investment use various aspects of the tax code (such as depreciation
and savings alternatives. expenses) to legitimately reduce an investor’s tax liability.
As we’ll explore in Part 5 on managing investments, Tax planning considers all these factors and more. It in-
seemingly small differences in various investment man- volves looking at your current and projected earnings
agement fees can also translate into significant differ
differ- and then developing strategies that will defer and mini-
ences in net investment returns over long periods of mize taxes. Tax plans are closely tied to investment plans
time. The length of time you keep your money invested and will often specify certain investment strat-
is just as important as the rate of return egies. Although tax planning is most com com-
you earn on your investments. You can mon among individuals with high incomes,
accumulate more than twice as people with lower incomes can also
much capital by investing for 40 obtain sizable savings. We’ll ex ex-
rather than 30 years with either amine taxes and tax planning in
rate of return (4 percent or 6 Chapter 3.
percent). This is the magic
Retirement and Estate
of compound interest,
Planning While you’re still
which explains why it’s so
working, you should be
Angela Waye/Shutterstock.com
important to create strong
managing your finances to
savings and investment hab-
attain those goals you feel are
its early in life. We’ll examine
important after you retire. These
compounding more fully in
might include maintaining your
Chapter 2, savings in Chapter 4,
standard of living, extensive travel,
and investments in Chapters 11,
visiting children, frequent dining at
12, and 13.
better restaurants, and perhaps a vaca
vaca-
Employee Benefit Planning Your employer tion home or boat. Retirement planning
may offer a wide variety of employee benefit plans, es- should begin long before you retire.
pecially if you work for a large firm. These could include Most people don’t start thinking about retirement
life, health, and disability insurance; tuition reimburse- until well into their 40s or 50s. This is unfortunate, be-
ment programs for continuing education; pension, profit- cause it usually results in a substantially reduced level
sharing, and 401(k) retirement plans; flexible spending of retirement income. The sooner you start, the bet-
accounts for child care and health care expenses; sick ter off you’ll be. Take, for instance, the traditional IRA
leave, personal time, and vacation days; and other mis- (individual retirement account), whereby certain wage
cellaneous benefits such as employee discounts and sub- earners were allowed to invest up to $6,500 per year in
sidized cafeterias or parking. 2016. We’ll look at IRAs and other aspects of retirement
Managing your employee benefit plans and coor coor- planning in Chapter 14.
dinating them with your other plans is an important
part of the overall financial planning process. Espe-
cially in today’s volatile labor market, you can no lon- EXAMPLE: The Sooner You Start an IRA, the
ger assume that you’ll be working at the same company Better If you start investing for retirement at age 40,
for many years. If you change jobs, your new company put only $2,000 a year in an IRA earning 5 percent for
may not offer the same benefits. So your personal fi- 25 years, you will have $95,454 at age 65. However, if
nancial plans should include contingency plans to re- you start the same retirement plan 10 years earlier at
place employer-provided benefits as required. We’ll age 30, you’ll have $180,641 at age 65!
discuss employee benefits in greater detail in this
chapter under Special Planning Concerns and in
Chapters 2 (planning); 3 (taxes); 8, 9, and 10 (insur- Accumulating assets to enjoy in retirement is only
ance); and 14 (retirement). part of the long-term financial planning process. As peo-
ple grow older, they must also consider how they can
Tax Planning Despite all the talk about tax reform, our most effectively pass their wealth on to their heirs, an ac-
tax code remains highly complex. Income can be taxed tivity known as estate planning. We’ll examine this com-
as active (ordinary), portfolio (investment), passive, tax- plex subject—which includes such topics as wills, trusts,
free, or tax-deferred. Then there are tax shelters, which and the effects of gift and estate taxes—in Chapter 15.
1-3c Special Planning Concerns
Students may not think that they need to spend much
time on financial planning—not yet, anyway. However,
the sooner you start, the better prepared you’ll be to
adapt your plans to changing personal circumstances.
Such changes include changing or losing a job, relocat-
Clownbusiness/Shutterstock.com
ing to a new state, getting married, having children, be-
ing in a serious accident, getting a chronic illness, losing
a spouse through divorce or death, retiring, or taking
responsibility for dependent parents. These and other
stressful events are “financial shocks” that require re-
evaluation of your financial goals and plans.
major financial impact on family income. Most Ameri-

Go to Smart Sites can families depend solely on employer-sponsored group
plans for their health insurance coverage and also for a
Would you like to know about free educational programs
big piece of their life insurance coverage and retirement
and tutorials on financial planning? The Federal Reserve
needs.
Bank of Chicago has put together a number of resources
Today’s employee benefits packages cover a full
for self-help on many topics.
spectrum that may include:
▶ Health and life insurance
Managing Two Incomes Did you know that the ▶ Disability insurance
earnings of the average dual-income family will add up ▶ Long-term care insurance
to more than $1 million over the wage earners’ lives? ▶ Pension and profit-sharing plans
Today, two-income couples account for the majority of
▶ Supplemental retirement programs such as 401(k) plans
U.S. households, and many depend on the second in-
come to make ends meet. Often, however, a second ▶ Dental and vision care
income doesn’t add as much as expected to the bottom ▶ Child care, elder care, and educational assistance
line. Higher expenses such as child care, taxes, clothing, programs
dry cleaning, transportation, and lunches may consume ▶ Subsidized employee food services
a large part of the second paycheck. And two-income
families tend to spend what they earn rather than save it. Some companies and industries are known for
Spouses should decide together how to allocate in- generous benefit plans; others offer far less attractive
come to household expenses, family financial goals, and packages. In general, large firms can afford more ben-
personal spending goals. Will you use a second income efits than small ones can. Because employee benefits
to meet basic expenses, afford a more luxurious lifestyle, can increase your total compensation by 30 percent
save for a special vacation, or invest in retirement ac- or more, you should thoroughly investigate your em-
counts? Some couples place all income into a single, ployee benefits to choose those appropriate for your
joint account. Others each contribute equal amounts personal situation. Be sure to coordinate your benefits
into a joint account to pay bills but retain individual dis- with your partner’s to avoid paying for duplicate cov-
cretion over remaining income. Still others contribute a erage. Companies change their benefit packages and
proportional share to finance joint expenses and goals. many are shifting more costs to employees. Although
In any case, both spouses should have money of their an employer may pay for some benefits in full, typi-
own to spend without accountability. For examples of cally employees pay for part of the cost of group health
managing two incomes, see the worksheets in Chapter 2. insurance, supplemental life insurance, long-term care
insurance, and participation in voluntary retirement
Managing Employee Benefits If you hold a full-time programs.
job, then your employer probably provides various em- Due to the prevalence of two-income families and
ployee benefits, ranging from health and life insurance an increasingly diverse workforce, many employers are
to pension plans. These valuable benefits can have a replacing traditional programs, where the company sets
PLANNING FOR CRITICAL LIFE EVENTS
Just like you, financial plans go through stages and the greater safety is appealing, the reduced expect-
must adapt to changes over your lifetime. Here are ed returns are also sobering. In addition, this could
some of the critical life events that may make you re- be the time to consider long-term care insurance for
consider and possibly revise an existing financial plan. possible use in retirement.
● Death of a parent. The estate must be settled, and help
● Marriage. Finances must be merged, and there may
may be needed in managing a possible inheritance.
be a need for life insurance.
● Retirement. Hopefully, your financial plan provided
● Children. It’s time to start a college saving plan and
the amount needed to fund retirement. During re-
revise your budget accordingly. A will is needed that
tirement, you will try to preserve your capital and will
makes provisions for guardianship if both parents
rely on the income generated by your investments to
die while the children are minors.
fund your living expenses. Although investment risk
● Divorce. Financial plans based on two incomes are should be reduced greatly, it cannot be eliminated
no longer applicable. Revised plans must reflect any because inflation risk must be managed. Money will
property settlements, alimony, and/or child support. be withdrawn from tax-deferred retirement accounts
● Moving into middle age. Although having started but taxes will be due. The risk of increases in future tax
a savings and investing plan early in life should be rates can be managed, in part, with Roth IRAs, which
paying off, the number of working years is declining, are retirement accounts where your original contribu-
along with future earning ability. The shorter time tions are not tax-deductible but your earnings on the
horizon implies that you may want to take less risk account are not taxed. Estate planning and long-term
by keeping less money in the stock market. While care issues should also be addressed.
the type and amount of benefits, with flexible-benefit personal, local developments. The effects of recessions and
(cafeteria) plans. In flexible-benefit programs, the em- financial crises divide people into three groups: (1) those
ployer allocates a certain amount of money to each em- who are directly and severely hurt through job loss, (2) those
ployee and then lets the employee “spend” that money who are marginally hurt by reduced income, and (3) those
for benefits that suit his or her age, marital status, num- who are not directly hurt. If you are in either of the first two
ber of dependent children, level of income, and so on. groups, then you must make significant lifestyle changes to
These plans usually cover everything from child care to reduce spending. Even if you are in the last group, a re-
retirement benefits, offer several levels of health and cession affects you indirectly. For example, retirement ac-
life insurance coverage, and have some limits on the counts typically drop in value, and financial plans must be
minimum and maximum amounts of coverage. Within revised. And everyone’s expectations are at least temporar
temporar-
these constraints, you can select the benefits that do ily affected, which causes most people to be more cautious
you the most good. In some plans, you can even take about their expenditures during a recession or crisis.
part of the benefits in the form of more take-home pay The financial crisis of 2008 and 2009, and the subse-
or extra vacation time! quent long period of high employment, was a macroeco-
nomic challenge of historic, global proportions. It drives
Managing Your Fi- home the benefits of having a sound financial plan—and
flexible-benefit (cafeteria)
nances in Tough Eco- dramatized the cost of not having one. The precipitous
plans the employer allocates a
certain amount of money to each nomic Times Tough decline in stock and home prices, and the number of
employee and then lets the employee economic times can be people laid off from their jobs, made everyone think a lot
“spend” that money on the benefits due to broad macro- more about financial planning in general and how to sur sur-
that suit his or her age, marital status,
economic trends like a vive a financial crisis in particular. Although we all hope
number of dependent children, and
level of income recession, or they can that such broad crises will be rare, it is important to plan
be brought on by more for a possible recurrence. All of the financial planning
principles explained in this book remained valid during on products they sell, offering lower fees if you make
the global financial crisis of 2008–2009 and should con- product transactions through them.
tinue to serve us well in any future similar situations.
So how do you best plan to survive a broad-based
financial crisis? First, you remind yourself of the key 1-4 THE PLANNING
principles of financial planning presented in this book:
ENVIRONMENT
▶ Spend less than you earn.
▶ Keep investing so your money continues to work LO4 Financial planning takes place in a dynamic eco-
toward your goals. nomic environment created by the actions of govern-
▶ Know where you are and plan for the unexpected. You ment, business, and consumers. Your purchase, saving,
cannot know where you are financially unless you care- investment, and retirement plans and decisions are
fully—and frequently—update your family’s budget. influenced by both the present and future states of the
And it is important to set aside money for an emergen- economy. Understanding the economic environment
cy fund. As discussed earlier in this chapter, you should will allow you to make better financial decisions.
set aside enough cash to last six months. Consider that a strong economy can lead to high re-
turns in the stock market, which in turn can positively
Second, don’t panic when financial markets crash!
affect your investment and retirement programs. The
This means that you shouldn’t try to time the market by
economy also affects the interest rates you pay on your
buying when the experts say it’s at a low or by selling
mortgage and credit cards as well as those you earn on sav-
when they say it’s at a high. Continue to invest for the
ings accounts and bonds. Periods of high inflation can lead
long term but keep in mind how close you are to achiev-
to rapid price increases that make it difficult to make ends
ing your financial objectives. For example, if you pull
meet. Here we look at two important aspects of the plan-
all of your money out of the stock market when it has
ning environment: the major financial planning players and
fallen, you will not be positioned to take advantage of
the economy.
its eventual recovery. Recessions and financial crises can
be challenging. A financial plan that considers such con-
tingencies will help you weather the storm. Part 5 of the 1-4a The Players
book focuses on investment management. The financial planning environment contains various in-
terrelated groups of players, each attempting to fulfill
certain goals. Although their objectives are not necessar
necessar-
ily incompatible, they do impose some constraints on one
DO IT NOW: Start Building an Emergency Fund another. There are three vital groups: government, busi-
What would happen if you lost your job, got hurt, or ness, and consumers. Exhibit 1.6 shows the relationships
had an unexpected big expense? Even if you’re not among these groups.
making much money now, you could start building an
emergency fund by putting aside even $10 a month.
As this chapter points out, your goal is to eventually set
aside enough to last at least 6 months. Considering the
risk of not doing so, you can do it now.
1-3d Using Professional

Financial Planners
Most financial planners fall into one of two catego-
Anthony Correia/Shutterstock.com
ries based on how they are paid: by commissions or

by fees. Commission-based planners earn commissions
on the financial products they sell, whereas fee-only
planners charge fees based on the complexity of the
plan they prepare. Many financial planners take a hy-
brid approach and charge fees and collect commissions
Exhibit 1.6
The Financial Planning Environment
Government, business, and consumers are the major players in our economic system. They interact with one another to
produce the environment in which we carry out our financial plans.
Money payments of wages,
rents, interest, profit
Land, labor, and financial capital
Public goods and services, Public goods and services,

regulations, and revenues regulations, and wages
Private goods
and services
Business Government Consumers
Taxes Taxes
Goods and services
Money payments for goods and services
Government Federal, state, and local governments Consumers The consumer is the central player in
provide us with many essential public goods and ser ser- the financial planning environment. Consumer choices
vices, such as police and fire protection, national de- ultimately determine the kinds of goods and services
fense, highways, public education, and health care. The that businesses will provide. The consumer’s choice of
federal government plays a major role in regulating eco- whether to spend or save also has a direct impact on
nomic activity. Government is also a customer of busi- present and future circular flows of money. Cutbacks in
ness and an employer of consumers, so it’s a source of consumer spending are usually associated with a decline
revenue for business and of wages for consumers. The in economic activity, whereas increases in consumer
two major constraints from the perspective of personal spending help the economy to recover.
financial planning are taxation and regulation.
Business As Exhibit 1.6 shows, business provides con-

1-4b The Economy
sumers with goods and services and in return receives
payment in the form of money. Firms must hire labor and Our economy is influenced by interactions among govern-
use land and financial capital (economists call these fac- ment, business, and consumers as well as by world eco-
tors of production) to produce those goods and services. nomic conditions. Through specific policy decisions, the
In return, firms pay out wages, rents, interest, and prof
prof- government’s goal is to manage the economy to provide
its to the various factors of production. Thus, businesses economic stability and a high level of employment. Gov-
are an important part of the circular flow of income that ernment decisions have a major impact on the economic
sustains our free-enterprise system. In general, they cre- and financial planning environment.
ate a competitive environment in which consumers may The federal government’s monetary policy—
select from an array of goods and services. All businesses programs for controlling the amount of money in cir-
are limited in some way by federal, state, and local laws. culation (the money supply)—is used to stimulate or
financial crisis since the Great Depression of the 1930s
in the United States.
Economic Cycles Although the government uses
monetary and fiscal policy to manage the economy and
provide economic stability, the level of economic ac-
tivity changes constantly. The upward and downward
movement creates economic cycles (also called business
cycles), which vary in length and in extent. An economic
cycle typically contains four stages: expansion, peak,
contraction, and trough.
Exhibit 1.7 shows how each of these stages relates to
real (inflation-adjusted) gross domestic product (GDP),
which is an important indicator of economic activity. The
stronger the economy, the higher the levels of real GDP
and employment. During an expansion, real GDP in-
creases until it hits a peak, which usually signals the end
of the expansion and the beginning of a contraction.
During a contraction (also known as a recession), real
GDP falls into a trough, which is the end of a contrac-
tion and the beginning of an expansion. For about
75 years, the government has been successful in keeping
Liviu Toader/Shutterstock.com
the economy out of a depression, although we have

experienced periods of rapid expansion and high infla-
tion followed by periods of deep recession. And some
would argue that the financial crisis of 2008–2009 came
close to precipitating a depression.
Inflation, Prices, and Planning As we’ve discussed,

moderate economic growth. For example, increases in our economy is based on the exchange of goods and
the money supply tend to lower interest rates. This services between businesses and their customers—
typically leads to a higher level of consumer and busi- consumers, government, and other businesses—for a
ness borrowing and spending that increases overall medium of exchange called money. The mechanism that
economic activity. The reverse is also true. Reducing facilitates this exchange is a system of prices. The price
the money supply raises interest rates, which reduces of something is the amount of money a seller is willing
consumer and business borrowing and spending and to accept in exchange
thus slows economic activity. The historically low in- for a given quantity
expansion the phase of the economic
terest rates in the wake of the financial crisis of 2008– of some good or ser ser-
cycle when real GDP increases until it hits
2009 and beyond reflect the efforts of the Federal vice—for example, $3 a peak
Reserve (Fed) to bolster the sagging economy and for a pound of meat
peak the phase of the economic cycle
decrease unemployment. or $10 for an hour of
when an expansion ends and a contraction
The government’s other principal tool for man- work. begins
aging the economy is fiscal policy—its programs of The economy is
contraction the phase of the
spending and taxation. Increased spending for social said to be experi- economic cycle when real GDP falls
services, education, defense, and other programs stim- encing a period of
ulates the economy, whereas decreased spending slows inflation when the trough the phase of the economic
cycle when a contraction ends and an
economic activity. Increasing taxes, on the other hand, general level of prices expansion begins
gives businesses and individuals less to spend and, increases over time.
as a result, negatively affects economic activity. Con- The most common inflation a state of the economy in
which the general price level is increasing
versely, decreasing taxes stimulate the economy. The measure of inflation,
importance of fiscal policy is illustrated by the govern- the consumer price consumer price index (CPI) a
measure of inflation based on changes in
ment’s massive spending to stimulate the U.S. econ- index (CPI), is based the cost of consumer goods and services
omy in 2008 and 2009 as a way to address the greatest on changes in the cost
Exhibit 1.7
The Business Cycle
The business cycle consists of four stages: expansion, peak, contraction, and trough.
Peak
Contraction
Real GDP
Expansion Trend
Trough
Year 1 Year 2 Year 3 Year 4 Year 5

Time
Source: Adapted from William Boyes and Michael Melvin, Economics, 8th ed. (Cengage, 2011), p. 135.
of consumer goods and services. At times, the rate of in-

flation has been substantial. In 1980, for instance, prices
EXAMPLE: Impact of Inflation on Financial
went up by a whopping 13.6 percent. Fortunately, infla-
Planning Caroline earned $50,000 in 2017, and ex-
tion has dropped dramatically in this country, and the an-
pected to receive annual raises that would bring her
nual rate of inflation has remained below 5 percent every
salary to $54,000 by 2020. While the annual growth
year since 1983, except in 1990, when it was 5.4 percent.
rate in her salary is 2.6 percent, assume that inflation
While there was mild deflation of 20.34 percent during
averaged 3 percent per year. Caroline’s salary needs to
the financial crisis in 2009, inflation moved up to about
grow to $54,636 just to keep pace with inflation. So, her
3.2 percent in 2011, and has remained below 2 percent
real salary will decline.
since then.
Inflation is of vital concern to financial planning. It
affects not only what we pay for our
goods and services but also what we Inflation also directly affects inter
inter-
earn in our jobs. Inflation tends to give Sustained high rates of est rates. High rates of inflation drive
an illusion of something that doesn’t unexpected inflation can up the cost of borrowing money as lend-
exist. That is, though we seem to be have devastating effects ers demand compensation for the erod-
making more money, we really aren’t. on retirement plans and ing value of the loan payments they are
As prices rise, we need more income other long-term financial to receive. Higher interest rates mean
because our purchasing power—the goals. higher mortgage payments, higher
amount of goods and services that each monthly car payments, and so on. High
dollar buys at a given time—declines. inflation rates also have a detrimental
So be sure to look at what effect on stock and bond prices. Finally, sustained high
you earn in terms of its rates of unexpected inflation can have devastating effects
purchasing power the amount
purchasing power, not on retirement plans and other long-term financial goals.
of goods and services that each
dollar buys at a given time simply in terms of abso- Indeed, for many people, inflation can put such goals out
lute dollars. of reach.
1-5 WHAT
HA DETERMINES
HAT incomes typically fall into the very young or very
old age groups. Heads of households who have
YOUR PERSONAL more formal education earn higher annual
incomes than do those with less
INCOME? education.
LO5, LO6 An obvious and imporimpor-

tant factor in determining how
1-5a Where You Live
well we live is the amount of in- Geographic factors can also af af-
come we earn. In the absence fect your earning power. Sala-
of any inheritance or similar fi- ries vary regionally, tending to
nancial windfall, your income be higher in the Northeast and
will largely depend on such fac- West than in the South. Typi-
tors as your age, marital status, cally, your salary will also be
education, geographic location, and higher if you live in a large
choice of career. A high level of in- metropolitan area rather
come—whether derived from your than a small town or rural
job, your own business, or your invest- area. Such factors as economic
ments—is within your reach if you have the conditions, labor supply, and in-
dedication, commitment to hard work, and well- dustrial base also affect salary levels
Guru 3D/Shutterstock.com
thought-out financial plans. in different areas.
The data in Exhibit 1.8 show how income changes Living costs also vary considerably throughout the
with age and education. For example, people with low country. You’d likely earn more in Los Angeles than in
Exhibit 1.8
How Age and Education Affect
A Annual Income
The amount of money you earn is closely tied to your age and education. Generally, the closer you are to middle age (45–65)
and the more education you have, the greater your income will be.
Annual Income (Head of Household)*

Age Median Annual Income ($)*
25–34 57,366
35–44 71,417
45–54 73,857
55–64 62,802
65–74 47,432
75 and over 30,635
Education Median Annual Income ($)*
No formal educational credential 21,420
High school diploma or equivalent 36,210
Bachelor’s degree 70,400
Master’s degree 66,420
Doctoral or professional degree 100,490
*2015 data.
Source: Adapted from U.S. Census Bureau, Age of Head of Household by Median and Mean Income, Table H-10, http://www.census.gov/hhes/www/income/data/historical/household/index.html, accessed
September 2016; and U.S. Bureau of Labor Statistics, data from Occupational Employment Statistics program, http://www.bls.gov/emp/ep_table_education_summary.htm, accessed September 2016.
BE AWARE OF POTENTIAL FINANCIAL ADVISOR CONFLICTS OF INTEREST
When interviewing a prospective financial advisor, you based on the amount of assets under management
should be aware of potential conflicts of interest: tend to encourage you to invest more with them.
How is the advisor compensated? Financial advisors Good questions to ask. Ask a prospective advisor how
can be compensated by product sale commissions he or she is compensated. If an advisor receives com-
and/or by client-paid fees. Client-paid fees can include missions, ask for a description of the commissions on
an hourly fee, an annual retainer, a fee that is based on their products. Alternatively, ask a fee-paid advisor for
the amount invested with the advisor, or a flat fee for a schedule of fees for each type of service provided. It
each service provided. Some advisors are paid using a would be helpful to use the questionnaire provided on
combination of commissions and fees. the National Association of Personal Financial Advisors
(NAPFA) website, www.napfa.org. The questionnaire
Conflicts of interest. While most advisors are honest,
has good questions to ask when interviewing a prospec-
opportunities for conflicts of interest abound. Advisors
tive advisor and provides a form that your advisor can
who get a commission have an incentive to sell you
use to disclose the commissions that he or she receives.
the products that generate the most money for them,
but those are not necessarily the best products for you. Source: Adapted from Jennifer Lane, CFP, with Bill Lane, “Advisor
Fees and Conflicts,” http://www.netplaces.com/money-for-40s
Advisors who are paid an hourly fee have an incentive -50s/do-you-need-an-advisor/advisor-fees-and-conflicts.htm,
to add hours to your bill. And advisors who earn a fee accessed September 2016.
Little Rock, Arkansas but your salary would probably one area affect the other. Like financial planning, ca-
not go as far owing to the much higher cost of living in reer planning is a lifelong process that includes short-
Los Angeles. and long-term goals. Since your career goals are likely
to change several times, you should not expect to stay
in one field, or to remain with one company, for your
1-5b Your Career
whole life.
A critical determinant of your lifetime earnings is
your career. The career you choose is closely related
to your level of education and your particular skills,
interests, lifestyle preferences, and personal values. Go to Smart Sites
Social, demographic, economic, and technological The U.S. News & World Report Career Center has material
trends also influence your decision as to what fields on a variety of career topics ranging from internships and
offer the best opportunities for your future. Although résumés to the hottest careers and benefits.
not a prerequisite for many types of careers (e.g.,
sales, service, and certain types of manufacturing and
clerical work), a formal education generally leads to
greater decision-making responsibility—and conse- The average American starting a career today
quently increased income potential—within a career. can expect to have at least 10 jobs with five or more
Exhibit 1.9 shows the differences in average compen- employers, and many of us will have three, four, or
sation among selected college-educated majors over even more careers during our lifetimes. Some of these
the course of their associated careers. changes will be based on personal decisions; others
may result from layoffs or corporate downsizing. For
example, a branch manager for a regional bank who
1-5c Planning Your Career
feels that bank mergers have reduced her job pros-
Career planning and personal financial planning are pects in banking may buy a quick-print franchise and
closely related activities, so the decisions you make in become her own boss. Job security is practically a
Exhibit 1.9
Median Annual Wages for College-Educated Majors (Ages 25–59)
Science, technology, engineering, and mathematics (STEM) majors typically have the highest income.
STEM $76,000
Health $65,000
Business $65,000
All majors $61,000
Social sciences $60,000
Career-focused $54,000
Arts, liberal arts, and humanities $51,000
Teaching and serving $46,000
High school graduate $36,000
Source: Georgetown University Center on Education and the Workforce, analysis of U.S. Census Bureau, American Community Survey micro data, 2009-2013, “The Economic Value of College Majors, Figure 1.2,
https://cew.georgetown.edu/wp-content/uploads/The-Economic-Value-of-College-Majors-Full-Report-web-FINAL.pdf, accessed September 2016.
thing of the past, and corporate loyalty has given way ▶ Develop and use an action plan to achieve those goals.
to a more self-directed career approach that requires ▶ Review and revise your career plans as your situation
new career strategies. changes.
A personal portfolio of skills, both general and

technical, will protect your earning power during eco-
nomic downturns and advance it during prosperous
Go to Smart Sites times. It’s important to keep your skills current with on-
One of the first steps in the job search process is to the-job training programs and continuing education.
assess your personality. Link to the Keirsey Temperament Adding proficiency in technology or languages puts you
Sorter®-11 as a starting point. ahead of the pack in dealing with changing workplace
requirements.
Good job hunting skills will serve you well throughout
your career. Learn how to research new career opportuni-
Careful career planning can improve your work situ- ties and investigate potential jobs, taking advantage of on-
ation and help you gain greater personal and professional line resources as well as traditional ones. Develop a broad
satisfaction. Some of the steps are similar to the financial base of career resources, starting with your college place-
planning process described earlier: ment office, the public library, and personal contacts such
as family and friends. Know how to market your qualifica-
▶ Identify your interests, skills, needs, and values. tions to your advantage in your résumé and cover letters,
▶ Set specific long- and short-term career goals. on the phone, and in person during a job interview.
FINANCIAL IMPACT OF PERSONAL CHOICES
Ethan Cuts Back on Lunch

Out and Lattes
Ethan buys lunch out most days and buys a latte every morning. He
believes he could cut back a bit and save $5 a day, which is $35 a week
and $140 a month. What is the impact of this seemingly modest cut-
back?
If Ethan invests his $35 savings a week every month at 5 percent, he will have
the following in the future:
● 20 years: $57,545
30 years: $116,516
ter sto ck .co m

●
● 40 years: $213,643
No rG al/ Shut
The seemingly small act of investing only $5 a day would have a dramatic
long-term effect on Ethan’s future accumulated wealth.
STUDY
DY
TOOLS 1
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◻ Chapter Review Card ◻ Complete interactive content at PFIN6 Online.
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personal finance.
Financial Planning Exercises
LO1 1. BE N E FI TS OF PE RS O N AL FI N AN C I AL PLAN N I N G . LO5, 6 9. CARE E R PLAN N IN G . Tom Walker a 52-year-old
How can using personal financial planning retail store manager earning $90,000 a year,
tools help you improve your financial situation? worked for the same company during his entire
Describe changes you can make in at least three 25-year career. Tom was laid off and is still
areas. unemployed 10 months later, and his severance
pay and unemployment compensation have
LO2, 3 2. PE RSON AL FIN AN CIAL GOALS AN D TH E LIFE CYCLE. run out. Because he adopted careful financial
USE WO R SH E E T 1.1. Fill out Worksheet 1.1, planning practices, he now has sufficient
“Summary of Personal Financial Goals,” with savings and investments to carry him through
goals reflecting your current situation and your several months of unemployment. Tom is
expected life situation in 5 and 10 years. Discuss actively seeking work but finds that he is
the reasons for the changes in your goals and overqualified for available, lower-paying jobs
how you’ll need to adapt your financial plans as and underqualified for higher-paying, more
a result. desirable positions. There are no openings for
LO2 3. PE RSO N AL FIN AN CIAL GO ALS . Recommend three positions equivalent to the manager’s job he
financial goals and related activities for someone lost. He lost his wife several years earlier and is
in each of the following circumstances: very close to his two grown children, who live in
the same city.
a. A junior in college
Tom has these options:
b. A 30-year-old computer programmer who
plans to earn an MBA degree ● Keep looking for a new job.
c. A couple in their 30s with two children, ● Move to another area of the country where
ages 5 and 9 store manager positions are more plentiful.
d. A divorced, 52-year-old man with a ● Accept a lower-paying job for two or three
16-year-old child and a 78-year-old father years and then go back to school evenings
who is ill to finish his college degree and qualify for
a better position.
LO3 4. LIFE CY CLE O F FIN AN CIAL PLAN S . Explain the life
cycle of financial plans and their role in achieving ● Consider other types of jobs that could
your financial goals. benefit from his managerial skills.
LO4 5. I M P A C T O F E C O N O M I C E N I RO N M E N T O N a. What important career factors should

FI N A N C I A L PLA N N I N G . Summarize current and Tom consider when evaluating his
options?
projected trends in the economy with regard
to GDP growth, unemployment, and inflation. b. What important personal factors
How should you use this information to should he consider when deciding
make personal financial and career planning among his career options?
decisions?
c. What recommendations would you
LO4 6. EFFE CTS O F IN FLATIO N . How does inflation affect give him in light of both the career and
interest rates, security prices, and financial personal dimensions of his options
planning? noted above?
LO5 7. EFFE CT OF AG E AN D GE O G RAP H Y ON IN CO M E . d. What career strategies should today’s

Evaluate the impact of age, and geographic workers use in order to avoid Tom’s
location on personal income. dilemma?
LO6 8. CARE E R CH O ICE S AN D FIN AN CIAL PLAN N IN G . LO5, 6 10. IN C O M E A N D ED U C A TI O N . Using Exhibit 1.8,
Assume you graduated from college with a discuss the relationship between annual income
major in marketing and took a job with a large, and the highest level of education completed.
consumer-products company. After three years, Provide specific examples of the difference
you are laid off when the company downsizes. between having no high school diploma and
Describe the steps you’d take to “repackage” having a bachelor’s degree, and between having
yourself for another field. a bachelor’s degree and a professional degree.
2 Using Financial
Statements
and Budgets
LEARNING OBJECTIVES
After studying this chapter, you will be able to…
LO1 Understand the relationship between financial plans and statements. After you finish
LO2 Prepare a personal balance sheet. this chapter go
to PAGE50 for

LO3 Generate a personal income and expense statement.
LO4 Develop a good record-keeping system and use ratios to evaluate personal financial statements. STUDY TOOLS
LO5 Construct a cash budget and use it to monitor and control spending.
LO6 Apply time value of money concepts to put a monetary value on financial goals.
How Will This Affect Me? A recent survey shows that only 38 percent of Americans
could cover an unexpected $500 expense with money from their checking or saving
accounts. The rest would have to cover it by reducing spending on other things,
using a credit card, or borrowing money from family or friends.* These are scary
numbers ... and this chapter explains what you can do to avoid being part of that
alarming statistic.
Everyone knows it’s hard to get where you need to go if you don’t know where
you are. Financial goals describe your destination, and financial statements and
budgets are the tools that help you determine exactly where you are in the journey.
This chapter helps you define your financial goals and explains how to gauge your
progress carefully over time.
*Claes Bell, “Budgets Can Crumble in Times of Trouble,” http://www.bankrate.com/finance/smart-spending

/money-pulse-0115.aspx, accessed September 2016.
2-1 MAPPING OUT YOUR and purchases in a manner that is consistent with your
financial plans. These tools provide control by bring-
FINANCIAL FUTURE ing the various dimensions of your personal financial
affairs into focus.
LO1 On your journey to financial se-
curity, you need navigational tools to Before you can set 2-1a The Role of
guide you to your destination: namely, realistic goals, develop Financial Statements in
the fulfillment of your financial goals. your financial plans,
Operating without a financial plan is
Financial Planning
or effectively manage
like traveling without a road map (or Before you can set realistic goals, develop
your money, you must
GPS). Financial plans, financial state- your financial plans, or effectively man-
ments, and budgets provide direction
understand your current
age your money, you must understand
by helping you work toward specific financial situation.
financial goals. Financial plans are personal financial
the roadmaps that show you the way, whereas personal your current financial statements balance sheets and
financial statements let you know where you stand fi- situation. You’ll also income and expense statements that
serve as planning tools that are essential
nancially. Budgets, detailed short-term financial fore- need tools to monitor to developing and monitoring personal
casts that compare estimated income with estimated your progress. Personal financial plans
expenses, allow you to monitor and control expenses financial statements
CHAPTER 2: Using Financial Statements and Budgets 29
Exhibit 2.1
The Interlocking Network of Financial Plans and Statements
Personal financial planning involves a network of financial reports that link future goals and plans with actual results. Such a
network provides direction, control, and feedback.
Evaluate and plan major outlays

Manage credit
Secure adequate insurance coverage
Establish savings/investment programs Financial
Manage employee benefits plans
Reduce taxes
Implement retirement program
Feedback
Minimize estate taxes
Monitor and control income,

living expenses, purchases, Budgets
and savings on a monthly basis
Feedback
Actual financial results:

Financial
Balance sheet
statements
Income and expense statement
are planning tools that provide an up-to-date evalu- the various financial statements and reports and their
ation of your financial well-being, help you identify relationship to each other in the personal financial
potential financial problems, and help you make bet- planning process. Financial plans provide direction to
ter-informed financial decisions. They measure your annual budgets.
financial condition so you can establish realistic finan-
cial goals and evaluate your progress toward those goals.
Knowing how to prepare and interpret personal finan-
cial statements is a cornerstone of personal financial
2-2 THE BALANCE SHEET:
planning. HOW MUCH ARE YOU
The balance sheet describes your financial
position—the assets you hold, less the debts you WORTH TODAY
DA ?
DAY
owe, equal your net worth (general level of wealth)—
at a given point in time. In contrast, the income LO2 Preparing a personal balance sheet, or statement of
and expense statement financial position, helps you get a handle on your finan-
balance sheet a financial statement measures financial per- cial well-being. Think of a balance sheet as a snapshot
that describes a person’s financial taken of your financial position on one day out of the year.
formance over time.
position at a given point in time
Budgets are forward A balance sheet has three parts that, taken together,
income and expense looking; they allow you summarize your financial picture:
statement a financial statement that
measures financial performance over time to monitor and control
▶ Assets: What you own
spending because they
budget a detailed financial report ▶ Liabilities, or debts: What you owe
that looks forward, based on expected
are based on expected
income and expenses income and expenses. ▶ Net worth: The difference between your assets and
Exhibit 2.1 summarizes liabilities
The accounting relationship among these three catego- it, such as a house. Real property generally
ries is called the balance sheet equation and is expressed has a relatively long life and high cost, and it may
as follows: appreciate, or increase in value. Personal property
is movable property, such as automobiles,
Total assets 5 Total liabilities 1 Net worth recreational equipment, household furnishings,
and and similar items. The left side of Worksheet 2.1
Net worth 5 Total assets 2 Total liabilities lists some of the typical assets you’d find on a
personal balance sheet.
In personal financial analysis, it is important for all

EXAMPLE: The Balance Sheet Identity Grace has assets, regardless of category, to be recorded on the bal-
total liabilities of $150,000 and a net worth of $75,000. ance sheet at their current fair market value, which may
This implies that she has total assets of $325,000 differ considerably from their original purchase price.
(total liabilities of $150,000 + net worth of $75,000 = Fair market value is either the actual value of the asset
$325,000 in total assets). (such as money in a checking account) or the price for
which the asset can reasonably be expected to sell in
the open market (as with a used car or a home). Under
Let’s now look at the components of each section of the generally accepted accounting principles (GAAP), the
balance sheet. accounting profession’s guiding rules, assets appear on
a company’s balance sheet at cost, not fair market value.
2-2a Assets: The Things You Own
Assets are the items you own. An item is classified as an 2-2b Liabilities: The Money You Owe
asset whether it was purchased with cash or financed using Liabilities represent an individual’s or a family’s debts. They
debt. A useful way to group assets is on the basis of their could result from department store charges, bank credit
underlying characteristics and uses. This results in four card charges, installment loans, or mortgages on housing
broad categories: liquid assets, investments, real property, and other real estate. A liability, regardless of its source, is
and personal property. something that you owe and must repay in the future.
▶ Liquid assets: Low-
Liabilities are generally classi-
risk financial assets
fied according to maturity.
held in the form of ▶ Current, or short-
cash or instruments term, liabilities:
that can be converted to Any debt currently
cash readily and quickly, with little or no loss in val- P o go nici owed and due within
/S hu tt er
st o ck .c o
m
ue. Cash on hand or in a checking or savings account, one year of the date
money market deposit accounts, money market
mutual funds, or certificates of deposit that mature
within one year are all examples of liquid assets. assets items that one owns
▶ Investments: Assets acquired to earn a return rather liquid assets assets that are held in the form of cash or can readily be
than provide a service. These assets are mostly intan- converted to cash with little or no loss in value
gible financial assets (stocks, bonds, mutual funds, investments assets such as stocks, bonds, mutual funds, and real estate
that are acquired in order to earn a return rather than provide a service
and other types of securities), typically acquired to
achieve long-term personal financial goals. Business real property tangible assets that are immovable: land and
anything fixed to it, such as a house
ownership, the cash value of life insurance and
pensions, retirement funds such as IRAs and 401(k) personal property tangible assets that are movable and used in
everyday life
plans, and other investment vehicles such as com-
fair market value the actual value of an asset, or the price for which it can
modities, financial futures, and options represent
reasonably be expected to sell in the open market
still other forms of investment assets.
liabilities debts, such as credit card charges, loans, and mortgages
▶ Real and personal property: Tangible assets that
current (short-term) liabilities any debt due within one year
we use in our everyday lives. Real property refers of the date of the balance sheet
to immovable property: land and anything fixed to
WORKSHEET 2.1 BALANCE SHEET FOR SILAS AND EMILY NELSON
A balance sheet is set up to show what you own on one side (your assets) and how you
paid for them on the other (your debt or net worth). As you can see, the Nelsons have
more assets than liabilities.
BALANCE SHEET
Name(s) Silas and Emily Nelson Date December 31, 2017
ASSETS LIABILITIES
Liquid Assets Current Liabilities
Cash on hand $ 150 Utilities $ 175
In checking 575 Rent
Savings accounts 760 Insurance premiums
Money market Taxes
funds and deposits 800 Medical/dental bills 125
Certificates of deposit Repair bills
Total Liquid Assets Bank credit card balances 425
$ 2,285
Dept. store credit card
Investments balances 165
Stocks 3,750 Travel and entertainment
Bonds Corp. 1,000 card balances 135
Certificates of deposit Gas and other credit card
Mutual funds 2,250 balances
Real estate Bank line of credit
Retirement funds, IRA 4,000 balances
Other Other current liabilities 45
Total Current Liabilities $ 1,070
Total Investments $ 11,000
Long-Term Liabilities
Real Property
Primary residence mortgage $ 160,000
Primary residence $ 225,000 Second home mortgage
Second home
Real estate investment
Other mortgage
Total Real Property $ 225,000 Auto loans 4,350
Appliance/furniture loans 800
Personal Property
Home improvement loans
Auto(s): '13 Toyata Corolla $ 10,600 Single-payment loans
Auto(s): '11 Ford Focus 6,700 Education loans 3,800
Recreational vehicles
Margin loans
Household furnishings 3,700 Other long-term loans
Jewelry and artwork 1,500 (from parents) 4,000
Other Total Long-Term Liabilities $ 172,950
Other
(II) Total Liabilities $ 174,020
Total Personal Property $ 22,500
Net Worth [(I) – (II)] $ 86,765
(I)Total Assets $ 260,785
Total Liabilities and Net Worth $ 260,785
of the balance sheet. Examples include charges ▶ Long-term liabilities: Debt due one year or more
for consumable goods, utility bills, rent, insurance from the date of the balance sheet. These liabilities
premiums, taxes, medi- typically include real estate mortgages, most con-
open account credit cal bills, repair bills, and sumer installment loans, education loans, and margin
obligations current liabilities that total open account credit loans used to purchase securities.
represent the balances outstanding
obligations—the out-
against established credit lines
standing balances against Although most loans will fall into the category of long-
long-term liabilities any debt term liabilities, any loans, or any portion thereof, that
established credit lines
due one year or more from the date
of the balance sheet (usually through credit come due within a year should be shown as current liabili-
card purchases). ties. Examples of short-term loans include a six-month,
assets. It represents the amount of money you’d have left
Go to Smart Sites after selling all your owned assets at their estimated fair
market values and paying off all your liabilities (assuming
What’s the fair market value of your car? The personal there are no transaction costs). Rearranging this equation,
watercraft your uncle gave you? A highlight box in each we see that net worth equals total assets minus total liabili-
chapter of PFIN Online includes “Smart Sites,” a list of ties. If net worth is less than zero, the family is technically
resources and sites that offer additional information on insolvent. Although this form of insolvency doesn’t neces-
topics in the PFIN text. Log in at www.cengagebrain.com. sarily mean that the family will end up in bankruptcy pro-
ceedings, it likely shows insufficient financial planning. Net
worth typically increases over the life cycle of an individual
single-payment bank loan, and a nine-month consumer or family, as Exhibit 2.2 illustrates.
installment loan for a refrigerator.
Regardless of the type of loan, only the latest out-
standing loan balance should be shown as a liability on the EXAMPLE: Calculating Net Worth A family has
balance sheet. This is because at any given time, it is the total assets of $225,000 and total liabilities of $175,000.
balance still due that matters, not the initial loan balance. Net worth is total assets of $225,000 less total liabilities
Another important and closely related point is that of $175,000, which equals $50,000. This is effectively the
only the outstanding principal portion of a loan or mort- amount of assets the family “owns” after paying off its
gage should be listed as a liability on the balance sheet. liabilities. It is also referred to as the family’s equity.
You’ll find the most common categories of liabilities on
Worksheet 2.1.
2-2c Net Worth: 2-2d Balance

A Measure of Your Sheet Format and
Financial Worth Preparation
Now that you’ve listed what you
You should prepare your per per-
own and what you owe, you can cal-
sonal balance sheet at least once
culate your net worth, the amount
a year, preferably every three
of actual wealth or equity that an
to six months. Here’s how to
individual or family has in its owned
do it, using the categories
in Worksheet 2.1 as a
HAVE REALISTIC BUDGET PLANS guide:
1. List your as-
● So what if it’s on sale? Don’t buy it if you wouldn’t
sets at their fair
have bought it anyway.
market value as of
● Spend less than you earn. You’ll need to pay off debt, the date you are
design a realistic budget, and save some of your income preparing the bal-
Arka38/Shutterstock.com
each month. ance sheet. You’ll

● Make more and buy less. Make your own lunches, find the fair market
coffee, and even home goods if you know how. value of liquid and
investment assets
● Live one raise behind. When you get a raise, continue
living and spending as you did before and put that
on checking and net worth an individual’s or family’s
additional income into savings.
savings account actual wealth; determined by subtracting
● Make 30-day lists. When you see something you re- records and total liabilities from total assets
ally want to buy, put it on a 30-day list and only buy it investment equity the actual ownership interest
if you still want it in 30 days. account state- in a specific asset or group of assets
Source: http://www.careeroverview.com/blog/2010/the ments. Estimate
-psychology-of-spending-money-25-tricks-you-need-to insolvency the financial state in
-know/, accessed September 2016. the values of which net worth is less than zero
homes and cars
Exhibit 2.2
Median Net Worth by Age
Net worth starts to build in the younger-than-35 age bracket and continues to climb, peaking at the 65–74 age bracket.
As indicated for the 74 and older age bracket, net worth declines after a person has been retired for a few years and has
consequently used his or her assets to meet living expenses.
$250,000
$232,100
$200,000 $194,800
$165,900
Median Net Worth
$150,000
$105,300
$100,000
$81,200
$46,700
$50,000
$10,400
$0
All Younger 35–44 45–54 55–64 65–74 75 and
than 35 Age older
Source: Adapted from Jesse Bricker, Lisa J. Dettling, Alice Henriques, Joanne W. Hsu, Kevin B. Moore, John Sabelhaus, Jeffrey Thompson, and Richard A. Windle, “Changes in U.S. Family Finances from 2010 to 2013:
Evidence from the Survey of Consumer Finances,” Board of Governors of the Federal Reserve System, Washington, D.C. (October 24, 2014; data are for 2013), http://www.federalreserve.gov/pubs/bulletin/2014/pdf
/scf14.pdf, Table 2, accessed September 2016.
using published sources of information, such as 2-2e A Balance Sheet for Silas
advertisements for comparable homes and the
Kelley Blue Book for used car values (see
and Emily Nelson
www.kbb.com). What can you learn from a balance sheet? Let’s exam-
2. List all current and long-term liabilities. Show ine a hypothetical balance sheet as of December 31,
all outstanding charges, even if you haven’t 2017, prepared for Silas and Emily Nelson the young
received the bill, as current liabilities on the balance couple (ages 28 and 26) we met in Chapter 1 (see
sheet. Worksheet 2.1). Here’s what this financial statement tells
us about the Nelsons’ financial condition:
3. Calculate net worth. Subtract your total liabili-
ties from your total assets. This is your net worth, ▶ Assets: Given their ages, the Nelsons’ asset position
which reflects the equity you have in your total looks quite good. The dominant asset is their house.
assets. They also have $11,000 in investments, which include
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STUDENTS SAY INSTRUCTORS REQUIRE

STUDENT RESOURCES: All Student Resources

+ Understanding the Financial

Using Financial Statements

WEAK RATE AND ORGANIZE

Product Manager: Laura Redden

Printed in the United States of America

PART 1 FOUNDATIONS OF FINANCIAL

PART 2 MANAGING BASIC ASSETS

PART 3 MANAGING CREDIT

PART 4 MANAGING INSURANCE NEEDS

PART 5 MANAGING INVESTMENTS

PART 6 RETIREMENT AND ESTATE PLANNING

Brief Contents iii

Part 1 3 Preparing Your Taxes 54

1 Understanding the Financial

2 Using Financial Statements 4 Managing Your Cash and

8 Insuring Your Life 196

6 Using Credit 144

7 Using Consumer Coverage 225

14 Planning for Retirement 370

15 Preserving Your Estate

12 Investing in Stocks and 15-6 Estate Planning Techniques 420

Bonds 308 Appendix A 424

13 Investing in Mutual Funds, Index 430

ETFs, and Real Estate 340

About the Authors vii

viii About the Authors

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2 PART ONE: Foundations of Financial Planning

CHAPTER 1: Understanding the Financial Planning Process 3

Financial Basic asset decisions Financial

1-1b Spending Money Wisely

4 PART ONE: Foundations of Financial Planning

Financial Planning Tips 1-1c Accumulating Wealth

CHAPTER 1: Understanding the Financial Planning Process 5

1-2 THE PERSONAL FINANCIAL

6 PART ONE: Foundations of Financial Planning

2. Develop financial plans and strategies to achieve goals.

3. Implement financial plans and strategies.

help you implement those goals through financial

1-2b Defining Your Financial Goals

CHAPTER 1: Understanding the Financial Planning Process 7

Practicing Financial Self-Awareness

8 PART ONE: Foundations of Financial Planning

CHAPTER 1: Understanding the Financial Planning Process 9

10 PART ONE: Foundations of Financial Planning

Long-Term Goals Long-term financial goals should

CHAPTER 1: Understanding the Financial Planning Process 11

Personal Financial Goals

Goal Priority Target Date Cost Estimate

Intermediate Goals (2 to 5 years)

Goal Priority Target Date Cost Estimate

Goal Priority Target Date Cost Estimate

Begin college fund for children High 2023 ? /year

12 PART ONE: Foundations of Financial Planning

CHAPTER 1: Understanding the Financial Planning Process 13

Retirement and estate planning

Employee benefit planning

Savings and investment planning

Liability and insurance planning

Asset acquisition planning