ManagingPersonalFinancescom What You Must Know About Managing Your Personal Finances Your Financial Guide to Doing It Right! 2010 Edition
Table of Contents Table of Contents 2 Introduction 3 Getting and Saving 4 Managing Your Debt 8 Planning For Retirement 11 Investing 14 Personal Taxes 18 2
Introduction This mini e-book has been prepared to introduce you to the full range of topics that we cover in our newsletter and in future e-books at wwwmanagingpersonalfinancescom It includes sections on: 1 Getting and Saving 2 Managing Your Debt 3 Planning for Retirement 4 Investing 5 Personal Taxes We hope that you can take away some ideas that you can implement today, and ideas for the future, as you manage your own personal finances 3
Getting and Saving I m going to ask you to do something that scares away most people from ever thinking about their personal finances I m going to ask you to prepare a simple budget for your family card statements, and other information Most people hate even the idea of a budget It doesn t sound like fun It involves numbers It involves spending an hour or two digging out some financial records, credit People have misconceptions about budgets Some people think that budgets mean that I am going to compare you to other families and say the average couple spends X on food in a month, so should you Others may think that having a budget means that they can only spend money on food and shelter, with nothing left over for fun stuff and anything else that they want Not at all! There is no such thing as an average budget What you want is a simple, and flexible idea of three things: What you currently have What money is coming in (your income) What is going out the door (your spending) That s it If you like a simple plan, you can do all of the above on a single piece of paper If you want a more complex plan, you can create your own computer spread sheets or buy a program like Quicken (http://quickenintuitcom) Your budget accomplishes several worthwhile things It: Provides a starting point Allows you to prepare a strategy to achieve your goals and objectives 4
Allows you to measure your progress every time you update your net worth Provides a guideline and instils financial discipline Eliminates the uncertainty associated with not knowing your current financial status The starting point is determining where you are today: your net worth statement for your family The process of calculating you net worth begins with collecting all the relevant data You should have a rough idea of what your house and car are worth (that s really all that we are looking at a rough idea), and the amounts that you owe on credit cards, personal loans, and through your mortgage Gathering all this data isn t fun, but the result is a financial snapshot that you can use for other facets of financial planning such as tax, estate, and retirement planning You should determine your net worth as a family, so be sure to gather information from your spouse as well Here is one simple example, which can be adapted for your own circumstances What Do You Have? House Car(s) Savings Investment Retirement Other Total If you want to get more complicated you can think about any other assets that you have that may be significant, from a vacation home, to personal furniture Again, the goal here isn t to produce accurate appraisals of everything you have, but rather a fast idea of where you currently stand Now the other side of the equation: what do you owe? House (outstanding mortgage) Car loans Other loans Credit Card balance Total 5
Take the total of what you have, subtract what you owe, and you have what you are worth today This number will be a useful reference point for you in the future, when you come back and look at your net worth in 6 months or 1 years time The second part here is to produce a budget, looking at what money comes into your family, and what you spend Many investors find it useful to prepare a monthly budget, as many expenses are paid on a monthly basis If you are doing this, try to also account for some of the expenses that you might only pay once a year, or only a few times a year (all insurance premiums, home taxes, etc) What Comes In? (Per Month) Income Interest, Dividends Other (rental income, second business income?) Total What Goes Out? (Per Month) Taxes (withheld by your employer) Other withholding (health insurance, social security (CPP in Canada), union dues, unemployment insurance fees, life insurance) Mortgage (rent) payments Car (transportation) payments Credit card payments Other loan payments Food Clothing Entertainment Charity Other Savings/Investment Total What Goes In What Goes Out Totals 6
If you have gone through this exercise, prepare to be surprised by at least some of these numbers If, after looking at your credit card statements or check registry you and your spouse say something like I had no idea we spend X a month on food (or entertainment or transportation or ), then the budget planning process has been worthwhile Or if filling in the above budget leads to further questions ( How are we spending X thousand a month on other things or I thought that we were giving X to charity, but it turns out we are giving only Y to charity ), then you have learned something about how you get and how you spend money The budget process should lead to discussions with your spouse, or even your whole family over what you all consider is important, and what isn t If you are, as a family, spending X on entertainment and you are happy with that then fine If the amount surprises you, then you may want to think about changing your priorities Finally, remember that a budget is not a one time thing that you do, and then put away If you decide to make some changes as a result of going through the above steps, you will want to revisit your budget in six months or maybe a year 7
Managing Your Debt This is probably the most important section of the entire e-book check online if you don t believe me Let s do a small exercise using some math I promise that this won t be too painful, and you really don t have to do any calculations on paper Everything that I ask you can do in your head and You already know that any debt, whether it is on your credit card, a personal loan, or a mortgage, should be paid off as quickly as you can But the real world is full of competing uses for your money Does it really matter if you only make a minimum payment, for example, on your credit card? It is really very easy, as with most credit card statements, the minimum monthly payment is the one number that is usually bolded, and with many people that is the one number that they pay attention to Well, yes, it makes a big difference Let s test this out Let s say you buy a computer or other item costing $1,000 In more technical terms, there is a $1,000 charge on your credit card You make the minimum payment of 2% ($20) a month How long will it take you to pay off this single charge of $1,000? If you want the fine print to this exercise, I am assuming just for this example, that your card has an interest rate of 19% (your own credit cards may be at a higher or lower rate, but many cards are around this level) Your minimum payment is calculated as 2% (which is $20) of the amount owing different cards have different ways of calculating the minimum balance, but this is a popular one 8
Anyway, back to the original question, which is How long will it take to pay off a $1,000 charge if you are paying the minimum of 2% (which is $20) I ll wait as you do this calculation Most people would say something like Well, $1000 divided by $20 = 50 So the answer should be 50 months Other people would take the answer of 50 months, and say something like Well the answer is 50 months if no interest is charged, but with interest I ll add a few months to the total, and maybe a month or 2 recognizing that you won t always be paying a minimum of $20 as the balance declines you will be paying a bit less every month at the end of the payment periods So, in other words, they would guess 55 months or even 60 months Before you go farther, please stop here and think about what your guess would be And if you have printed out this e-book, you can write down your answer here Are you ready now? The answer is (Scroll down for the answer) 169 months That works out to over 14 years So while it would take 50 months ($1000 divided by $20 =50) without interest, it would take over 100 months MORE (actually 119 months more) if you are paying interest and the minimum balance of 2% 9
I don t expect you to believe me, so go to the source of these calculations here: http://wwwbankratecom/calculators/managing-debt/minimum-paymentcalculatoraspx You will see that over this period of years, you end up paying almost $1,700 in interest all on an original balance of $1,000 This is a great calculator to figure out what the numbers are for your particular credit card While your mileage will vary, the principal here stays the same Let s change one of the variables As the calculator shows, if you made a fixed payment of $20 a month, the interest still works against you and you would take 100 months to pay off the same debt And over these 100 months, you would end up paying almost $1,000 in interest, on your $1000 original balance So paying the minimum balance every month doesn t do you any favours The lesson here is to pay off your credit card balance as quickly as you can Even relatively small increases in your monthly payment will have a big effect, as the calculator shows Let s say that instead of paying $2000 a month, you increase this monthly payment by only a single dollar Does this extra 25 cents a month really matter? Yes Try this on the calculator You will see that paying $21 a month reduces your pay back period to 90 months, rather than 100 So you end up chopping off 10 months of payments This extra $1 over 90 months saves you 10 payments at $20 ($200) In other words, you are paying $90 to get $200 in savings Let s see any type of investment duplicate what you could save by paying off your credit card balance as quickly as you can PS The same idea works for mortgages too, as future lessons in the e-book and newsletter will show 10
Planning For Retirement There are a few problems with the title of this section that you see above The word retirement to many people seems like a goal that may be so far in the future, that it has little concern to our daily life right now Added to that is the word planning, which seems to be dull discussions about insurance, budgets and annuities, and I m surprised that there are any readers left here So let s change the title to: How to Work Towards Financial Independence and Personal Security in Your Older Years Thinking about your retirement is important no matter who you are, and where you are today If you are in your 20s or 30s, retirement might seem to be too far off to worry about today as you cope with everyday challenges of living and making money And while I agree that you shouldn t worry about your retirement, the cold fact is that retirement planning is as important to you, the younger person, as it is the older worker near retirement age will show you that in a few slides The earlier you will start planning, the less it will cost you in the long run Here is a quick example: A Young Saver manages to put away $2,000 a year between the ages of 20 and 30 (for a grand total of $20,000) They then stop planning for their retirement Here is how that $20,000 investment plays out (at an assumed rate of 5%) at age 30 $26,413 at age 35 $33,711 at age 40 $43,024 11
at age 65 $145,697 So that $20,000 investment grows to about $145,000 at a retirement age of 65 Let s compare this to another investor An I ll Invest Later investor invests $5,000 a year between the ages of 40 and 50 (for a grand total of $50,000) They then stop investing Here is how their $50,000 investment plays out: at age 50 $66,033 at age 65 $137,279 So this $50,000 investment grows to about $137,000 at a retirement age of 65 There are no tricks here, just the reality of compound interest The choice is yours: for almost the same retirement payout, you can invest $20,000 when you are young, or more than double that ($50,000), when you are older The take away from this is that small amounts of money, compounding over large amounts of time, and with no tax consequences, can make a huge difference If you are in the United States, this tax free compounding can be found in your 401 (k) plan, or in any of the different types of IRAs If you are Canadian, you can achieve this tax free compounding in an RRSP or a TFSA The need for this build up of wealth is also clear You will need more financial resources than a person retired today needs due to ever increasing life expectancy You may well spend 25 or more years in retirement more than twice what some people in the recent past have experienced All of this is good news, but comes with an increased cost of paying for this retirement In North America, the average person retires at age 58 If you are in good health at age 55, regardless of whether you are male or female, you can now expect to live to your late 80s This means that retirement could potentially be the longest phase of your life Retirement planning is just another form of life planning And added to this, is a changing definition of what people consider retirement to be The retirement that baby boomers will enjoy is going to be different from the one that their parents had Many will want more out of this period of their lives 12
than the occasional vacation and prolonged periods of golfing They will be looking to travel more and spend more Yet at the same time, the next group of retirees may face: Entering their retirement years with an outstanding mortgage or credit card debt Becoming part of the sandwich generation, faced with looking after the needs of both aging parents and older children who have yet to leave the next, or have left home and then returned, at the same time Increasing health care costs A changing idea of work and what this means While many retirees are delaying their retirement to age 65 or even longer, and often because they need to continue to earn money, others are finding that they are keeping their jobs because they want to They may be moving to a period of parttime employment, finding that both the extra income as well as the other benefits of work are a desired part of their retirement, not just a necessity The many facets of retirement and retirement planning will be examined in future e-books and our newsletter We ve said before that the path to financial success is really simple, just not easy A lot of the tasks that are needed to get ahead financially are really quite simple Things like saving regularly, looking at tax deferred vehicles, paying off debt, and spending less than you earn on an ongoing basis over time As simple as these things are, they are not easy to do because they require discipline and the word that we started this off with planning 13
Investing The investing world is full of, literally, thousands of investments In any stock market in North America there are thousands of stocks that you could buy There are at least as many mutual funds to choose from There are the straight forward investments you can buy from your local bank for a few hundred dollars, ranging to specialized investments such as hedge funds that can legally be sold only to certain types of investors (normally the very wealthy) Added to this are some of the names that different banks or financial institutions give to their own particular investment product names that really aren t found anywhere else This can all become very complicated Yet it doesn t have to be What follows is a system for understanding the various investments that exist out in the world While there are many different ways to characterize (and ultimately to judge) different investments, take a look at the following and see if this system helps you to understand your next investment, or even one that you have already made Pick an investment you have made (or perhaps are thinking of making) and see how it stacks up against this 3- factor model a The Risk/Return Trade Off The principle in play here is that an investment s risk, and the amount of money you can make from it (the return) are closely related Investments that are very safe (ie have almost no risk) include many of the products offered by banks: savings accounts, certificates of deposit (known as Guaranteed Investment Certificates in Canada), other forms of guaranteed term deposits, US Savings bonds (or Canada Savings Bonds) or money market mutual funds In return for 14
this low level of risk, comes a low level of return (currently only a few percentage points) Other investments have the potential for higher returns, but at a higher level of risk of loss Many stocks, for example, (as well as mutual funds that purchase stocks) have a potential to rise in value in addition to any dividends that they may pay out to shareholders However, there is the very real risk of stock market declines (which we have seen for most of this century), and even total loss if the company issuing the stock goes bankrupt (which we have also seen recently) Finally, there are some investments that have the potential for very high returns (commodities like gold and silver, very small companies that issue stock, investment real estate, futures and options based on other products), but with a very real risk of losing some or all of your investment The point here is that there is no single answer to what is the correct balance of risk and reward in any investment People differ in how they are willing to take risk Some general ideas about peoples approach to risk include: Where you are in your lifecycle The idea here is that when you are younger you are more able to take on riskier investments than when you are older This has nothing to do with your mindset, but everything to do with your earning potential at the time you make your investment, as well as your lifespan to recover from any loss As an example, let s say that you are 30 years old and make a $5,000 investment in a stock Like almost any stock in the past few years, let s assume it has declined in value to $1,000 Where are you today? Well, while nobody likes taking a $4,000 loss, you are in better shape with this loss (all other things being equal) when you are 30 years old than when you are 70 years old A 30 year old has several decades of earning a living (and saving) ahead of them, in order to make up this loss By comparison, a 70 year old probably has no other outside income (aside from savings, pension income, and investment income) to balance off against this loss The 30 year old can also hold onto this stock for the next 5 years or more, in the hope that the stock will rise again The 70 year old, by comparison, probably does not have a 5 year or more investment outlook, and may need the money generated by the stock today, not at some time in the future What your overall financial picture is Again, generally speaking, a person with investments of $100,000 and a house with a paid off mortgage, is more willing to take a risk (and accept the loss) on stocks that were purchased for $5,000 and are now worth $1,000, than is an investor where the $5,000 represents almost all of their current wealth 15
Where the rest of your investments are A key financial idea, which we will be talking about in later e-books, is diversification, which simply means spreading your investment dollars (and risk) across several different investment In other words, don t put all of your investment eggs in one basket An investor with several other investments that are very safe may be more willing to take on a higher risk investment as a small part of an overall portfolio By comparison, another investor with many risky investments may decide that the next investment they make will be a lower risk investment in order to provide balance to their overall portfolio b How Liquid Is The Investment? The word liquid refers to how easily an investment can be sold and how fair the price is if you have to sell an investment quickly Some investments are not at all liquid Locked in term deposits and many annuities and some insurance-based investment products cannot be sold at all before a certain period is up With these products you are truly locked-in Other products are not very liquid Real estate is a classic example of an investment that is not very liquid Even if you stuck a for sale sign on your house, or other property, right now, it might take weeks or months to find a buyer (at a price you think is fair), and a few weeks more for the deal to close and for you to get cash in your pocket And, of course, the selling price is not equal to the actual amount of money that ends up in your hand You have to subtract sales commission, and legal and other fees For all of these reasons, real estate is thought of as a notvery-liquid investment This stands in contrast to stocks that are widely held, and are thought of as highly liquid If you want to sell your shares of Microsoft right now (and stock markets are open), you can phone your broker or click a mouse, and sell your shares quite quickly and easily The sales commissions that you will have to pay to do so are typically only a small percentage of your overall trade value Of course we would all like all of our investments to be highly liquid That will seldom be the case The key factor in assessing liquidity in any investment is to realistically ask yourself how likely you are to need money quickly in the future If you may need your money back next month, you shouldn t be buying real estate today However, if you can invest for the longer term, and you already have existing liquid investments like money market funds, many mutual funds, and many stocks, you can probably live with a larger amount of not-very-liquid investments like real estate, smaller company stocks, bonds, or hedge funds 16
c How Is Your Profit From An Investment Taxed? Different income from investments is taxed in different ways When comparing the potential return from two (or more) different investments, you have to think about the amount of money that stays in your pocket after you pay the taxes due on your investments Generally speaking, safe investments that pay you interest, have that interest taxed at your marginal rate of tax Investments that rise or fall in value (ie a stock that you purchase) produce what are called capital gains In most countries around the world, capital gains are taxed at a lower rate than is interest, which means that investments that produce capital gains are worth more to an investor Dividends that can come from either stocks or from some mutual fund shares are also eligible for some special tax treatment This means that an investment that pays 2% a year in interest might only be worth a 1% return to an investor once they have paid taxes By comparison, an investment yielding a dividend of 2%, or rising in value by 2%, would be worth far more to an investor than the 1% that they would receive from normal interest 17
Personal Taxes There will be some useful tax advice we will be dispensing in future e-books and in our newsletter But before we get too complicated, let s look at seven good tax ideas for you to follow, no matter how much you make, or where you live in the world 1 Always File On Time Look, we are all human We all leave things to the last minute And nobody enjoys filling out tax forms However there are some serious reasons why you should pay particular attention to filing your tax return on time A late tax return will tend to get special attention, which is never a good thing, and will expose you to substantial penalties Do everything that you can to pay anything that you owe with the return, but if you just can't pay, send in the return on time anyway with a letter informing either the IRS or the Canada Revenue Agency (the new name for Revenue Canada) detailing how you are going to look after the taxes that are due Never avoid filing your return just because you don't have the money to pay any taxes that are due at that time 2 Learn to Complete Your Own Tax Return This is something that is easier said than done, but if at all possible, learn to fill out your own tax return It's doesn t have to that difficult, and our future e-books and newsletter will give you all the help that you need Doing this yourself especially if you have never done this before, is an education all by itself Passing along a box full of receipts to a tax preparer may be easy, but it isn t cheap More importantly, it doesn t give you an understanding of what you currently pay in tax, and how you can prepare your life to pay less in the future Maybe because of our age, but we are partial to filling out tax returns by hand If you don t like the old-fashioned pen and paper approach, there are plenty of good, cheap computer tax programs that are available These programs will also help you to avoid simple arithmetical mistakes, or forgetting about a deduction that you are legally allowed to take It is worth the effort and time investment to learn how to use any one of these programs 18
A potential disadvantage of these programs is that you never get a true understanding of how various tax decisions are related to each other You can complete the information in the easy-to-use pop up boxes, answer some questions, and the results are printed for you It is worthwhile to stop with these programs every once in a while and ask yourself why as in why is your taxable income so high, and what can you do about it, or Why don t you qualify for a certain deduction and is there anything you can do about it? Also remember that all these programs do is help you to fill out the forms It is up to you to structure your own affairs to minimize your overall tax burden This doesn t happen at the time you are filling out your tax forms, but rather is a year-round event 3 Pay Your Taxes on Time The third rule, which is closely related to the first rule, is to pay your taxes on time If you are required to pay instalments on self employed earnings (or on a significant amount of investment income), pay those on time as well If you are a Canadian small business (or even a large one), be sure to make your GST payments on time 4 Double Check Your Return Double check your return for any errors, especially math errors Check that the numbers entered match your information slips All of these are simple errors that are also red flags to the IRS and the Canada Revenue Agency 5 Plan Your Taxes, Don t Just Fill Out The Forms As you work on completing your tax forms, don t forget to stand back every once in a while to think about overall tax planning From January to April, most people will be so bogged down preparing their previous year s income tax returns that they will forget all about looking after their current year s tax year That means putting off planning for at least half a year That is not a good idea Keeping good records throughout the year can result in significant tax savings So what can you do to start your tax planning off right? Take a little time in January to decide what savings contributions and charitable donations you want to make during the year Where possible, set up automatic deductions Otherwise, plan to write checks or pay with a credit card to keep track of payments Create a tax filing system Suggested files can include medical bills, personal property tax payments, donation receipts, stock purchases and sales, documents from the sale or purchase of a home and information on home equity loans If you are self-employed, there is a whole other set of files you should keep to track your income and expenses Remember that keeping track of the paperwork is half of the battle in understanding your tax situation 19
6 Understand What Your Marginal Tax Rate Is Understanding your marginal tax rate is important for understanding not just the taxes you pay, but the taxes you can save Your marginal tax rate is the tax that you will pay on the next dollar that you earn Most tax systems around the world have progressive tax systems, where the more income that a person makes, the more that they pay A person making $20,000 a year will pay tax at a lower rate on the next dollar they earn (ie $20,001 as a simplified example), than someone earning $200,000 a year will pay on the next dollar that they earn ($200,001 as a simple example) It is important that you understand the tax brackets that are used to calculate taxes so that you will have a greater appreciation of the impact any strategies you use to reduce your income, and thus the amount of tax you pay Claiming deductions will reduce an individual's tax liability by a rate equal to the marginal tax rate of their particular tax bracket, with a corresponding reduction in returns as the individual crosses in to a lower tax bracket 7 Don t Forget the Obvious In the constant race to look at different investments, or even tax-sheltered investments, many investors forget to maximize the easier ways to accomplish the same thing Consider contributing to your State's 529 college plan Adjust any 401(k) contributions to accommodate pay raises or bonuses Don t forget about your IRA If you are a Canadian, think about maximizing your contributions to an RRSP and a TSFA before exploring new opportunities and tax shelters 20