Chapter 23: Managing Your Personal Finances

Business in the 21^st Century

Perhaps more than any recent generation, young adults like Todd and Amy are interested in financial planning and know that it is important to their future success. Many factors, both demographic and economic, have contributed to this interest in financial planning:

          - As a result of having children later in life and increased longevity,

more families (now called sandwich families) find themselves financially responsible for both their children and their aging parents at the very time in their lives when they hoped to retire.

          - Divorce and remarriage are creating an increasing number of

blended families.

          - A significant number of single individuals are solely responsible for

their own finances.

          - Although unemployment is at a record low, large numbers of people

have experienced job loss due to the corporate down-sizing of the late 1980s and 1990s.

          - The average cost of raising a child to age 18 for a middle-income

family is now $153,660; the cost of a college education averages $9,635 per year at a public university and $24,000 or more at a private one.

          - Employees are increasingly responsible for accumulating their own

retirement funds.

          - People have more financial products from which to choose and an

overwhelming amount of financial information to help them make those choices.

This chapter will introduce you to the information and skills need to meet the many challenges of managing your own finances. First, we’ll show you how the personal financial planning process can help you meet your financial goals. Next we’ll turn to managing your personal cash flow, and describe various types of savings instruments. Then we’ll explain how to use consumer credit wisely. The focus next shifts to managing taxes and selecting insurance. Then we’ll discuss how to set investment goals and develop an investing strategy. Finally, we’ll consider emerging trends in personal finance.

Financial Planning and Cash Management

Personal Financial Planning

Personal financial planning is the process of managing one’s personal finances to achieve financial goals. The reason the process is so important in managing your finances is that it starts with your goals and then logically proceeds through information gathering, analysis of the data, and then development, implementation, and monitoring of a financial plan designed to meet your goals. Exhibit 23-1, page 681, illustrates the personal financial planning process.

The Cash Flow Plan

Cash Management

Cash management is generally defined as the day-to-day handling of one’s liquid assets.

Liquid Assets

Liquid assets include cash and other assets that can be converted into cash both quickly and at little or no cost, such as checking accounts and various savings instruments.

Cash Flow Plan

A cash flow plan (often called a budget) is an important tool for cash management and includes a plan for managing for managing income and expenses, including contributions to savings and investments needed to accomplish one’s financial goals. The following steps will help you develop and utilize a cash flow plan:

          - Establish your goals and calculate how much you need to save to

meet them. For goals to be useful, you must identify each goal, estimate how much money it will take to accomplish the goal, and specify the time frame for the goal. It is also helpful to prioritize your goals because you will often have more goals than you have money.

          - Estimate your income and your expenses, including any

contributions to savings. Evaluate your monthly income and estimate your monthly expenses. The monthly budget worksheet in Exhibit 21-5 in Chapter 21 illustrates one way to monitor your income and expenses. You can also create a spreadsheet that covers several months.

          - Track your actual income and expenses for a one-month period.

Write down all your income and expenses. Carry a pad of paper with you so you don’t forget the numerous small expenditures you make. At the end of the month, total the income and expenses for each category and enter them on Exhibit 21-5 in the actual column.

          - Compare your planned and actual income and expenses. Analyze

each category that was either over or under your estimate in the “planned” column. For example, if you planned to spend $150 on clothing but actually spent $285, determine whether this was an unusual situation (you need a suit for an unexpected interview) or a normal pattern of spending. If you find that it was normal, decide whether you want to cut back your expenditures on your clothing budget for the next month. Of course, if you add $135 to the clothing category, you will need to reduce something else by that same amount.

- Modify your estimates for the next month and repeat the process.

Depending on your analysis, you will want to make some changes in your original plan. You must be flexible as it may take several months before you are actually able to live within your cash flow plan. But within a short period of time, you will be in control of your spending and saving.

The Net Worth Statement

Net Worth Statement

While cash flow management will help you live within your means, a net worth statement provides information about your assets and liabilities. As Chapter 19 explained, assets are the things you own. The are valued at their current market value on a personal net worth statement. Liabilities are what you owe, and they are recorded at the amount you would have to pay if you paid off the entire debt immediately. A net worth statement is a summary of your financial situation on a given day whereas a cash flow statement reflects the flow of funds over a period of time. Exhibit 23-2, page 683, is an example of an net worth statement. Note that if you complete a net worth statement regularly, perhaps annually, you will be able to track your financial progress. It’s like taking a picture of a baby at 3 months, 6 months, 9 months, and a year. Each picture captures a point in time, but the series of pictures shows change.

Checking Accounts

Check

Checking accounts and savings accounts are the most common liquid assets held by consumers. A check is a written order, drawn on a depository institution by a depositor, ordering the depository institution to pay on demand a specific amount of money to the person or firm named on the check. You will probably find that a checking account is a necessity in managing your income and expenses. Several types of checking accounts are widely available to meet the diverse needs of consumers.

Savings Instruments

Checking accounts are excellent for money that you will need very soon, but savings instruments are more appropriate for accumulating money for short-term goals (like buying a new television or holiday spending) and for unexpected expenses (emergencies and opportunities). Banks, thrift institutions, and credit unions offer a variety of savings instruments, as noted in Chapter 20. Exhibit 23-4, page 685, summarizes the features of some popular savings instruments.

Before selecting a savings vehicle, consider your goals and how you want to use the instrument. Regardless of the type of instrument you select, you should compare the interest rate you will receive with that paid by other institutions. Rates are always changing, but there are several excellent sources of information including financial institutions, magazines such as Kiplinger’s Personal Finance and Money, and the Internet.

Using Consumer Credit

Credit Cards

Open-End Credit

Credit cards are the most common type of open-ended credit used to day. Open-ended credit includes any type of credit where you apply for the credit and then, if approved, are allowed to use it over and over again. Some credit cards have an annual fee and some do not.

Line of Credit

You will be given a line of credit, the maximum amount you can have outstanding at any one time. Some cards require you to pay the entire balance upon billing, but most require only that you make a minimum monthly payment.

Revolving Credit Cards

Those cards that not require full payment upon billing are called revolving credit cards. All will send you a monthly bill, and if you don’t pay the entire balance, you will be charged interest. Some (those that do not have a grace period) even charge interest if you do pay the entire bill monthly.

Grace Period

The grace period gives you a period after making a purchase during which interest is not owed if you pay the entire balance on time….

Loans

Loans differ from credit cards because loans are closed-end agreements. You borrow a specific amount of money, the principal, for a stated period of time and agree to pay off the debt either in installments or as a lump sum at the end of the term. Interest will be charged on the amount of the principal borrowed, and you may be required to secure the loan with something of value. An auto loan is an example of a secured, installment loan—you are expected to pay back the loan in equal monthly installments….

Three of the most important factors to consider when comparing loans are the dollar cost of credit (finance cost), the annual percentage rate of interest (APR), and the monthly payment. According to the federal Truth-in-Lending Law, lenders must calculate the APR in a standardized way, so, other things being equal, a loan with a lower APR will be less expensive….

Prepayment Penalties

In addition to these factors, check a loan for prepayment penalties, additional fees owed if you decide to repay the loan early,

Security Requirements

and a security requirements , which allow the lender to take back the collateral if you do not repay the loan according to the terms of the agreement.

Credit Life Insurance

Also beware of add-ons a lender may offer. For example, credit life insurance will repay the loan if you die whole the loan is still outstanding. Although this sounds like a good idea, first consider whether you really need life insurance for this purpose….

Managing Taxes

In 1998 the average American had to work about 124 days to pay for federal, state, and local taxes. Taxes are the largest expenditure category in the average American families’ budget, but they are paid incrementally as payroll deductions or as a small percentage of the purchase price of goods and services.

Income Taxes

Income tax is the largest single tax expenditure for the average American. Because the tax code is very complex, lack of knowledge about federal income taxes is often the reason for most common financial mistakes.

Progressive Tax

The federal income tax is a progressive tax, meaning that the higher your taxable income, the higher the percentage of that income you pay in taxes. Tax payers in the lowest tax bracket pay 15 percent of taxable income, and higher-income tax payers pay at rates of 28, 31, 36, and 39.6 percent. As a result of the progressive structure and automatic deductions, people with low incomes pay little or no federal income taxes.

Pay-As-You-Go System

The Federal government expects us to pay both federal income taxes and Social Security taxes (discussed later) as we earn income. This is accomplished through tax withholding by employers and by filing quarterly tax estimates on self-employment, investment, and other income that is not subject to withholding.

Filing Status and Withholding Allowances

When you start a new job, your employer will ask you to fill out a W-4 form on which you will report your filling status (similar to your marital status) and the number of withholding allowances you want to claim. The more withholding allowances claimed, the less your employer will withdraw from each paycheck. However, the goal is to have the right amount withheld, so use the W-4 worksheet for guidance.

Minimum Filing Requirements

The federal government does not require all income earners to file federal income tax returns. If your income is below the minimum filing requirement in a given year, you do not have to file. If you are entitled to a tax refund, however, you must file to receive the refund.

Personal Exemptions

Taxpayers can claim personal exemptions that reduce the amount of income on which they pay taxes. You can take a personal exemption for yourself, your spouse, and each of your dependents. If you are a taxpayer who is claimed as a dependent by someone else, however, you cannot claim the personal exemption. In 2000 an exemption was worth $2,800.

Standard Deduction

The standard deduction is another amount that most taxpayers can automatically deduct from gross income. In 2000 the standard deduction for the two most common filing categories was $4,400 for single people and $7,350 for married couples filing jointly. If a tax payer elects to itemize deductions, the standard deduction would not be permitted.

Filing a Federal Income Tax Return

Individuals may use one of three basic forms when filing their income tax returns; the 1040EZ, the 1040A, and the 1040. The 1040EZ and the 1040A are limited to taxpayers with relatively simple finances. In addition, some taxpayers can use the TeleFile system to file their returns by punching in their tax data on touch-tone phones.

Earned Income and Unearned Income

When completing a tax return, you start by listing your gross income. This includes earned income (wages, tips, and self-employment income) and unearned income (interest, dividends, and other investment income). Students must include in gross income scholarship and grant proceeds to the extent that they exceed the direct cost of the education. After totaling your gross income from all sources, the nest step is to subtract any legal deductions you are eligible to take: adjustments to gross income, itemized deductions, and tax credits….

Social Security and Medicare Taxes

Like income taxes, the Social Security and Medicare taxes are payroll taxes—the tax is deducted from each employee’s paycheck. Social Security taxes, often seen on a payroll stub as FICA (Federal Insurance Contributions Act), are paid at a uniform rate on a specified amount of earned income (the wage base)….

Property and Liability Insurance

Property Insurance

Property insurance covers financial losses from damage to or destruction of the insured assets as a result of specified perils, such as fire, or theft.

Liability Insurance

Liability insurance covers financial losses from injuries to others and damage to or destruction to others’ property when the insured is considered to the be cause. Is also covers the insured’s legal defense fees. The two property and liability policies most often purchased by individuals are automobile insurance and homeowner’s/ renter’s insurance.

Automobile Insurance Auto insurance covers financial losses form such perils as accidents, theft, fire, and liability lawsuits. The two main types of automobile insurance are liability coverage and physical damage coverage.

Automobile Liability Insurance

Automobile liability insurance protects the insured from financial losses caused by automobile-related injuries to others and damage to their property.

Automobile Physical Damage Insurance

Automobile physical damage insurance covers damage to or loss of the policyholder’s vehicle from collision, theft, fire, or other perils. It includes collision coverage for damage caused by colliding with another vehicle or object and

Comprehensive (other-than-collision) coverage

comprehensive (other-than-collision) coverage for losses due to perils such as fire, flood, theft, and vandalism….

Homeowner’s/Renter’s Insurance

Homeowners and renters purchase this insurance to protect themselves against both property damage and liability losses. Originally, it covered only losses due to fires, but coverage has now been extended to include perils such as windstorms, lightening, hurricanes, vandalism, riots, frozen water pipes, and falling airplanes….

Actual Cash Value

A standard policy pays only the actual cash value (similar to market value) on personal property.

Replacement Cost Coverage

Replacement cost coverage that provides enough money to replace lost and damaged personal property costs about 10 to 15 percent more.

Health Insurance

COBRA

A federal regulation that allows most employees and their families to continue group health insurance coverage at their own expense for up to 18 months after leaving an employer.

Indemnity (fee-for-service) Plans

Health insurance plans that reimburse the insured for medical costs covered by the insurance policy. The policyholder selects the health care providers.

Managed Care Plans

Health insurance plans that generally pay only for services provided by doctors and hospitals that are part of the plan.

Major Medical Insurance

Major Medical Insurance

Health insurance that covers a wide range of medical costs with few exclusions and high maximum limits. The insured pays a deductible and a coinsurance portion.

Coinsurance (participation)

A percentage of covered expenses that the holder of a major medical insurance policy must pay.

Health Maintenance Organizations (HMOs)

Managed care organizations that provide comprehensive health care services for a fixed periodic payment.

Preferred Provider Organizations (PPOs)

Networks of health care providers who enter into a contract to provide services at discount prices; combine a major medical insurance plan with a network of health care providers.

Disability Income Insurance

Waiting Period (elimination period)

In disability income insurance, the period between the onset of the disability and the time when insurance payments begin.

Duration of Benefits

In disability income insurance, the length of time the insurance coverage payments will continue.

Life Insurance

Term Life Insurance

Life insurance that covers the insured’s life for a fixed amount and a specific period and has no cash value; provides the maximum amount of life insurance coverage for the lowest premium.

Cash Value

The dollar amount paid to the owner of a life insurance policy if the policy is canceled before the death of the insured.

Whole Life (straight life, cash value, continuous pay) Insurance

Life insurance that covers the insured’s entire life, as long as the premiums are paid; has a cash value that increases over the life of the policy.

Universal Life Insurance

A combination of term life insurance and a tax-deferred savings plan. Part of the premium is invested in securities, so the cash value earns interest at current market rates.

Investing

The process of committing money to various instruments in order to obtain future financial returns.

Developing an Investment Strategy

Emergency Fund

Liquid assets that are available to meet emergencies.

Diversification

As investment strategy that involves investing in different asset classes, such as cash equivalents, stocks, bonds, and real estate, and combining securities with different patterns and amounts of return.

Portfolio

A collection of investments.

Dividend Reinvestment Plan (DRIP)

A program in which dividends paid by a stock are automatically reinvested in that stock along with any additional stock purchases submitted by the stockholder.

Guaranteed Investment Contracts (GICs)

Insurance company products that are similar to bank certificates of deposit.

Summary of Learning Goals

>lg 1. What is the personal financial planning process, and how does it

facilitate successful financial management?

Financial planning is a six-step process that includes establishing financial goals, gathering financial and non-financial information, analyzing the information, developing the plan, and monitoring the plan. The process starts with your own goals and provides a way to meet those goals.

>lg 2. How can cash flow planning and management of liquid assets help

you meet your financial goals?

A cash flow plan is a plan for managing income and expenses. It is based on financial goals and includes saving for those goals. Since money is being set aside to pay for the goals, you are more likely to actually achieve them. Liquid assets such as checking and savings-type accounts are important for day-to-day spending, to meet short-term goals, and for unexpected expenditures. Liquid assets can be held in safe, convenient accounts so that money will be readily available when needed.

>lg 3. What are the advantages and disadvantages of using consumer

credit?

The benefits of consumer credit include convenience, purchasing an item sooner, taking advantage of bargains, better service, establishing a credit rating, convenient record keeping, meeting a financial emergency, and perks such as rebates and frequent flyer miles. Using consumer credit also has important disadvantages including the ease of overspreading, the cost of credit (interest charges), the possibility that merchandise may cost more, and the reduction in future discretionary income due to the legal commitment to repay debt.

>lg 4. What are the major types of taxes paid by individuals?

The major taxes paid by individuals are income, Social Security, sales, and property taxes. Income and Social Security taxes called payroll taxes because they are based on income and deducted from an employee’s paycheck. Sales taxes are assessed on purchases made, and property taxes are based on the value of the property owned, usually real estate.

>lg 5. What is the most important principle in deciding what types of

insurance to purchase?

The key to managing your insurance needs in the most cost-effective way is to budget for problems that represent a small financial loss. Set aside money in savings so that you can pay for the loss when it happens. Buy good insurance policies to cover major losses, those that would cause a large financial loss if they occurred.

>lg 6. What personal characteristics are important when making

investment decisions?

Investment decisions should be based on your goals and on your risk tolerance. Examples of investment goals include the desire for income from interest and dividends, the need for growth (capital gains), and the need for safety.

>lg 7. What are the emerging trends in personal financial planning?

Both in the insurance area, where an increasing number of cafeteria benefit plans are being offered, and in the retirement area, where increasing numbers of employers are offering self-directed retirement plans, the trend is toward more employee responsibility for the choices made in employer fringe benefit plans. Although this may be a positive trend given the great diversity and mobility of our workforce, it further emphasizes the importance of all individuals understanding their financial needs and the best ways to achieve them.

>lg 8. What is risk, and how can it be managed? What makes a risk

insurable?

Risk is the chance for financial loss due to a peril. Both individuals and businesses need to protect themselves against several types of risks. Many of these—death, poor health, property damage—can be covered by insurance, which pays the insured up to a specified amount in the event of a loss from a particular peril. Risk can be managed by avoiding situations known to be risky, by assuming the responsibility for losses due to certain types of risk (called self-insurance), by reducing it by adopting safety measures, and by transferring it to an insurance company to be insurable a risk must meet certain criteria.

>lg 9. What types of insurance coverage should businesses consider?

Property insurance covers losses arising from damage to property owned by the insured person or business. Liability insurance covers losses due to injuries to others or their property determined to be caused by the insured. Other important coverages include business interruption, automobile, theft, fidelity and surety bonds, personal liability, professional liability, and product liability.

Businesses must also be knowledgeable about health and life insurance, which they typically offer employees as part of fringe benefits packages.