Financial goals can range from short-term goals such as saving for a new stereo to long-term goals such as saving enough to start your own business. Reaching your particular goals requires different types of financial planning. Let’s take a brief look at what each major plan category includes.
Asset Acquisition Planning
One of the first categories of financial planning we typically encounter is asset acquisition. We accumulate assets things we own throughout our lives. These include liquid assets (cash, savings accounts, and money market funds) used to pay everyday expenses, investments (stocks, bonds, and mutual funds) acquired to earn a return, personal property (movable property such as automobiles, household furnishings, appliances, clothing, jewelry, home electronics, and similar items), and real property (immovable property; land and anything fixed to it, such as a house).
Liability and Insurance Planning
Another category of financial planning is liability planning. A liability is something we owe, which is measured by the amount of debt we incur. We create liabilities by borrowing money. By the time most of us graduate from college, we have debts of some sort: education loans, car loans, credit card balances, and so on. Our borrowing needs typically increase as we acquire other assets such as a home, furnishings, and appliances. Whatever the source of credit, such transactions have one thing in common: the debt must be repaid at some future time. How we manage our debt
Savings and Investment Planning
As your income begins to increase, so does the importance of savings and 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 the subsequent investing of funds in various investment vehicles: common or preferred stocks, government or corporate bonds, mutual funds, real estate, and so on. The higher the returns on the investment of excess funds, the greater wealth they accumulate.
Exhibit 1.8 shows the impact of alternative rates of return on accumulated wealth. The graph shows that if you had $1,000 today and could keep it invested at 8%, then you would accumulate a considerable sum of money over time. For example, at the end of 40 years, you’d have $21,725 from your original $1,000. Earning a higher rate of return has even greater rewards. Some might assume that earning, say, 2 percentage points more (i.e., 10% rather than 8%) would not matter a great deal.
Asset Acquisition Planning
One of the first categories of financial planning we typically encounter is asset acquisition. We accumulate assets things we own throughout our lives. These include liquid assets (cash, savings accounts, and money market funds) used to pay everyday expenses, investments (stocks, bonds, and mutual funds) acquired to earn a return, personal property (movable property such as automobiles, household furnishings, appliances, clothing, jewelry, home electronics, and similar items), and real property (immovable property; land and anything fixed to it, such as a house).
Liability and Insurance Planning
Another category of financial planning is liability planning. A liability is something we owe, which is measured by the amount of debt we incur. We create liabilities by borrowing money. By the time most of us graduate from college, we have debts of some sort: education loans, car loans, credit card balances, and so on. Our borrowing needs typically increase as we acquire other assets such as a home, furnishings, and appliances. Whatever the source of credit, such transactions have one thing in common: the debt must be repaid at some future time. How we manage our debt
Savings and Investment Planning
As your income begins to increase, so does the importance of savings and 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 the subsequent investing of funds in various investment vehicles: common or preferred stocks, government or corporate bonds, mutual funds, real estate, and so on. The higher the returns on the investment of excess funds, the greater wealth they accumulate.
Exhibit 1.8 shows the impact of alternative rates of return on accumulated wealth. The graph shows that if you had $1,000 today and could keep it invested at 8%, then you would accumulate a considerable sum of money over time. For example, at the end of 40 years, you’d have $21,725 from your original $1,000. Earning a higher rate of return has even greater rewards. Some might assume that earning, say, 2 percentage points more (i.e., 10% rather than 8%) would not matter a great deal.
But it certainly would! Observe that if you could earn 10% over the 40 years then you’d accumulate $45,259, or more than twice as much as you’d accumulate at 8%. This powerful observation applies not only to seemingly modest difference in rates of return over time. As we’ll explore in Part 5 on managing investments, apparently small differences in various investment management fees can translate into significant differences in net investment returns over long periods of time. The length of time you keep your money invested is just as important as the rate of return you earn on your investments. You can accumulate more than twice as much capital by investing for 40 rather than 30 years with either rate (8% or 10%) of return. This is the magic of compound interest, which explains why it’s so important to create strong savings and investment habits early in life.
Employee Benefit Planning
Your employer may offer a wide variety of employee benefit plans, especially if you work for a large firm. These could include life, health, and disability insurance; tuition reimbursement programs for continuing education; pension and profit-sharing plans, and 401(k) retirement plans; flexible spending accounts for child care and health care expenses; stock options; sick leave, personal time, and vacation days; and miscellaneous benefits such as employee discounts and subsidized meals or parking Managing your employee benefit plans and coordinating them with your other plans is an important part of the overall financial planning process. For example, tax-deferred retirement plans and flexible spending accounts offer tax advantages. Some retirement plans allow you to borrow against them. Employer-sponsored insurance programs may need to be supplemented with personal policies. In addition, in today’s volatile labor market, you can no longer assume that you’ll be working at the same company for many years. If you change jobs, your new company may not offer the same benefits. Your personal financial plans should include contingency plans to replace employer-provided benefits as required.
Tax Planning
Despite all the talk about tax reform, our tax code remains highly complex. Income can be taxed as active (ordinary), portfolio (investment), passive, tax-free, or tax-deferred. Then there are tax shelters, which use various aspects of the tax code (such as depreciation expenses) to legitimately reduce an investor’s tax liability. Tax planning considers all these factors and more. It involves looking at your current and projected earnings and then developing strategies that will defer and minimize taxes. Tax plans are closely tied to investment plans and will often specify certain investment strategies. Although tax planning is most common among individuals with high incomes, people with lower incomes can also obtain sizable savings.
Retirement and Estate Planning
While you’re still working, you should be managing your finances to attain those goals you feel are important after you retire. These might include maintaining your standard of living, extensive travel, visiting children, frequent dining at better restaurants, and perhaps a vacation home or boat. Retirement planning should begin long before you retire. As a rule, most people don’t start thinking about retirement until well into their 40s or 50s. This is unfortunate, because it usually results in a substantially reduced level of retirement income. The sooner you start, the better off you’ll be. Take, for instance, the IRA (individual retirement arrangement), whereby certain wage earners were allowed to invest up to $6,000 per year in 2009. If you start investing for retirement at age 40, put only $2,000 per year in an IRA earning 5% for 25 years, then your account will grow to $95,454 at age 65. However, if you start your retirement program 10 years earlier (at age 30), your IRA will grow to a whopping $180,641 at age 65. Although you’re investing only $20,000 more ($2,000 per year for an extra 10 years), your IRA will nearly double in size.
Employee Benefit Planning
Your employer may offer a wide variety of employee benefit plans, especially if you work for a large firm. These could include life, health, and disability insurance; tuition reimbursement programs for continuing education; pension and profit-sharing plans, and 401(k) retirement plans; flexible spending accounts for child care and health care expenses; stock options; sick leave, personal time, and vacation days; and miscellaneous benefits such as employee discounts and subsidized meals or parking Managing your employee benefit plans and coordinating them with your other plans is an important part of the overall financial planning process. For example, tax-deferred retirement plans and flexible spending accounts offer tax advantages. Some retirement plans allow you to borrow against them. Employer-sponsored insurance programs may need to be supplemented with personal policies. In addition, in today’s volatile labor market, you can no longer assume that you’ll be working at the same company for many years. If you change jobs, your new company may not offer the same benefits. Your personal financial plans should include contingency plans to replace employer-provided benefits as required.
Tax Planning
Despite all the talk about tax reform, our tax code remains highly complex. Income can be taxed as active (ordinary), portfolio (investment), passive, tax-free, or tax-deferred. Then there are tax shelters, which use various aspects of the tax code (such as depreciation expenses) to legitimately reduce an investor’s tax liability. Tax planning considers all these factors and more. It involves looking at your current and projected earnings and then developing strategies that will defer and minimize taxes. Tax plans are closely tied to investment plans and will often specify certain investment strategies. Although tax planning is most common among individuals with high incomes, people with lower incomes can also obtain sizable savings.
Retirement and Estate Planning
While you’re still working, you should be managing your finances to attain those goals you feel are important after you retire. These might include maintaining your standard of living, extensive travel, visiting children, frequent dining at better restaurants, and perhaps a vacation home or boat. Retirement planning should begin long before you retire. As a rule, most people don’t start thinking about retirement until well into their 40s or 50s. This is unfortunate, because it usually results in a substantially reduced level of retirement income. The sooner you start, the better off you’ll be. Take, for instance, the IRA (individual retirement arrangement), whereby certain wage earners were allowed to invest up to $6,000 per year in 2009. If you start investing for retirement at age 40, put only $2,000 per year in an IRA earning 5% for 25 years, then your account will grow to $95,454 at age 65. However, if you start your retirement program 10 years earlier (at age 30), your IRA will grow to a whopping $180,641 at age 65. Although you’re investing only $20,000 more ($2,000 per year for an extra 10 years), your IRA will nearly double in size.
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