The cost of attending college is becoming more expensive. Because of inflation, the cost of most goods and services normally increases over time, but college education costs have historically increased more rapidly than most other goods and services. Saving for future college expenses has become an essential part of the financial planning process for many families. Education planning requires a projection of future college costs and a savings plan that will prepare families for those future costs.
To help project future costs of goods and services, we evaluate historical inflation rates. The U.S. Consumer Price Index (CPI) is commonly used as a measure of inflation in the United States. CPI measures the change in average price of a defined basket of goods and services purchased by U.S. consumers. Based on the CPI, the average annual inflation rate over the past 20 years (1990 through 2009) was 2.8%. The average inflation rate during the 1990s was 3.0% per year and during the 2000s was 2.6% per year.
We also need an inflation measure specific to college expenses. A not-for-profit organization named College Board conducts an annual survey of colleges around the country and compiles data lists regarding the average cost of college. One of the College Board lists shows the historical average cost of tuition, fees, room and board at public and private four-year universities. Based on the College Board data, the average annual increase in college cost over the past 20 years (school years 1990-1991 through 2009-2010) was 6.0% at public institutions and 5.4% at private institutions.
As you can see from the data, the cost of college has been rising at about double the rate of inflation. What does this mean for families? Assume a family with a newborn child earns $100,000 annual income. 18 years from now, they want to send their child to a college that currently costs $15,000 per year, or 15% of their income. Assume their income inflates by 3% annually, and the college cost inflates by 6% annually. After 18 years, their income inflates to about $170,000 per year and the college cost inflates to about $43,000 per year. The family planned on sending their child to a college that costs 15% of their income, but after 18 years, the college now costs 25% of their income, which may be more than their budget can handle.
How can families prepare for future college expenses? Paying for all college expenses as they are incurred is too stressful on most families budgets, so a better alternative is to save for college expenses in the years before those expenses are expected to be incurred. Education planning can help families establish a savings strategy that achieves their goals for college education funding. As the cost of attending college increases, so does the significance of the education planning process. We cannot control the rising cost of college, but we can control how we plan and prepare for it.
Sources: Bureau of Labor Statistics, College Board
2010/09/01
2010/08/16
Investment Return Calculations
Investment returns should be evaluated and compared in reference to a specified length of time. A 7% total return is not meaningful performance data without knowing the length of time it took to earn the 7%. Likewise, comparing a 7% total return over three years versus a 7% total return over five years will not provide a fair comparison. To help people better evaluate and compare total investment returns over various time periods, they are often calculated as annual returns. Let's examine how total returns and annual returns are calculated.
Assume a $10,000 investment grows to $12,000 over a five year period. To calculate the total return over the period, divide the ending value by the beginning value and then subtract one. [ (12,000/10,000) - 1 = 0.20 = 20% ] It might seem like a 20% return over five years would equate to a 4% annual return. [ 20% / 5 = 4% ] However, calculating annual return this way ignores the benefit of compound interest. Compound interest occurs when investment earnings are added to the principal investment so that future investment growth applies to both the initial investment and accumulated earnings. If we assume the investment earns 4% per year on both the initial investment and the accumulated earnings, the total return after five years would be more than 20%. Therefore, simply dividing the total return by the number of years of the investment period is not the correct way to calculate annual return.
To calculate annual return on both the initial investment and the accumulated earnings over the period, divide the ending value by the beginning value to derive the total return, raise the total return to the power of one divided by the number of years of the investment period, and then subtract one. [ Annual Return = (ending value / beginning value)^(1 / number of years) - 1 ] When we know the annual return but not the total return, we can calculate total return by adding one to the annual return rate and raising it to the power of the number of years of the investment period. [ Total Return = (1 + annual return)^(number of years) ]
Let's return to the example where a $10,000 investment grows to $12,000 over a five year period. The annual return is calculated as [ (12,000/10,000)^(1/5) - 1 = 0.0371 = 3.71% ]. Using the annual return number of 3.71%, we can calculate the total return over five years as [ (1+0.0371)^(5) - 1 = 0.1998 = 19.98% ] which when rounded, is the 20% total return we initially calculated. The same formulas apply even if the investment period is less than one year. Assume the $10,000 investment grows to $12,000 over a nine month period. Nine months is 75% of one year, so the annual return is calculated as [ (12,000/10,000)^(1/0.75) - 1 = 0.2752 = 27.52% ].
In the formulas, when we raise a number to the power of a number, that means we multiply a number times itself for the number of times of the power. [ example: four raised to the power of three = 4^3 = 4*4*4 = 64 ] This part of the formula can get complicated, so a calculator is highly recommended for performing investment return calculations. Investment return itself is not difficult to derive with the use of a calculator. Knowing and using the correct formulas is the key to successfully calculating investment returns. Recognizing the difference between total return and annual return is essential to evaluating and comparing various investment returns.
Assume a $10,000 investment grows to $12,000 over a five year period. To calculate the total return over the period, divide the ending value by the beginning value and then subtract one. [ (12,000/10,000) - 1 = 0.20 = 20% ] It might seem like a 20% return over five years would equate to a 4% annual return. [ 20% / 5 = 4% ] However, calculating annual return this way ignores the benefit of compound interest. Compound interest occurs when investment earnings are added to the principal investment so that future investment growth applies to both the initial investment and accumulated earnings. If we assume the investment earns 4% per year on both the initial investment and the accumulated earnings, the total return after five years would be more than 20%. Therefore, simply dividing the total return by the number of years of the investment period is not the correct way to calculate annual return.
To calculate annual return on both the initial investment and the accumulated earnings over the period, divide the ending value by the beginning value to derive the total return, raise the total return to the power of one divided by the number of years of the investment period, and then subtract one. [ Annual Return = (ending value / beginning value)^(1 / number of years) - 1 ] When we know the annual return but not the total return, we can calculate total return by adding one to the annual return rate and raising it to the power of the number of years of the investment period. [ Total Return = (1 + annual return)^(number of years) ]
Let's return to the example where a $10,000 investment grows to $12,000 over a five year period. The annual return is calculated as [ (12,000/10,000)^(1/5) - 1 = 0.0371 = 3.71% ]. Using the annual return number of 3.71%, we can calculate the total return over five years as [ (1+0.0371)^(5) - 1 = 0.1998 = 19.98% ] which when rounded, is the 20% total return we initially calculated. The same formulas apply even if the investment period is less than one year. Assume the $10,000 investment grows to $12,000 over a nine month period. Nine months is 75% of one year, so the annual return is calculated as [ (12,000/10,000)^(1/0.75) - 1 = 0.2752 = 27.52% ].
In the formulas, when we raise a number to the power of a number, that means we multiply a number times itself for the number of times of the power. [ example: four raised to the power of three = 4^3 = 4*4*4 = 64 ] This part of the formula can get complicated, so a calculator is highly recommended for performing investment return calculations. Investment return itself is not difficult to derive with the use of a calculator. Knowing and using the correct formulas is the key to successfully calculating investment returns. Recognizing the difference between total return and annual return is essential to evaluating and comparing various investment returns.
Category:
Investments
2010/08/04
Hedging with Futures Contracts
A futures contract is an agreement between two parties to buy or sell a specified asset at a future time and price. The quantity and quality of the asset and the future price and time of the transaction are all agreed upon when the futures contract is made. To complete the contract, the seller must deliver the asset at the future time and the buyer must accept the asset and pay the seller the previously agreed upon price. A majority of the time, futures contracts are never completed. Rather, the buyer and/or seller purchase the opposite position of a different futures contract, allowing them to reverse out of their original position.
Futures contracts can be made on different types of assets, including commodities such as metals, fuels, crops, and livestock. Producers of commodities commonly use futures contracts to reduce their risks from fluctuating commodity prices. They hedge against the price risk by purchasing futures contracts in a position opposite to their current position. A long position benefits from a price increase, and a short position benefits from a price decrease. Producers have a long position in the product they are selling, so they may enter into a short hedge if they want to reduce the price risk of a product they are selling. Producers have a short position in any product they need for production, so they may enter into a long hedge if they want to reduce the price risk of a raw material they use in production. Let’s cover a couple of examples to show how futures contracts can be used as a hedge. For the sake of simplicity, these examples ignore transaction costs and taxes.
Long Position, Short Hedge: The price of cattle is currently 90 cents per pound. Mr. Rancher needs to sell his cattle six months from now but is unsure what the future price of cattle will be. He wants to lock-in a future price, so he looks for someone who will buy his cattle six months from now at 90 cents per pound. Mr. Butcher offers to buy Mr. Rancher’s cattle six months from now at a price of 90 cents per pound, so they agree to a futures contract. After six months pass, the price of cattle may be either higher or lower than 90 cents per pound. Let’s evaluate what happens under each scenario.
Price Increase: Six months pass, and the price of cattle increases to 95 cents per pound. To complete the contract, Mr. Rancher would deliver the cattle to Mr. Butcher for 90 cents per pound, thereby selling for 5 cents less than the market rate but still getting the 90 cents per pound previously locked-in. However, Mr. Rancher could reverse out of his futures contract position by purchasing a contract to buy cattle currently at 95 cents per pound and using that contract to cover his obligation to sell cattle at 90 cents per pound. Mr. Rancher incurs a 5 cent loss on his futures contract and then sells his cattle at the current market price of 95 cents per pound, so his net revenue would be 90 cents per pound, his previously locked-in price.
Price Decrease: Six months pass, and the price of cattle decreases to 85 cents per pound. To complete the contract, Mr. Rancher would deliver the cattle to Mr. Butcher for 90 cents per pound, thereby selling for 5 cents more than the market rate but still getting the 90 cents per pound previously locked-in. However, Mr. Rancher could reverse out of his futures contract position by purchasing a contract to buy cattle currently at 85 cents per pound and using that contract to cover his obligation to sell cattle at 90 cents per pound. Mr. Rancher earns a 5 cent gain on his futures contract and then sells his cattle at the current market price of 85 cents per pound, so his net revenue would be 90 cents per pound, his previously locked-in price.
Short Position, Long Hedge: The price of hay feed is currently 15 cents per pound. Mr. Rancher needs to buy hay to feed his cattle over the next several months but is unsure what the future price of hay will be. He wants to lock-in a future price, so he looks for someone who will sell him hay three months from now at 15 cents per pound. Mr. Farmer offers to sell Mr. Rancher hay three months from now at a price of 15 cents per pound, so they agree to a futures contract. After three months pass, the price of hay may be either higher or lower than the 15 cents per pound. Let’s evaluate what happens under each scenario.
Price Increase: Three months pass, and the price of hay increases to 20 cents per pound. To complete the contract, Mr. Farmer would deliver the hay to Mr. Rancher for 15 cents per pound, and Mr. Rancher would buy for 5 cents less than the market rate, paying just the 15 cents per pound previously locked-in. However, Mr. Rancher could reverse out of his futures contract by selling to someone else his contract to buy hay at 15 cents per pound and then purchasing hay at the current market rate of 20 cents per pound. Mr. Rancher earns a 5 cent gain on his futures contract and then buys hay at the current market price of 20 cents per pound, so his net cost would be 15 cents per pound, his previously locked-in price.
Price Decrease: Three months pass, and the price of hay decreases to 10 cents per pound. To complete the contract, Mr. Farmer would deliver the hay to Mr. Rancher for 15 cents per pound, and Mr. Rancher would buy for 5 cents more than the market rate, paying the 15 cents per pound previously locked-in. However, Mr. Rancher could reverse out of his futures contract by selling to someone else his contract to buy hay at 15 cents per pound and then purchasing hay at the current market rate of 10 cents per pound. Mr. Rancher incurs a 5 cent loss on his futures contract and then buys hay at the current market price of 10 cents per pound, so his net cost would be 15 cents per pound, his previously locked-in price.
As you can see, in both the long position and the short position, the use of a futures contract can lock-in a price. The hedge can reduce price risk, but it may not eliminate price risk. Mr. Rancher needs to accurately predict the quantity, quality, and timing of the cattle he will sell and the hay feed he will need in order to achieve a perfect hedge. It should be noted that Mr. Rancher has locked-in a price only because he has hedged opposite to his current position. Futures investors who are not producers or users of the underlying assets are not trying to reduce price risk; they are trying to realize an investment gain. Futures contracts are still subject to gains and losses even if the futures investor owns or uses the underlying assets. Futures contracts are complex financial products subject to investment risk. However, futures contracts can be very a useful tool for commodity producers and consumers who are completely exposed to price risk.
Futures contracts can be made on different types of assets, including commodities such as metals, fuels, crops, and livestock. Producers of commodities commonly use futures contracts to reduce their risks from fluctuating commodity prices. They hedge against the price risk by purchasing futures contracts in a position opposite to their current position. A long position benefits from a price increase, and a short position benefits from a price decrease. Producers have a long position in the product they are selling, so they may enter into a short hedge if they want to reduce the price risk of a product they are selling. Producers have a short position in any product they need for production, so they may enter into a long hedge if they want to reduce the price risk of a raw material they use in production. Let’s cover a couple of examples to show how futures contracts can be used as a hedge. For the sake of simplicity, these examples ignore transaction costs and taxes.
Long Position, Short Hedge: The price of cattle is currently 90 cents per pound. Mr. Rancher needs to sell his cattle six months from now but is unsure what the future price of cattle will be. He wants to lock-in a future price, so he looks for someone who will buy his cattle six months from now at 90 cents per pound. Mr. Butcher offers to buy Mr. Rancher’s cattle six months from now at a price of 90 cents per pound, so they agree to a futures contract. After six months pass, the price of cattle may be either higher or lower than 90 cents per pound. Let’s evaluate what happens under each scenario.
Price Increase: Six months pass, and the price of cattle increases to 95 cents per pound. To complete the contract, Mr. Rancher would deliver the cattle to Mr. Butcher for 90 cents per pound, thereby selling for 5 cents less than the market rate but still getting the 90 cents per pound previously locked-in. However, Mr. Rancher could reverse out of his futures contract position by purchasing a contract to buy cattle currently at 95 cents per pound and using that contract to cover his obligation to sell cattle at 90 cents per pound. Mr. Rancher incurs a 5 cent loss on his futures contract and then sells his cattle at the current market price of 95 cents per pound, so his net revenue would be 90 cents per pound, his previously locked-in price.
Price Decrease: Six months pass, and the price of cattle decreases to 85 cents per pound. To complete the contract, Mr. Rancher would deliver the cattle to Mr. Butcher for 90 cents per pound, thereby selling for 5 cents more than the market rate but still getting the 90 cents per pound previously locked-in. However, Mr. Rancher could reverse out of his futures contract position by purchasing a contract to buy cattle currently at 85 cents per pound and using that contract to cover his obligation to sell cattle at 90 cents per pound. Mr. Rancher earns a 5 cent gain on his futures contract and then sells his cattle at the current market price of 85 cents per pound, so his net revenue would be 90 cents per pound, his previously locked-in price.
Short Position, Long Hedge: The price of hay feed is currently 15 cents per pound. Mr. Rancher needs to buy hay to feed his cattle over the next several months but is unsure what the future price of hay will be. He wants to lock-in a future price, so he looks for someone who will sell him hay three months from now at 15 cents per pound. Mr. Farmer offers to sell Mr. Rancher hay three months from now at a price of 15 cents per pound, so they agree to a futures contract. After three months pass, the price of hay may be either higher or lower than the 15 cents per pound. Let’s evaluate what happens under each scenario.
Price Increase: Three months pass, and the price of hay increases to 20 cents per pound. To complete the contract, Mr. Farmer would deliver the hay to Mr. Rancher for 15 cents per pound, and Mr. Rancher would buy for 5 cents less than the market rate, paying just the 15 cents per pound previously locked-in. However, Mr. Rancher could reverse out of his futures contract by selling to someone else his contract to buy hay at 15 cents per pound and then purchasing hay at the current market rate of 20 cents per pound. Mr. Rancher earns a 5 cent gain on his futures contract and then buys hay at the current market price of 20 cents per pound, so his net cost would be 15 cents per pound, his previously locked-in price.
Price Decrease: Three months pass, and the price of hay decreases to 10 cents per pound. To complete the contract, Mr. Farmer would deliver the hay to Mr. Rancher for 15 cents per pound, and Mr. Rancher would buy for 5 cents more than the market rate, paying the 15 cents per pound previously locked-in. However, Mr. Rancher could reverse out of his futures contract by selling to someone else his contract to buy hay at 15 cents per pound and then purchasing hay at the current market rate of 10 cents per pound. Mr. Rancher incurs a 5 cent loss on his futures contract and then buys hay at the current market price of 10 cents per pound, so his net cost would be 15 cents per pound, his previously locked-in price.
As you can see, in both the long position and the short position, the use of a futures contract can lock-in a price. The hedge can reduce price risk, but it may not eliminate price risk. Mr. Rancher needs to accurately predict the quantity, quality, and timing of the cattle he will sell and the hay feed he will need in order to achieve a perfect hedge. It should be noted that Mr. Rancher has locked-in a price only because he has hedged opposite to his current position. Futures investors who are not producers or users of the underlying assets are not trying to reduce price risk; they are trying to realize an investment gain. Futures contracts are still subject to gains and losses even if the futures investor owns or uses the underlying assets. Futures contracts are complex financial products subject to investment risk. However, futures contracts can be very a useful tool for commodity producers and consumers who are completely exposed to price risk.
Category:
Investments
2010/07/13
Gift Tax
A gift is a transfer of property from a giver to a receiver without the giver receiving something of at least equal value in return. The federal government has the power to tax individuals who give gifts of money or property. Whenever federal gift tax is owed, the tax is always owed by the giver, never by the receiver. The amount of gift tax a giver may owe depends on the recipients of the gifts and the value of the assets gifted.
Gifts to some recipients are not subject to gift taxes, regardless of the value of the gifts. Gift taxes are not owed when the recipient is a U.S. citizen spouse, a charity, or a political organization. Gift taxes are also not owed when a giver pays someone else’s school tuition or medical expenses only if the giver makes payment directly to the educational or medical institution. For example, parents who contribute money to their child’s account for college tuition are making gifts to their child that may be taxable. Parents’ payments to support their minor children are not taxable gifts since they are legally required, but payments to their children for college education are not legally required and are therefore taxable gifts. If the recipient of a gift does not fit one of these exempt categories, the applicability of gift tax will depend on the value of the gifts.
The federal government allows individuals to give an amount each year that is not subject to gift taxes, known as the annual exclusion. The gift tax annual exclusion is $13,000 in 2010 and is set to increase with inflation in future years. The annual exclusion applies per giver, per receiver, per year. For example, a mother can give $13,000 annually to her son and $13,000 annually to her daughter without owing gift taxes. The father of those children can also give $13,000 annually to the same son and $13,000 annually to the same daughter without owing gift taxes. So in total, the mother and father can give a combined $52,000 annually to their two children, and all $52,000 is excluded from gift taxes. The number of people an individual can give the annual exclusion amount to each year is unlimited. An individual who gives $13,000 per year to 1,000 different people can give away $13,000,000 per year without owing any gift taxes! Individuals also have the option to give five years worth of annual exclusions all in one year. Rather than give $13,000 per year to a receiver for five years, the giver can give $65,000 in one year, as long as he or she does not give any additional gifts to that receiver during the next five years. If the giver makes any additional gift to the same receiver during that five year window, the giver will exceed the annual exclusion amount.
Gifts in excess of the annual exclusion amount count against the giver’s lifetime gift tax credit. As of 2010, individuals are exempt from paying the first $345,800 in gift taxes they may owe during their lifetimes. This $345,800 lifetime gift tax credit allows an individual to give up to $1,000,000 during his or her lifetime, in excess of the $13,000 annual exclusion, without owing any gift taxes. For example, a father gives his daughter $30,000 during 2010. The first $13,000 is excluded from gift tax, and the next $17,000 is a taxable gift. The gift tax on $17,000 is calculated to be $3,200. The father does not pay this $3,200 gift tax but rather uses $3,200 of his $345,800 lifetime gift tax credit. So his lifetime gift tax credit is reduced to $342,600 and will be further reduced by any gift tax he owes in future years. Once an individual has used up all $345,800 of his or her lifetime gift tax credit, he or she must then pay gift taxes on any future gifts given.
Individuals who want to minimize their potential federal estate taxes may want to limit their use of the lifetime gift tax credit. This is because the federal estate tax credit and the lifetime gift tax credit come from the same pool of available credits, together known as the unified credit. Every dollar an individual uses of his or her lifetime gift tax credit is one less dollar the individual has available for his or her estate tax credit. For 2010, there is no federal estate tax, but the federal estate tax is scheduled to return in 2011. Just like with the lifetime gift tax credit, the estate tax credit exempts individuals from paying the first dollars in estate taxes they may owe. For 2011, the federal estate tax credit is scheduled to be $345,800 which will allow individuals to die with an estate valued up to $1,000,000 without owing any federal estate taxes. However, if the individual uses some amount of his or her $345,800 lifetime gift tax credit, his or her $345,800 estate tax credit will be reduced by the amount of gift tax credit used.
Let’s look at an example that shows how the federal estate tax credit and the lifetime gift tax credit are interrelated, assuming a $345,800 credit for each. A gentleman gives $100,000 in excess of the annual exclusion amount during his lifetime. The gift tax on the $100,000 taxable gift is calculated to be $23,800. He does not pay the $23,800 gift tax, but instead he uses up $23,800 of his $345,800 lifetime gift tax credit. The gentleman later dies with a taxable estate of $1,000,000 of which estate taxes are calculated to be $345,800. If the gentleman had not used $23,800 of his lifetime gift tax credit, his estate would get to use all $345,800 of the estate tax credit and avoid paying any federal estate taxes. However, the $23,800 of previously used gift tax credit reduces his available estate tax credit to $322,000. As a result, his estate must pay the $23,800 of estate taxes that the remaining estate tax credit does not cover.
The future of federal estate taxes and gift taxes is extremely unclear at this point in time. The gift tax law may change, but most likely, a gift tax annual exclusion and a lifetime gift tax credit will remain in existence at some level. Most people’s gifts fall under the $13,000 annual exclusion amount, so gift taxes are never a concern for the majority; however, for individuals who give high value assets and have taxable estates, gift taxes are an important financial planning issue. Gift taxes and estate taxes may be unavoidable for some individuals, but with the appropriate financial planning, those individuals can minimize the gift taxes and estate taxes they ultimately have to pay.
Sources: TurboTax, IRS Publication 950, IRS Form 709
Gifts to some recipients are not subject to gift taxes, regardless of the value of the gifts. Gift taxes are not owed when the recipient is a U.S. citizen spouse, a charity, or a political organization. Gift taxes are also not owed when a giver pays someone else’s school tuition or medical expenses only if the giver makes payment directly to the educational or medical institution. For example, parents who contribute money to their child’s account for college tuition are making gifts to their child that may be taxable. Parents’ payments to support their minor children are not taxable gifts since they are legally required, but payments to their children for college education are not legally required and are therefore taxable gifts. If the recipient of a gift does not fit one of these exempt categories, the applicability of gift tax will depend on the value of the gifts.
The federal government allows individuals to give an amount each year that is not subject to gift taxes, known as the annual exclusion. The gift tax annual exclusion is $13,000 in 2010 and is set to increase with inflation in future years. The annual exclusion applies per giver, per receiver, per year. For example, a mother can give $13,000 annually to her son and $13,000 annually to her daughter without owing gift taxes. The father of those children can also give $13,000 annually to the same son and $13,000 annually to the same daughter without owing gift taxes. So in total, the mother and father can give a combined $52,000 annually to their two children, and all $52,000 is excluded from gift taxes. The number of people an individual can give the annual exclusion amount to each year is unlimited. An individual who gives $13,000 per year to 1,000 different people can give away $13,000,000 per year without owing any gift taxes! Individuals also have the option to give five years worth of annual exclusions all in one year. Rather than give $13,000 per year to a receiver for five years, the giver can give $65,000 in one year, as long as he or she does not give any additional gifts to that receiver during the next five years. If the giver makes any additional gift to the same receiver during that five year window, the giver will exceed the annual exclusion amount.
Gifts in excess of the annual exclusion amount count against the giver’s lifetime gift tax credit. As of 2010, individuals are exempt from paying the first $345,800 in gift taxes they may owe during their lifetimes. This $345,800 lifetime gift tax credit allows an individual to give up to $1,000,000 during his or her lifetime, in excess of the $13,000 annual exclusion, without owing any gift taxes. For example, a father gives his daughter $30,000 during 2010. The first $13,000 is excluded from gift tax, and the next $17,000 is a taxable gift. The gift tax on $17,000 is calculated to be $3,200. The father does not pay this $3,200 gift tax but rather uses $3,200 of his $345,800 lifetime gift tax credit. So his lifetime gift tax credit is reduced to $342,600 and will be further reduced by any gift tax he owes in future years. Once an individual has used up all $345,800 of his or her lifetime gift tax credit, he or she must then pay gift taxes on any future gifts given.
Individuals who want to minimize their potential federal estate taxes may want to limit their use of the lifetime gift tax credit. This is because the federal estate tax credit and the lifetime gift tax credit come from the same pool of available credits, together known as the unified credit. Every dollar an individual uses of his or her lifetime gift tax credit is one less dollar the individual has available for his or her estate tax credit. For 2010, there is no federal estate tax, but the federal estate tax is scheduled to return in 2011. Just like with the lifetime gift tax credit, the estate tax credit exempts individuals from paying the first dollars in estate taxes they may owe. For 2011, the federal estate tax credit is scheduled to be $345,800 which will allow individuals to die with an estate valued up to $1,000,000 without owing any federal estate taxes. However, if the individual uses some amount of his or her $345,800 lifetime gift tax credit, his or her $345,800 estate tax credit will be reduced by the amount of gift tax credit used.
Let’s look at an example that shows how the federal estate tax credit and the lifetime gift tax credit are interrelated, assuming a $345,800 credit for each. A gentleman gives $100,000 in excess of the annual exclusion amount during his lifetime. The gift tax on the $100,000 taxable gift is calculated to be $23,800. He does not pay the $23,800 gift tax, but instead he uses up $23,800 of his $345,800 lifetime gift tax credit. The gentleman later dies with a taxable estate of $1,000,000 of which estate taxes are calculated to be $345,800. If the gentleman had not used $23,800 of his lifetime gift tax credit, his estate would get to use all $345,800 of the estate tax credit and avoid paying any federal estate taxes. However, the $23,800 of previously used gift tax credit reduces his available estate tax credit to $322,000. As a result, his estate must pay the $23,800 of estate taxes that the remaining estate tax credit does not cover.
The future of federal estate taxes and gift taxes is extremely unclear at this point in time. The gift tax law may change, but most likely, a gift tax annual exclusion and a lifetime gift tax credit will remain in existence at some level. Most people’s gifts fall under the $13,000 annual exclusion amount, so gift taxes are never a concern for the majority; however, for individuals who give high value assets and have taxable estates, gift taxes are an important financial planning issue. Gift taxes and estate taxes may be unavoidable for some individuals, but with the appropriate financial planning, those individuals can minimize the gift taxes and estate taxes they ultimately have to pay.
Sources: TurboTax, IRS Publication 950, IRS Form 709
2010/07/02
Texas Automobile Liability Insurance
The Texas Motor Vehicle Safety Responsibility Act states that ”a person may not operate a motor vehicle in this state unless financial responsibility is established for that vehicle.” Financial responsibility is “the ability to respond in damages for liability for an accident that arises out of the ownership, maintenance, or use of a motor vehicle.” Most Texas drivers establish financial responsibility by purchasing an automobile liability insurance policy. When you are at fault in an automobile accident, your liability insurance policy covers the medical expenses of people you injure and damages you cause to other people’s property. Liability insurance does not cover your own medical expenses or damages to your own property.
As of April 1, 2008, the minimum liability insurance coverage amounts Texas drivers must maintain are $25,000 per person, $50,000 per accident, and $25,000 for property damage. On January 1, 2011, the minimum liability insurance coverage amounts for Texas drivers will increase to $30,000 per person, $50,000 per accident, and $25,000 for property damage. These are the minimum coverage amounts required by Texas law, but because medical expenses and property damages can easily surpass these amounts, many drivers obtain automobile insurance policies with higher liability coverage limits.
Texas drivers who wish not to purchase automobile liability insurance have a few other options to establish the legally required financial responsibility. A person may file a surety bond with the Department of Public Safety. The surety bond pledges real property owned in Texas to be liquidated if necessary to meet the same minimum liability coverages required under the liability insurance option. A person may deposit $55,000 in cash or securities with the state comptroller or deposit $55,000 in cash or cashier’s check with the county judge, either of which would go towards covering any expenses that arise from the person’s automobile liability. If a person owns more than 25 automobiles, most likely a dealer, the person may apply to self-insure. The Department of Public Safety may issue a certificate of self-insurance if the owner of more than 25 automobiles proves to be capable of paying at least the minimum liability coverage amounts should such liability arise.
You have a few options to legally establish financial responsibility for automobile accidents in which you are at fault, but insurance is probably the safest way to protect against that liability. You probably want to have adequate liability coverage to protect your assets because any liabilities that exceed your insurance coverages will be your responsibility to pay out of pocket. Potential medical expenses and property damages can total much more than the minimum liability coverage requirements, so selecting higher liability coverages are a good way to protect against the risk of incurring these costs.
Sources: Texas Motor Vehicle Safety Responsibility Act, Texas Department of Insurance
As of April 1, 2008, the minimum liability insurance coverage amounts Texas drivers must maintain are $25,000 per person, $50,000 per accident, and $25,000 for property damage. On January 1, 2011, the minimum liability insurance coverage amounts for Texas drivers will increase to $30,000 per person, $50,000 per accident, and $25,000 for property damage. These are the minimum coverage amounts required by Texas law, but because medical expenses and property damages can easily surpass these amounts, many drivers obtain automobile insurance policies with higher liability coverage limits.
Texas drivers who wish not to purchase automobile liability insurance have a few other options to establish the legally required financial responsibility. A person may file a surety bond with the Department of Public Safety. The surety bond pledges real property owned in Texas to be liquidated if necessary to meet the same minimum liability coverages required under the liability insurance option. A person may deposit $55,000 in cash or securities with the state comptroller or deposit $55,000 in cash or cashier’s check with the county judge, either of which would go towards covering any expenses that arise from the person’s automobile liability. If a person owns more than 25 automobiles, most likely a dealer, the person may apply to self-insure. The Department of Public Safety may issue a certificate of self-insurance if the owner of more than 25 automobiles proves to be capable of paying at least the minimum liability coverage amounts should such liability arise.
You have a few options to legally establish financial responsibility for automobile accidents in which you are at fault, but insurance is probably the safest way to protect against that liability. You probably want to have adequate liability coverage to protect your assets because any liabilities that exceed your insurance coverages will be your responsibility to pay out of pocket. Potential medical expenses and property damages can total much more than the minimum liability coverage requirements, so selecting higher liability coverages are a good way to protect against the risk of incurring these costs.
Sources: Texas Motor Vehicle Safety Responsibility Act, Texas Department of Insurance
Category:
Insurance
2010/06/24
Target-Date Funds
A target-date retirement fund is a mutual fund composed an asset class mix that changes in allocation over time so the fund becomes more conservative as the investor approaches retirement. Many people are attracted to target-date retirement funds, also known as life-cycle funds or age-based funds, for their set-it-and-forget-it ease of management. They just select one mutual fund and keep contributing money to that fund without every having to worry about rebalancing or adjusting their allocation.
Investors are supposed to select a target-date fund that corresponds with the year of their expected retirement. For example, if the investor plans to retire in 2035, the investor selects a target-date fund intended for individuals retiring in 2035. The target-date fund will invest in a mix of stocks, bonds, and cash equivalents, and the allocation to each will depend on the number of years until the target-date is reached. For example, a target-date fund might hold 80% stocks and 20% bonds when the target date is 25 years away, but as the target date approaches, the target-date fund will decrease the allocation to stocks and increase the allocation to bonds, making the fund allocation more conservative. The allocation to each asset class and the transition rate to a more conservative allocation can vary greatly among the different target-date retirement funds at different mutual fund companies. This can make target-date funds extremely difficult for investors to evaluate, compare, and select among the many target-date funds available.
When selecting a target-date or life-cycle fund, people should evaluate their time horizon and their risk tolerance. A target-date fund considers an investor’s time horizon but may not account for the investor’s risk tolerance. This oversight can cause stress for owners of target-date funds. A conservative investor may be able to tolerate the volatility of a target-date fund when he is 25 years from retirement, but if the fund does not transition to a conservative allocation as quickly as he would like, then the investor may be dissatisfied with the volatility of the target-date fund when he is just 5 years from retirement. On the other hand, an aggressive investor may select a target-date fund that matches her expected date of retirement, but if the fund allocation is more conservative than her risk tolerance, then she may be dissatisfied with the fund’s lagging performance over time.
This one-size-fits-all approach is a significant drawback to target-date funds. Investors can select a target-date fund that matches their expected retirement date, but beyond that, they have little control. Target-date fund investors cannot dictate which asset classes they want to own or when they want to change the allocation. However, that is the purpose of target-date funds. People who select target-date funds would rather have a mutual fund manager make those decisions. Target-date retirement funds can be a suitable investment as long as people understand their limitations and agree with the mutual fund’s strategy. Target-date funds are not the one-size-fits-all way to save for retirement, but for those people who are comfortable with the set-it-and-forget-it investment strategy, target-date funds may serve as an acceptable autopilot.
Investors are supposed to select a target-date fund that corresponds with the year of their expected retirement. For example, if the investor plans to retire in 2035, the investor selects a target-date fund intended for individuals retiring in 2035. The target-date fund will invest in a mix of stocks, bonds, and cash equivalents, and the allocation to each will depend on the number of years until the target-date is reached. For example, a target-date fund might hold 80% stocks and 20% bonds when the target date is 25 years away, but as the target date approaches, the target-date fund will decrease the allocation to stocks and increase the allocation to bonds, making the fund allocation more conservative. The allocation to each asset class and the transition rate to a more conservative allocation can vary greatly among the different target-date retirement funds at different mutual fund companies. This can make target-date funds extremely difficult for investors to evaluate, compare, and select among the many target-date funds available.
When selecting a target-date or life-cycle fund, people should evaluate their time horizon and their risk tolerance. A target-date fund considers an investor’s time horizon but may not account for the investor’s risk tolerance. This oversight can cause stress for owners of target-date funds. A conservative investor may be able to tolerate the volatility of a target-date fund when he is 25 years from retirement, but if the fund does not transition to a conservative allocation as quickly as he would like, then the investor may be dissatisfied with the volatility of the target-date fund when he is just 5 years from retirement. On the other hand, an aggressive investor may select a target-date fund that matches her expected date of retirement, but if the fund allocation is more conservative than her risk tolerance, then she may be dissatisfied with the fund’s lagging performance over time.
This one-size-fits-all approach is a significant drawback to target-date funds. Investors can select a target-date fund that matches their expected retirement date, but beyond that, they have little control. Target-date fund investors cannot dictate which asset classes they want to own or when they want to change the allocation. However, that is the purpose of target-date funds. People who select target-date funds would rather have a mutual fund manager make those decisions. Target-date retirement funds can be a suitable investment as long as people understand their limitations and agree with the mutual fund’s strategy. Target-date funds are not the one-size-fits-all way to save for retirement, but for those people who are comfortable with the set-it-and-forget-it investment strategy, target-date funds may serve as an acceptable autopilot.
Category:
Investments,
Mutual Funds,
Retirement
2010/06/15
Credit History Report
One important step in building and maintaining a good credit history is to regularly monitor your credit history reports for mistakes. Inaccuricies on your credit reports can cause lenders to charge you higher interest rates or even deny you for loans. You want to make sure your credit history reports are accurate because they may be evaluated by insurance agencies when you apply for an insurance policy, by landlords when you apply for leasing an apartment or house, and may be considered by employers when you apply for a job. Checking credit reports can also help you recognize identity theives who may have illegally opened credit accounts in your name. The best thing about checking you credit history is that it’s free.
The Fair Credit Reporting Act allows you to obtain one free credit report per twelve months from each of the three consumer credit reporting companies. Those companies are Equifax, Experian, and TransUnion. You should not contact the credit reporting companies directly for your free credit reports. The place to obtain your free credit reports is AnnualCreditReport.com. You can obtain your credit reports through other websites, but they often try to sell you additional products with your credit report. AnnualCreditReport.com is the only website authorized by federal law to provide the free annual reports. You can also request your free annual credit reports by phone (1-877-322-8228) or by mail if you prefer not to access the reports online.
You should request your free credit reports from all three of the credit reporting agencies because your credit history information can differ between them. For example, a lender may report to Equifax about your loan but not to Experian, so if you just checked your Experian credit report, you would not see the loan in your credit history. You can obtain your credit reports from all three companies at the same time or just one at a time, as long as you request no more than one report from each company per twelve months. A good strategy is to request just one credit report every four months, alternating the company you request from each time. For example, you could request your Equifax report every January 1st, your Experian report every May 1st, and your TransUnion report every September 1st. This four-month rotation would allow you to keep a more continuous watch on your credit history over the year.
If you find incomplete or incorrect information in your credit history report, you should dispute the inaccuracy by contacting the credit reporting agency and the entity that provided the incorrect information. Supplying any evidence you have to dispute the inaccuracy will help get it corrected. The information provider must research the matter, and if it determines the information is inaccurate, it must notify all three of the credit reporting agencies so they can correct your credit history reports. If the credit reporting agency or information provider determines the information is accurate as is, they may not change your credit report. In that case, you should request a copy of your written dispute be included with your future credit reports so any entities that receive your credit reports are aware of your dispute regarding the inaccurate information.
Please note that your credit report is different than your credit score. Credit scores are calculated based on information in your credit reports and used by lenders to grade your credit worthiness. Credit scores are most relevant to individuals who are trying to obtain large loans, such a home mortgage, because lenders use credit scores to determine what interest rate to charge the borrower. The Fair Credit Reporting Act does not require any companies to provide your credit score for free, so be prepared to pay for your credit score if you want it. Purchasing your credit score is not really necessary if your only objective is monitoring your credit history to detect errors and identity theives. Obtaining your three free credit reports on an annual basis should be a sufficient way to monitor your credit history and ensure its accuracy.
Sources: Federal Trade Commission
The Fair Credit Reporting Act allows you to obtain one free credit report per twelve months from each of the three consumer credit reporting companies. Those companies are Equifax, Experian, and TransUnion. You should not contact the credit reporting companies directly for your free credit reports. The place to obtain your free credit reports is AnnualCreditReport.com. You can obtain your credit reports through other websites, but they often try to sell you additional products with your credit report. AnnualCreditReport.com is the only website authorized by federal law to provide the free annual reports. You can also request your free annual credit reports by phone (1-877-322-8228) or by mail if you prefer not to access the reports online.
You should request your free credit reports from all three of the credit reporting agencies because your credit history information can differ between them. For example, a lender may report to Equifax about your loan but not to Experian, so if you just checked your Experian credit report, you would not see the loan in your credit history. You can obtain your credit reports from all three companies at the same time or just one at a time, as long as you request no more than one report from each company per twelve months. A good strategy is to request just one credit report every four months, alternating the company you request from each time. For example, you could request your Equifax report every January 1st, your Experian report every May 1st, and your TransUnion report every September 1st. This four-month rotation would allow you to keep a more continuous watch on your credit history over the year.
If you find incomplete or incorrect information in your credit history report, you should dispute the inaccuracy by contacting the credit reporting agency and the entity that provided the incorrect information. Supplying any evidence you have to dispute the inaccuracy will help get it corrected. The information provider must research the matter, and if it determines the information is inaccurate, it must notify all three of the credit reporting agencies so they can correct your credit history reports. If the credit reporting agency or information provider determines the information is accurate as is, they may not change your credit report. In that case, you should request a copy of your written dispute be included with your future credit reports so any entities that receive your credit reports are aware of your dispute regarding the inaccurate information.
Please note that your credit report is different than your credit score. Credit scores are calculated based on information in your credit reports and used by lenders to grade your credit worthiness. Credit scores are most relevant to individuals who are trying to obtain large loans, such a home mortgage, because lenders use credit scores to determine what interest rate to charge the borrower. The Fair Credit Reporting Act does not require any companies to provide your credit score for free, so be prepared to pay for your credit score if you want it. Purchasing your credit score is not really necessary if your only objective is monitoring your credit history to detect errors and identity theives. Obtaining your three free credit reports on an annual basis should be a sufficient way to monitor your credit history and ensure its accuracy.
Sources: Federal Trade Commission
Category:
Credit
2010/06/04
Roth IRA Contribution Loophole
The Roth IRA is a handy retirement planning tool, but its availability may be limited for some individuals. A person’s eligibility to contribute to a Roth IRA depends on the person’s adjusted gross income (AGI) for the year. The Roth IRA contribution limit may be reduced below $5,000 to possibly $0 for people with high incomes. For single taxpayers, the Roth IRA contribution limit is phased out if AGI is between $105,000 and $120,000 and prohibited if AGI is above $120,000. For married taxpayers, the Roth IRA contribution limit is phased out if AGI is between $167,000 and $177,000 and prohibited if AGI is above $177,000. These AGI phase-out ranges apply to the 2010 tax year but may adjust annually based on inflation.
People with high incomes are prohibited from contributing to Roth IRAs, but they may be able to benefit from a Roth IRA conversion. A Roth IRA conversion allows people to transfer their IRA assets to a tax-exempt Roth IRA by paying ordinary income taxes on the tax-deferred amount that is converted. Before 2010, tax law prohibited Roth IRA conversions for people with AGI above $100,000. The income limit was eliminated for 2010 and years forward, so now even high income people can convert to a Roth IRA.
Traditional IRAs do not have an income limit on contribution eligibility. High income individuals may not be able to deduct IRA contributions on their tax returns if they are covered by an employer retirement plan, but high income taxpayers are still eligible to make non-deductible contributions to a traditional IRA regardless of their income amount. This eligibility to contribute to a traditional IRA combined with the eligibility to convert a traditional IRA to a Roth IRA provides the loophole for high income individuals to add money to a Roth IRA.
Let’s walk through an example to demonstrate how the loophole works. Mr. Wealthy earns $200,000 per year, is covered by a retirement plan at work, and does not currently have an IRA. He is not eligible to contribute to a Roth IRA, so he makes a non-deductible contribution of $5,000 to a traditional IRA. Mr. Wealthy’s IRA contribution grows from $5,000 to $6,000 the following year, and he decides to convert the $6,000 to a Roth IRA. Mr. Wealthy does not pay income taxes on the $5,000 that represents his non-deductible IRA contribution, but he must pay ordinary income taxes on the $1,000 of tax-deferred growth. Mr. Wealthy pays the income taxes from his other taxable assets, and after the conversion is completed, he has $6,000 in a Roth IRA .
The tax laws do not specify how long money contributed to an IRA must be held in the IRA before it can be converted to a Roth IRA. Theoretically, an individual could contribute $5,000 to an IRA on day 1 and then convert that $5,000 to a Roth IRA on day 2. However, some financial experts suggest you avoid such obvious exploitation of the loophole by allowing some time to pass between the IRA contribution and the Roth IRA conversion. It may be only a matter of time before the IRS notices people taking advantage of this loophole and decides to change the tax laws.
People with high incomes are prohibited from contributing to Roth IRAs, but they may be able to benefit from a Roth IRA conversion. A Roth IRA conversion allows people to transfer their IRA assets to a tax-exempt Roth IRA by paying ordinary income taxes on the tax-deferred amount that is converted. Before 2010, tax law prohibited Roth IRA conversions for people with AGI above $100,000. The income limit was eliminated for 2010 and years forward, so now even high income people can convert to a Roth IRA.
Traditional IRAs do not have an income limit on contribution eligibility. High income individuals may not be able to deduct IRA contributions on their tax returns if they are covered by an employer retirement plan, but high income taxpayers are still eligible to make non-deductible contributions to a traditional IRA regardless of their income amount. This eligibility to contribute to a traditional IRA combined with the eligibility to convert a traditional IRA to a Roth IRA provides the loophole for high income individuals to add money to a Roth IRA.
Let’s walk through an example to demonstrate how the loophole works. Mr. Wealthy earns $200,000 per year, is covered by a retirement plan at work, and does not currently have an IRA. He is not eligible to contribute to a Roth IRA, so he makes a non-deductible contribution of $5,000 to a traditional IRA. Mr. Wealthy’s IRA contribution grows from $5,000 to $6,000 the following year, and he decides to convert the $6,000 to a Roth IRA. Mr. Wealthy does not pay income taxes on the $5,000 that represents his non-deductible IRA contribution, but he must pay ordinary income taxes on the $1,000 of tax-deferred growth. Mr. Wealthy pays the income taxes from his other taxable assets, and after the conversion is completed, he has $6,000 in a Roth IRA .
The tax laws do not specify how long money contributed to an IRA must be held in the IRA before it can be converted to a Roth IRA. Theoretically, an individual could contribute $5,000 to an IRA on day 1 and then convert that $5,000 to a Roth IRA on day 2. However, some financial experts suggest you avoid such obvious exploitation of the loophole by allowing some time to pass between the IRA contribution and the Roth IRA conversion. It may be only a matter of time before the IRS notices people taking advantage of this loophole and decides to change the tax laws.
Category:
Accounts,
Retirement
2010/05/28
Roth IRA Conversion Considerations
Roth IRA conversion is currently a popular topic in financial planning, but many people are not sure whether a Roth IRA conversion is right for them. A Roth IRA conversion should be evaluated as part of your overall financial plan to see if the conversion improves the results of your plan. Whether a Roth IRA conversion will improve the results of your overall financial plan depends on both future income tax rates and future investment performance. Let’s review both of these factors and how they affect the attractiveness of a Roth IRA conversion.
For any tax-deferred IRA assets you convert to a Roth IRA, you must pay income taxes on those assets at the time of conversion. For any IRA assets you do not convert, you can continue deferring income taxes on those assets and pay the income taxes when you withdraw those assets in retirement. So from strictly an income tax perspective, a Roth IRA conversion would appear unfavorable if your income tax rates before retirement are higher than your income tax rates during retirement. On the other hand, a Roth IRA conversion would appear favorable if your income tax rates before retirement are lower than your income tax rates during retirement.
In regards to investment performance, there is a positive correlation between performance and the attractiveness of a Roth IRA conversion. Paying income taxes on a Roth IRA conversion will reduce your total current assets, so the investment growth of your converted assets must be enough to recover the taxes paid on the conversion. A Roth IRA conversion would appear unfavorable if the investment growth of your converted assets is less than the amount of taxes you paid on the conversion. On the other hand, a Roth IRA conversion would appear favorable if the investment growth of your converted assets is greater than the amount of taxes you paid on the conversion.
Since future income tax rates and future investment returns are very unpredictable, we cannot know for sure whether a Roth IRA conversion will ultimately be beneficial to the overall financial plan. What we can do is make assumptions and identify scenarios where a Roth IRA conversion would be beneficial or detrimental to the plan. If we are willing to consider the past to provide a basis for what could happen in the future, we may also be able to assign probabilities to different scenarios. However, we should remember that anything is possible, and the decision of Roth IRA conversion is ultimately based on your expectations for the future
For any tax-deferred IRA assets you convert to a Roth IRA, you must pay income taxes on those assets at the time of conversion. For any IRA assets you do not convert, you can continue deferring income taxes on those assets and pay the income taxes when you withdraw those assets in retirement. So from strictly an income tax perspective, a Roth IRA conversion would appear unfavorable if your income tax rates before retirement are higher than your income tax rates during retirement. On the other hand, a Roth IRA conversion would appear favorable if your income tax rates before retirement are lower than your income tax rates during retirement.
In regards to investment performance, there is a positive correlation between performance and the attractiveness of a Roth IRA conversion. Paying income taxes on a Roth IRA conversion will reduce your total current assets, so the investment growth of your converted assets must be enough to recover the taxes paid on the conversion. A Roth IRA conversion would appear unfavorable if the investment growth of your converted assets is less than the amount of taxes you paid on the conversion. On the other hand, a Roth IRA conversion would appear favorable if the investment growth of your converted assets is greater than the amount of taxes you paid on the conversion.
Since future income tax rates and future investment returns are very unpredictable, we cannot know for sure whether a Roth IRA conversion will ultimately be beneficial to the overall financial plan. What we can do is make assumptions and identify scenarios where a Roth IRA conversion would be beneficial or detrimental to the plan. If we are willing to consider the past to provide a basis for what could happen in the future, we may also be able to assign probabilities to different scenarios. However, we should remember that anything is possible, and the decision of Roth IRA conversion is ultimately based on your expectations for the future
Category:
Accounts,
Retirement
2010/05/18
Early Retirement
The ability to retire at an early age is a desirable goal for many working individuals. The motivation for early retirement can vary. Some people grow tired of working and are ready for days of less structure. Some people enjoy working but want to reach a status of not needing earned income. In any case, the financial capacity for early retirement can be difficult to achieve. Early retirement does not come without some financial sacrifice. Let’s examine the financial aspects of early retirement to determine what makes this such a challenging goal.
Most working individuals who wish to retire someday should be regularly saving a portion of their income to be used to fund their living expenses during retirement. Because those individuals also need a portion of their income to fund their current living expenses during their working years, the amount they can save each year is limited. The variable they can control is the number of years they work and save. An individual who chooses to retire five years early has five fewer years to save for retirement, which means the individual will have less retirement savings and may not have enough to fully fund his or her retirement. On the other hand, an individual who chooses to work and save five additional years will have more retirement savings and possibly have more to spend in retirement.
Once an individual retires, that person will start withdrawing an amount from his or her savings portfolio to fund his or her living expenses each year until death. Since most retired people have a minimum amount they need for living expenses each year, they usually cannot afford to reduce the amount they withdraw from their savings portfolios. The variable people can control is the number of years they must withdraw from their savings portfolios. An individual who chooses to retire early will require more years of withdraws from his or her savings portfolio, so he or she may have to withdraw a smaller amount each year. On the other hand, an individual who chooses to work longer and delay retirement will require fewer years of withdrawals from his or her savings portfolio, so he or she may be able to withdraw a larger amount each year.
As you can see, early retirement is difficult to achieve because of two main reasons: fewer years to save and more years of spending. We call this the double-edged sword because you cannot reduce the total amount you save without increasing the total amount you need for retirement. To achieve early retirement, you must sacrifice your lifestyle expenditures in both your working years and retirement years. You sacrifice during working years by spending less so you can save more money for retirement. You sacrifice during retirement years by continuing to spend less so your savings portfolio is not depleted before death. Early retirement is difficult to achieve, but if you are willing to sacrifice some lifestyle expenditures, you may be ready for the challenge.
Most working individuals who wish to retire someday should be regularly saving a portion of their income to be used to fund their living expenses during retirement. Because those individuals also need a portion of their income to fund their current living expenses during their working years, the amount they can save each year is limited. The variable they can control is the number of years they work and save. An individual who chooses to retire five years early has five fewer years to save for retirement, which means the individual will have less retirement savings and may not have enough to fully fund his or her retirement. On the other hand, an individual who chooses to work and save five additional years will have more retirement savings and possibly have more to spend in retirement.
Once an individual retires, that person will start withdrawing an amount from his or her savings portfolio to fund his or her living expenses each year until death. Since most retired people have a minimum amount they need for living expenses each year, they usually cannot afford to reduce the amount they withdraw from their savings portfolios. The variable people can control is the number of years they must withdraw from their savings portfolios. An individual who chooses to retire early will require more years of withdraws from his or her savings portfolio, so he or she may have to withdraw a smaller amount each year. On the other hand, an individual who chooses to work longer and delay retirement will require fewer years of withdrawals from his or her savings portfolio, so he or she may be able to withdraw a larger amount each year.
As you can see, early retirement is difficult to achieve because of two main reasons: fewer years to save and more years of spending. We call this the double-edged sword because you cannot reduce the total amount you save without increasing the total amount you need for retirement. To achieve early retirement, you must sacrifice your lifestyle expenditures in both your working years and retirement years. You sacrifice during working years by spending less so you can save more money for retirement. You sacrifice during retirement years by continuing to spend less so your savings portfolio is not depleted before death. Early retirement is difficult to achieve, but if you are willing to sacrifice some lifestyle expenditures, you may be ready for the challenge.
Category:
Retirement
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