Fundamentals of Financial Planning

What Is It? Financial planning is the process of solving financial problems and achieving financial goals by developing and implementing a personalized "game plan." In order to be effective this "plan" must take into consideration an individuals overall picture. It must be:

coordinated comprehensive continuous

Financial planning is like all other phases of life; it involves choices Spend now or save for later? Pay off existing bills or increase retirement savings? Focus savings rupees on short term or long term goals? A true financial plan does not focus one aspect or product, but instead seeks to take all areas of planning into consideration when making financial decisions.

What is Included?

Cash Flow Management This aspect of planning deals with the day to day allocation of income; and its effective use in paying for current living expenses and in accumulating assets which will be used in meeting financial goals.

Tax Planning and Management This area focuses on the understanding of and application of federal and state income tax law, estate and inheritance taxes; and, when possible, minimizing these taxes.

Risk Planning and Management This area of planning deals with the risk of losing life, income, or property. It includes the use of insurance products and strategies.

Investment Planning and Management Almost everyone has accumulation goals for which investments must be made and managed. These could include buying a home; planning for college; or providing for retirement.

Retirement Planning and Management By far the most common accumulation goal is the ability to become financially independent. Retirement strategies encompass the understanding of the Social Security system; employer-sponsored retirement plans; and personal savings accumulation plans.

We will examine each of these areas in more detail.

Why Plan? Anyone who has financial challenges to solve or financial goals to achieve needs financial planning. Financial Planning can help to achieve both greater wealth and financial security. Inadequate or improper planning can be financially disastrous. An uninsured loss can wipe out accumulated wealth; insufficient savings for retirement can force a reduced lifestyle and/or postponement of retirement; and improper tax planning can result in higher than necessary taxes causing dollars to be lost to an accumulation plan or to ones heirs. Why Do People Fail to Plan?

They may feel they do not have enough income or financial assets to consider planning.

They may believe that they are too young/old to begin planning. They may be reluctant to consider some of the less pleasant aspects of planning such as thinking about death, disability, illness, etc.

They may believe that financial planning is too expensive THEY MAY PROCRASTINATE! (The Number One Reason For Failure)

The Steps in Financial Planning Identify Goals and Objectives: Gather the necessary data Analyze present situation and consider alternatives Develop strategies to achieve goals. Implement the strategies Review and Revise periodically 3

Cash Management and Budgeting

Cash Management involves how you handle your cash resources on an ongoing basis. There are a number of financial products and services, which can assist you in this.

Managing Cash & Savings

1) Financial Institutions

Traditional financial institutions include banks, savings and loan associations, savings banks and credit unions.

Many different accounts are available from these institutions:

o

Demand Deposit Accounts Withdrawals may be made whenever demanded by the accountholder (checking accounts)

Time Deposit Accounts Deposits in these accounts are intended for longer accumulation. An Accountholder may be required to give a specific notice prior to withdrawal (Passbook or Regular Savings Accounts)

o o

MMDA Accounts Money Market Demand Accounts are similar to MMMF Accounts Money Market Mutual Funds pool funds from many investors and use these funds to purchase short term securities such as commercial paper, etc. They also offer a rate of return and easy access to funds through withdrawals or checking.

Deposits in banks, savings and loan associations, or credit unions are insured against the failure of the institution up to Rs.100,000 per account.

2) Developing Savings Habits

A portion of your financial assets should be kept liquid and readily accessible for dayto-day needs and emergencies. Most planners believe that you should maintain such an account in an amount equal to at least three to six months living expenses. Once this fund is established, you may then begin to consider the funding of more long-term savings goals. The most appropriate savings vehicle for these savings goals will vary, depending on time horizon of the savings goal; risk tolerance; etc. However, as a rule of thumb, a savings goal of 15% of gross income is a good target, although you may not be able to achieve this goal all at once. Some savings vehicles available through traditional financial institutions or through brokers are:

3) The Power of Compound Interest

How much you earn on your accumulated investment funds will be determined by several factors:

Your initial Investment and subsequent additional investments The amount of time the money is left on deposit The rate of interest being paid The method of interest calculation

The future value of your investment can be determined by the use of a simple calculation: Future Value is the amount to which todays investment will grow over a given period of time at a specific rate of interest. This process is referred to as "compounding." 5

Example Assume that you were to make a Rs.2000 deposit into a Certificate of Deposit earning 5% interest per year. At the end of 20 years, total deposits would have been Rs.40,000 (20 years x Rs.2000 per year). However, the total account value would be Rs.66,132, due to the compounding of interest over that period of time. To apply this to a goal-setting problem, if you were to identify a savings goal of Rs.20,000 as down payment for a home in five years, (with Rs.5000 already saved), you could not simply divide the Rs.15,000 remaining accumulation goal by 5 to find out how much you would have to save per year to reach your goal. This process would ignore the interest factor, for which we will use 10%. FUTURE VALUE = AMOUNT INVESTED X FUTURE VALUE FACTOR This future value factor may be arrived at by using a financial calculator, or by using a Future Value Table. To use this Table, locate the factor (1.6105) which lies at the intersection of 5 on the vertical axis (for 5 years); and locate 10 on the horizontal axis (for 10% interest). The factor (1.6105) is then inserted into the formula: FV = Rs.5,000 x 1.6105 = Rs.8,052.50 Thus, your Rs.5,000 will be worth Rs.8,052.50 in 5 years. Subtracted from our total goal of Rs.20,000 there is still Rs.11,947.50 needed. The second step of our problem involves using the future value formula again to determine how much savings per year will be necessary (still at the 10%) for the 5 year period in order to reach the Rs.11,947.50 goal.

A second time value formula involving a cash flow (sometimes called an annuity) can be used: YEARLY SAVINGS = AMOUNT DESIRED DIVIDED BY FUTURE VALUE ANNUITY FACTOR This computation uses a Future Value of an Annuity Table. You again locate the intersection of 5 years and 10 percent interest with a factor of 6.1051. Plugged into the formula, the computation becomes: YS = Rs.11,947.50 DIVIDED BY 6.1051 = Rs.1,956.97 So, you would have to save Rs.1,956.97 per year for five years, invested at 10% interest to reach your goal of Rs.11,947.50.

4) Present value calculation

Present Value is the value today of an amount to be received in the future; or the amount you would have to invest today at a given interest rate over the specified time period to accumulate the future amount. This process is known as "discounting", and is the inverse of compounding. Example Present Value calculations are frequently used in retirement projection calculations. For example, if you are 35 years old and wish to accumulate a Rs.300,000 retirement fund by age 60 (25 years from now), you would use a Present Value Table .

PRESENT VALUE = FUTURE VALUE X PRESENT VALUE FACTOR If we assume a 25-year investment at 7% the solution would look like this: PV = Rs.300,000 x .1842 = Rs.55,260 This is the lump sum you would have to deposit today to reach your goal with no further contributions. Another example involving present value deals with regular payments.

Example

Suppose you this is in the fall of your son or daughter's senior year in high school and you want to know how much money you need to have today in order to make tuition and fee payments of Rs.18,000 at the beginning of each of the four years of your child's college education. You believe you can achieve a 12% yield on your funds during this time. To do this, use a Present Value of an Annuity Table. PRES. VALUE = ANNUITY VAL. X PRES. VAL. OF AN ANNUITY FACTOR Enter the Present Value of an Annuity Table at four years and 12% interest and obtain the factor of 3.0373. Therefore, if you have Rs.54,671.40 invested today at 12% interest, you will be able to withdraw Rs.18,000 one year from today and for each of the following three years.

Preparation of Personal Financial Statements

The preparation of certain personal financial statements will clarify the current status of your financial situation and provide the"starting point" for any future action. These statements are very helpful in assisting you in evaluating your own situation or in gathering the information needed to work with a financial planner. The two forms we will be working with are the Personal Financial Statement; the

Personal Budget.

THE PERSONAL BUDGET

Why Prepare a Personal Budget? A Budget can be used as a tool in identifying how and when money is being spent. It can help to identify cash flow problems and can also identify dollars which may be redirected toward achieving financial goals. Steps in Budgeting 1. The first step is to record historical information as to income. This information will come from pay stubs or statements or tax returns. 2. The next step is to record historical information concerning your personal expenses. This information will be found in your cancelled checks; checkbook registers; paid receipts (cash); credit card statements and/or tax returns. 3. You may wish to segregate your expenses by type. ("Fixed" expenses refer to payments which are equal and non-varying each payment period and "variable" expenses involve payments that vary in amount from one time period to the next.)

4. Once existing patterns are identified, you can identify those areas which you may wish to target for change. 5. The next step in the budgeting process involves preparing projected income and expenses for the next budgeting period (usually one year). You should include any targeted changes you have identified in Step 3. 6. Next, you will maintain Records of income and expenses as they occur. 7. Periodically compare actual results to desired target. Make changes as needed. 8. A budget will only help you achieve your goals if is honest; if it is used; and if adjustments are made, as needed. It also makes sense to get into the habit of "paying yourself first" by making the first check you write once you get paid to yourself to be deposited to you savings and investment program. If you wait to see what is left over, it is usually nothing! Personal Budgeting Worksheet (Period covering _______________to ________________) Item Household Expenses Food Clothing Transportation Personal Insurance Professional Debt Repayment Miscellaneous Savings and Investment Historical Target Actual Difference

Grand Total
10

THE PERSONAL FINANCIAL STATEMENT

Why Prepare a Personal Financial Statement? The Financial Statement is like a snapshot of your financial condition as of a certain date. The categories on a balance are assets, liabilities, and net worth. Financial statements should be prepared at least once per year. The Personal Financial Statement will include the following information: Assets Assets are the things that you own. They are often grouped into broad categories:

Liquid Assets - Cash or other financial assets, which can be easily and quickly converted into cash with little or no loss in value. (Checking Accounts, Money Market Accounts, Savings Accounts)

Investment Assets Assets which are held for their financial return, rather than for personal use. Stocks, Bonds, Mutual Funds, etc.) These assets generally

appreciate (increase) in value.

Real Property Land and things attached to it (house, garage, etc.) Personal Property Movable property usually held for personal use (automobile, furniture, clothing, etc. These assets generally depreciate (decrease) in value.

Liabilities Liabilities are the things that you owe. They are also grouped into broad categories:

11

Current Liabilities Bills that are currently due and will be paid off within one year (Rent, Current Months unpaid utility bills; medical bills; credit card balances, etc.)

Long Term Liabilities Liabilities on which the payment stream will continue for more than one year (long term loans for auto, home, education etc.)

Net Worth Net Worth is the net amount of wealth or equity you own, based on your assets and liabilities. It is calculated by subtracting liabilities from assets. Net worth is increased when assets are added or debts are reduced or eliminated.

Utilizing and Analyzing the Information on your Personal Financial Statement Important areas to examine are:

Net Worth If your familys net worth is less than zero, than you are insolvent. A familys net worth should increase over time.

Solvency Ratio This calculation shows how much of a financial cushion you have in relation to your financial obligations.

Liquidity Ratio This calculation shows how long you could pay your current bills from your assets.

12

Understanding the Use of Credit

Appropriate Use of Credit
The use of credit (posting payments until a future time) can be a useful tool for individuals, businesses and governments. There are numerous valid reasons for the use of credit, such as

Safety/Convenience Consumer does not need to carry large amounts of cash, which could be lost or stolen . Also, recourse is provided for unsatisfactory purchases and returns can be re-credited to the account.

Emergencies Consumer can deal with short term unexpected situations (auto repairs, medical expenses, etc.) when cash is not available.

Record-Keeping Credit borrowing provides an itemized record of all transactions.

Opportunity Consumer can make unanticipated purchases when cash resources are not available

Facilitation of Transaction Consumer can make certain purchases indirectly by telephone or Internet or directly such as automobile rental; airplane tickets, etc. when other payment forms are not practical.

Identification Credit cards are often used as a form of identification for other transactions such as cashing a check; applying for credit, etc.

Inappropriate Use of Credit

There exists, however, the potential for abuse of credit which leads to overindebtedness and financial problems and may ultimately impede or prevent the achievement of financial goals..

13

The biggest problem with credit is the tendency to overspend. Credit should not be used for routine basic living expenses or impulse purchases

Credit should also not be used for the purchase of short-lived goods and services. (Rule of thumb: an item purchased by credit should not be used up

sooner than the bill is paid off!)

Monthly debt repayment should not exceed 20% of monthly take-home pay.
High interest costs on unpaid balances can accumulate rapidly.

Computation of Finance Charges on Credit Accounts

Various charges, fees and interest computations may all affect the cost of credit when using a credit card. Be sure to compare!

Calculation of Interest rate on Unpaid Balances May be fixed or variable. Issuers must disclose the "APR" (Annual Percentage Rate) and the "PIR" (Periodic Interest Rate) for each billing cycle.

Computation of Unpaid Balance The method by which a card issuer calculates the unpaid balance on an account. This balance multiplied by the periodic interest rate determines the finance charge, so it is very important! 1. Average Daily Balance Method Each day the issuer subtracts any payments and adds new purchases to the account balance. These balances are they added together for the billing period and divided by the number of days in that cycle. 2. Previous Balance Method The issuer charges interest on the balance outstanding at the end of the previous billing cycle. This is the most

14

expensive method for the consumer since interest is charged on the

outstanding balance at the beginning of the billing period. 3. Adjusted Balance Method The issuer starts with the previous balance, subtracts any payments or credits, and charges interest on any remaining unpaid amount. 4. Past Due Balance Method With this method the issuer does not charge any interest for cardholders who pay the account in full before a specific period of time; otherwise, the finance charge is imposed under one of the three preceding methods.

Fees Some card issuers charge an annual fee, just to have access to the card. Separate fees may be charged for cash advances, late payments, exceeding the credit limit and other services, such as lost card replacement.

Grace Period The amount of time during which no interest is charged, if the entire amount is paid .

Other Benefits A card may provide other benefits such as cash advances, flight insurance, replacement of broken items, discounts on merchandise or purchasing clubs.

Acceptance Some cards are more widely accepted than other cards

15

Income Tax Planning

WHAT IS IT?? As the old saying goes Nothing is certain but death and taxes. Financial Planning cannot postpone or prevent the first inevitable (death),but, in some instances ,planning can postpone, reduce, or even eliminate the impact of the second (taxes).

Income tax planning encompasses several areas to include: Understanding the structure and operation of our tax laws Calculation and filing of federal income tax returns Planning to minimize taxes Other forms of personal taxation

CALCULATION AND FILING OF INCOME TAX RETURNS

There are several factors, which will determine the amount of income tax you will pay: Filing status Taxable Income (Gross) Allowable adjustments to income Allowable deductions to income Exemptions

16

FILING STATUS
The major categories are: An individual A hindu undivided family A company A firm An association of Persons or a body of individuals, whether incorporated or not A local authority Every artificial Juridical Person not falling within any of the preceding categories

GROSS INCOME DEFINED

The definition of income under the Income Tax Act is of an inclusive nature, i.e. Apart from the items listed in the definition, any receipt which satisfies the basic condition of being income is also to be treated as income and charged to income tax accordingly. Income includes: Profits or gains from business or profession including any benefit, allowance, amenity or perquisite obtained in the course of such business or profession. Salary Income including any benefit, allowance, amenity or perquisite obtained in addition to or in lieu of salary. Dividend income Winnings from lotteries, crossword puzzles, races, games, gambling or betting. Capital gains on sale of capital assets. Amounts received under a KeyMan Insurance Policy i.e. a life insurance policy taken by a person on the life of another person who is or was the employee of 17

the first mentioned person or is or was connected in any manner whatsoever with the business of the first mentioned person. Voluntary contributions received by a religious or charitable trust or scientific research association or a sports promotion association.

SOURCES OF INCOME EXCLUDABLE FROM TAXATION

Section 10 of the Income Tax Act, 1961 specifies those incomes, which are exempt from income tax, i.e. incomes on which no income tax is payable. Let us understand such incomes:-

A. Agricultural Income Under the constitution of India , taxation of agricultural income eis the right of the state governments. The Central Government cannot levy tax on such income. Section 2(1A) gives a detailed definition of agricultural income. Income derived from agricultural operation from land, which is situated in India, will be exempt agricultural income. Income form agriculture up to and exclusive of the processing state will be agricultural income. Income from processing stage and onwards will be taxable income. Similarly, Income from a farmhouse used for agricultural purposes will be treated as agricultural income.

Thus income form basic operations on land like cultivation, growing crops etc. and secondary operations like removal, digging, etc. can be classified as agricultural income and is exempt from tax. However, income from sale of trees, breeding livestock, fishing activities, poultry farming cannot be classified as agricultural income and is not exempt from income tax. 18

B. Receipt by a member out of a HUF income Any sum received by a member of a Hindu Undivided Family from out of the income of the family as well as the income received by an individual member from out of the income of the impartial estate is exempt. Impartible estate means property which cannot be disposed off or divided by the holder of the property. An HUF is separately taxed on its income. The rate of tax levied on a Hindu Undivided Family is quite high. Therefore, in order to avoid the same income from being taxed twice, distribution of HUF income amongst members is exempt from Income Tax.

C. Share of income of a partner from a firm Any sum received by a partner from a firm as his share in the total income of the firm is exempt from tax. The logic of such exemption is similar to that for granting exemption to income as share from HUF.

D. Casual or non-recurring receipts Any receipts which are of casual or non- recurring nature are exempt up to a sum of rs.5000 (rs. 2500 in case of winnings from races) in each previous year. Casual income is income which is accidental, received without stipulation or a receipt which is of a fortuitous nature and which cannot be foreseen. For example Prize won for taking part in a competition, reward for finding a lost child, etc. However the following income will not be treated as casual or nonrecurring: Capital gains 19

Receipts arising from business or from exercise of profession or occupation

Receipts by way of addition to the remuneration of an employee

E.

Amount received under a life insurance policy- including the bonus allocated on such policy Any amount received under a life insurance policy including a bonus either on maturity of the policy, or otherwise, is exempt from tax. However, this exemption is not available to receipts under a Keyman Insurance Policy.

F.

Payments from Public Provident Fund Any payments received from The Public Provident Fund(PPF) are exempt from tax.

G. Any scholarship granted to meet the cost of education is exempt

H. Income of a minor upto rs.1500 Any income which arises to a minor child of an assessee is added or clubbed to the parents income under Section 64(IA) of the Act. Section 10(32) however gives exemption from such clubbing up to a maximum of rs.1500 annually per child. I. Dividend received by a shareholder Any income received by way of dividend from a domestic company, or from UTI or from a recognized mutual fund by a shareholder/unit holder is fully exempt from tax.

20

J. Awards and Rewards Any award or reward, whether in cash or kind from Central or any state government or any other approved body in public interest is exempt from income tax.

K. Pensions received form gallantry award winners. Family pension received by individual who has been in the service of the Central or State Government and has been awarded Param Vir Chakra or Maha Vir Chakra or Vir Chakra or other notified gallantry award or by members of his family is exempt from income tax.

L. Interest incomes of certain types The following interest income is exempt from income tax: Interest on notified securities, bonds, certificates, deposits, etc. Interest on notified Capital Investment Bonds Interest on Relief Bonds Interest on notified Bonds in the hands of non-residents Interest on notified savings certificate Interest on Gold deposit bonds,1999

DEDUCTIONS FROM ADJUSTED GROSS INCOME

A. An individual assessee can claim a deduction (u/s 80 CCC) for any amount paid or deposited by him in any annuity plan of the Life Insurance Companies for receiving pension from a fund set up by the said corporation. The deduction is restricted to a maximum of rs.10000. 21

B. An assessee (u/s 80 D) is entitled to a deduction up to rs.10000 a year in respect of the premium paid by him/her by cheque for insurance: a) On his health or on the health of his spouse or dependent parents or children, and b) In case of a Hindu Undivided Family on the health of any member of such family Where any of the aforesaid persons is a senior citizen(i.e. one who has attained 65 years of age at any time during the previous year), the aforesaid limit has been increased upto rs.15000.

C. Section 80DDB has been inserted to specifically provide a separate deduction for expenditure incurred for the medical treatment for the individual himself or to his dependent relative or any member of the Hindu undivided family in respect of diseases or ailments as maybe specified in the rules. The amount of deduction shall be limited to a maximum of rs.40000. Moreover assessee or any member is a senior citizen (i.e. , at least 65 years of age at any time during the previous year), then a fixed deduction of rs.60000 shall be available. The amount of deduction available shall be further reduced by any amount received from an insurer for medical treatment. D. Any taxpayer can claim a deduction (u/s 80 G & u/s 80 GGA) in respect of donations made to certain funds, charitable institutions. E. An assessee can claim a deduction for the interest received on the following Securities: Interest on any securities of the Central or any State Government;

22

Interest on deposits under such National Deposit Scheme as may be framed by the Central Government and notified by it in this behalf in the official gazette;

Interest on deposits under the Post Office( Monthly Income Account).

F. An assessee shall be entitled to a deduction, from the amount of income tax (Section 88) on his total income with which he is chargeable for any assessment year, of an amount equal to 20 per cent of the aggregate of the sum. It includes contributions towards Life Insurance Premium, Post Office Savings Scheme, Public Provident Funds, etc.

23

TAX CREDITS
Once the amount of taxes due has been determined, there may be tax credits available to offset payment due. A tax credit is a reduction in the actual tax bill, and as such, is of more value than a deduction for an equal amount, which simply reduces the amount of taxable income. Limitations and exclusion apply to all of these credits and their use should be coordinated through your tax advisor.

So, now we complete our tax calculation as follows:

Gross Income Less: Adjustments to Gross Income

Equals: Adjusted Gross Income (AGI) Less Less Larger of Itemized or Standard Deductions Exemptions

Equals Taxable Income Times: Applicable Tax Rate Equals Tax Liability Less Tax Credits and Prepayments

Equals Tax or Refund Due

24

TAX PLANNING AND ITS ROLE IN THE FINANCIAL PLANNING PROCESS

Taxpayers are always seeking ways to eliminate or at least reduce their income tax burden. There are some strategies, when used in conjunction with the overall financial plan, which can accomplish these goals. Some popular tax-savings strategies are:

1) Taking Maximum Advantage of Tax Filing Options

This technique involves the maximization of available tax deductions, exemptions and credits (thereby reducing the amount of taxable income). These issues will vary by individual and should generally be discussed with a tax professional; however, some of the more important considerations are:
o

Are you aware of all available exemptions, deductions and credits to which you are entitled?

Is your present taxpayer status (joint return, separate return, Head of Household, etc.) best for you?

Will your AMT calculation exceed your regular tax calculation; and if so, what planning steps should you consider?

If self-employed, have you considered which form of business structure (Sole Proprietorship, Partnership, etc) is most advantageous from a tax perspective?

2) Acceleration and Deferral Techniques

Income tax liability can frequently be reduced though the techniques of deferral or acceleration. 25

Acceleration: Income may be accelerated (taken early) so as to include it for a taxable period in which taxable income is less than in the next taxable period; thereby reducing taxes. Expenses may also be accelerated. One reason this strategy would be used would be to take maximum advantage of deductions and exemptions. For example, if a taxpayer has already had medical deductions of 7.5% of AGI, this would mean that any additional qualifying medical expenses incurred during that tax year, would be eligible for a deduction. Another instance in which this acceleration technique would work would be if current year taxable income was considerably less than anticipated income for the upcoming tax period; and thus, deductions would be of more value in the future to offset the higher income.

Deferral: Deferring or postponing income may also result in tax savings. If taxable income is anticipated to be less in the next taxable period, deferring income into that period could result in lower taxes. Conversely, deferring expenses into the next taxable period would make sense if taxable income was anticipated to be higher than in the current income period.

3) Utilization of Non-Taxable Employee Benefits

You may have access to certain employer-sponsored benefits through your job, which may provide great economic benefit to your family without creating any taxable income. These may be at no cost to you; or may require that you share in the cost. Some of the most popular benefits, which result in no taxable income, are
o

Group medical and dental insurance (benefits received are not considered taxable income.)

26

Group term life insurance (death benefits of up to Rs.50,000 in most cases, are exempt from taxation.)

Group accidental death and dismemberment, travel accident and related plans

4) Income/Deduction shifting
The taxpayer shifts a portion of his/her income (and therefore taxes) to a family member or entity, which is in a lower tax bracket. Some useful techniques are:
o

Making a gift of incomeproducing property (such as stock, savings bonds, certain real estate, etc.) In this case, all future income will be taxed to the recipient, not the donor. It is important to note that this action may have Gift Tax implications, which should be discussed with your personal tax advisor.

Also, the property itself must be given away; since gifts of only the

income will not shift the income tax burden to the recipient. Also, the
Tax Reform Act of 1986 limited the usefulness of this technique between parents and children by taxing unearned income over Rs.1,400 per year for children who are under age 14 at their parents top tax rate.
o

The opposite of income shifting is deduction shifting. This is accomplished by shifting allowable tax deductions to a taxpayer who is in a higher bracket than the taxpayer who would otherwise be claiming this deduction.

5) Tax-Managing Your Investment Portfolio

o

As an investor, you may be able to time investment sales in order to maximize your tax advantage. If you have capital gains on securities or

27

other investment property, these gains may be offset by selling another security you own for a loss. This involves the planning in terms of the timing of the purchase and sale of these securities so that they fall within the same tax calculation period.
o

"Tax exchanges" are available which will permit the sale of a security for a loss, and yet maintain a similar investment position. (For example, if you originally purchased a technology stock at Rs.10 per share, but the stock had now declined to Rs.5 per share, you could sell this stock, taking advantage of the loss for income tax purposes and immediately purchase a different technology stock; thereby keeping your position in a technology investment. (Note: tax laws concerning this type transaction are somewhat complicated, so you should consult with your tax professional for personal advice before undertaking this strategy.)

Tax laws permit a taxpayer to select which stock/fund shares they want to sell if they are selling only a part of their holdings.

Example Suppose, if over time, you had purchased shares of a particular stock as follows: 100 shares at Rs.20 per share in 1985 50 shares at Rs.70 per share in 1990 100 shares at Rs.80 per share in 1995 The value of the stock is now Rs.70 per share. If you wish to sell 50 shares, you may sell shares which would result in a gain (those purchased in 1985); no loss or gain (those purchased in 1990) or a loss (those purchased in 1995).

28

Since capital gains laws favor investments held for periods of at least 12 months, (See Capital Gains Above), investment sales may be timed to take advantage of this lower tax rate.

6) Making Charitable Contributions

Charitable contributions are considered itemized deductions, which reduce your taxable income. These charitable gifts may take various forms:
o o

Gifts of cash Gifts of appreciated property such as stock or real estate (These gifts would generally be deductible at fair market value on the date of the gift, with no capital gain consequences to the donor.) This may, however, trigger Alternative Minimum Tax consequences.

The establishment of Charitable Remainder Trusts in which property is transferred to the trust, with the donor receiving and income stream from the investment, and the charity receiving the property. The taxpayer receives a current tax deduction for the value of the remainder interest that the charity is receiving.

7) Tax Shelters
Some investments, such as certain types of real estate, oil and gas drilling, historical rehabilitation, etc. are structured to take advantage of certain tax write-offs, such as depreciation, amortization or depletion. It should be noted that the effectiveness and availability of these types of investments have been greatly diminished by the Tax Reform Act of 1986. This was intended to discourage taxpayers from investing in a particular activity strictly for tax purposes.

29

8) Tax-Free Investing
Interest paid on some investments is free from federal income tax; and often from state and local taxes, as well. One such investment category is public purpose municipal bonds (that is, bonds issued by some governmental entities). However, you should be aware that the interest from certain tax-exempt municipal securities might be subject to the Alternative Minimum Tax computation.) Note: this strategy is generally of interest only to the higher tax brackets, due to the fact that at lower brackets, these bonds would not have as high a return as the taxable bonds even after the payment of taxes. Another investment potentially excludable from taxation is Series EE Bonds, when used for higher education purposes (Certain limitations apply.)

9) Tax Deferred Investing

Other investments do not eliminate tax, but simply postpone taxation until some future date. This may be advantageous if the taxpayer anticipates being in a lower tax bracket in the future. Another potential advantage of this technique is that investment return during the deferral period is enhanced, since the postponed amount of tax remains invested, earning interest, as well. Some of the most common vehicles for this deferral technique are:
o o o o

Qualified employer-sponsored retirement plans Employee Stock Options Plans Non-Qualified deferred compensation Plans Purchase of bonds (bonds issued by the state or central government on a discounted basis). Bond owners may elect when they want to be taxed on the increase in value of these funds; either yearly as interest accrues or upon maturity or when they are redeemed.

30

Life Insurance Cash Values and the interest/investment return they receive are not subject to current income taxation. If values remain in the policy until the death of the insured, they pass as a portion of the death benefit to the beneficiary with no income tax consequences ever! If values are withdrawn during the life of the insured, any gain over and above the initial investment of premium is taxed as ordinary income. (For more information, see Insurance Module.)

Deferred Annuity policies also feature the deferral of tax on investment growth until the policyholder withdraws these funds. (For more information, see Insurance and Retirement Modules.)

10) Tax Planning Wisdom

Tax planning is very important; however, it should never be over-emphasized at the expense overall financial goals and objectives. In some instances a strategy, which results in tax-savings also results in some loss of flexibility, control, or some other advantage. For example, tax-favored retirement plans offer deferral of taxes until retirement; however, they impose strict regulations and penalties which prevent the use of these funds prior to retirement age (59 in most cases). In general, if a strategy to save taxes does not make sense, other than for tax purposes, it should not be implemented. Also, a tax adviser should generally be consulted concerning the overall implications of any tax-savings strategies.

31

Insurance Planning and Risk Management

The Basics Risk Management is the cornerstone of any financial planning effort. It makes no difference how elaborate or effective the investment portfolio, the retirement plan, or the estate plan, if you have not taken the necessary steps to eliminate risk, all remaining planning efforts could be pointless. Risk management through the wise use of insurance removes the concern for the unknown from a financial plan.

How Does One Manage Risk?

There are four basic techniques for managing risk:

Risk Avoidance - This technique involves the avoidance of exposure to loss; either by not owning specific property that could be exposed to loss; or by not engaging in a specific activity which could create liability.

Example The ultimate avoidance of being killed in a plane crash is to refuse to fly. The ultimate avoidance of being sued by someone being injured on your trampoline is not to own one.

Risk Reduction/Loss Management and Control - This technique involves lowering the probability of a particular hazard occurring; and lessening the severity of the hazard by taking some positive action.

32

Example A risk reduction strategy for a swimming pool is to install warning alarms on all doors leading to the pool; a risk reduction strategy to prevent home fires would be to refrain from leaving greasy or chemically saturated rags near a gas hot water heater.

Risk Assumption/Retention - This technique involves the acceptance of the risk. Generally, this technique should be used only when the potential exposure is very small or has a low probability of occurrence. In other words, you should only self-insure what you can afford to lose. Unfortunately, many people self-insure by default. They do not consciously decide to take-on the full risk; they merely fail to plan and provide for an adequate risk management program.

Example Choosing not to insure a 15-year-old car with a value of less than Rs.1,000 for collision coverage is an example of Risk Assumption.

Sometimes partial risk retention is used, wherein the person at risk chooses to accept part of the potential liability for a certain hazard.

Example The selection of an insurance policy (health, auto, or homeowners) with a large deductible would involve partial retention.

33

Risk Transfer - This technique almost always involves some form of insurance. The risk of a particular hazard is transferred to another entity (usually an insurance company) in exchange for a payment of premium. This progress also involves the determination by the insurer of whether or not the risk to be assumed is acceptable at the given premium. This process is known as the underwriting process.

Life Insurance
The first application of Risk Transfer through insurance that we will address is the risk of death. Death always involves a loss, but in its financial sense, a loss due to death is measured in terms of incomplete financial goals and objectives. How Do I Determine My Potential Financial Loss Due to Death? Some of the financial needs that may be created by a death are as follows:

Final personal expenses final medical expenses, funeral, burial, etc. Estate / death expenses estate settlement costs to include federal and state estate taxes, probate, legal, accounting, appraisal fees, etc.

Family income support for surviving spouse and dependent children Additional expenses necessary additional household services, childcare, etc. Liquidation of debts payoff of mortgage, auto loan, credit cards educational loans, etc.

Special financial needs care of aging parents, special needs child, or other family member

Liquidity emergency fund; necessary immediate cash flow Bequests church, school, family members, friends employees, charities

34

Funding of established financial goals completing college funding; purchase of second home, pay off the mortgage, etc.

There may also be additional financial needs of a business nature such as funding the transfer of an existing business through; or protecting a business from the loss of an owner/key-employee. How Much Life Insurance Should I Buy? There are many formulas used in the calculation of life insurance need. The most meaningful methods consider both financial needs created at death and what available resources exist to address these financial needs. You should also remember that your needs will vary at different stages during your life. The first step is to establish the rupee value of the needs. Some of these may be expressed as lump sums; others as cash flow. The next step is to identify what available resources may be used to eliminate or reduce the financial shortfall. These resources will vary greatly from family to family, but may include:

Other sources of income from family members Survivor benefits (Social Security, employer-sponsored plans, etc.) Assets that may be easily liquidated and used to meet the established needs

Once available resources are applied against the identified needs, the amount of life insurance needed can be calculated. Once the amount of life insurance needed is determined, the next decision is what kind to purchase.

35

Kinds of Life Insurance

What Kind of Life Insurance Should I Purchase? There are several types of life insurance; each with numerous variations. The type of coverage that is best for you depends on a number of factors. First, a brief familiarity with the basic types will be helpful: 1) Term Insurance Term is insurance that is purchased for a certain period of time (its term). During that term, premiums are paid, and a death benefit will be received, if death occurs. There is no cash value build-up. Premiums on term plans are considerably less expensive than with other plans. At the end of the term, the insured will be faced with one of several choices, depending on the type of term policy purchased. If the need for insurance still exists, the insured will have to apply to purchase a new term policy; generally requiring evidence of insurability (good health); or may be allowed to continue with the existing plan, but at a considerably higher premium. Term plans are sometimes compared to renting a home. During the time premiums is being paid (rent); the insured receives the benefit of coverage. Once the premium period has ceased, the insured must move or pay higher rent. There is no equity (cash value). 2) Whole Life This is the oldest form of permanent/cash value life insurance. It features a guaranteed premium; a guaranteed cash value; and a guaranteed death benefit. The cash value earns a minimum guaranteed rate of return, and may also receive dividends or additional interest.

36

3) Endowment policy Endowment policies contain two components, insurance costs (which increase with the age of the insured) and the cash value component. Interest is paid on the cash value, with returns being similar to current money market returns.

How Do I Decide Which Company To Use? Once the amount of insurance needed, and the type of policy desired is determined, the next decision is the selection of a company. Important considerations are:

Cost - Costs may vary greatly from company to company, but cheapest is not
always the best.

Comparative Policy Benefits: - The policy provisions, guarantees, historical

performance are but a few of the factors which may vary from company to company and should be considered.

Financial Strength of the Issuing Company - The insurance companys

financial strength and stability as well as its national and local reputation are extremely important. Certain rating services are available to assist in comparing the financial aspects of companies being considered.

Availability of Local Professional Service Personnel: You will find the most
able assistance with your insurance purchase through a local professional agent/adviser. This individual can help you to analyze your personal situation and determine the amount, coverage type and provisions that will best meet your needs. Remember, there is no one policy that is right for all situations.

37

Life Insurance Features

What other considerations are there in deciding on a life insurance purchase? Finally, there are some unique features of life insurance, which make it a very valuable financial planning tool in some situations:

Death proceeds are received income tax-free (as long as the policy has met statutory requirements).

The growth of cash value within the life insurance contract grows on a tax-

deferred basis. So, no taxes are currently due. This is true so long as the policy
remains in force (as long as statutory requirements are met.)

If the cash value is ultimately withdrawn or the policy is surrendered prior to the death of the insured, the withdrawal is income tax free up to the total basis (premiums paid) of the policy. Thereafter, the gain is taxed as ordinary income.

Policy loans are a non-taxable event, unless the policy is later surrendered with the loan still outstanding.

Dividends paid on Whole Life policies are non-taxable, since they are considered a return of premium. (However, any interest paid on dividends left on deposit in the policy is taxable.)

Death proceeds payable to a named beneficiary do not become part of the estate, and generally are not subject to estate debts but may be subject to estate tax.

In most states, creditors are prevented from penetrating accumulated cash values in life insurance policies in the event of lawsuit or bankruptcy.

38

Health Insurance
The second application of Risk Transfer through insurance is the risk of overwhelming expenses related to heath conditions. These expenses can fall into several categories. What Risks Should I Consider In the Area of Health Insurance? Medical Expenses? Loss of Income Due to a Disability?

As with a loss due to death, the financial cost of an uninsured loss relating to health can be catastrophic. However, with the ever-rising cost of all forms of health insurance, this form of Risk Transfer can encompass a large portion of the family budget.

1) Medical Insurance
What Kinds of Medical Plans Are Available? Medical insurance may be available though your employer on a group basis. These plans are frequently more comprehensive in coverage and more cost-effective than the purchase of individual plans. However, both types of plans may very greatly in structure and cost. They are usually divided into two types:

Managed Care Plans Indemnity Plans

39

2) Disability Income Insurance

The odds of becoming disabled are greater at any age than are the odds of dying at that same age; yet many working adults have not made any provision to manage this risk. In many ways, disability is a more expensive risk to manage, since income flow would stop, as in the event of death; but in addition to that, there are usually extra medical and care-giving costs which actually increase the cost of living. Just as with medical insurance, group disability plans may be available to you through your employer, and if so, they may be more cost-effective than purchasing your own individual policy. However, group plans often do not contain definitions and coverage provisions that are as favorable for the insured as are those available with an individual plan. What are The Chances That I Will Be Disabled? Insurance industry studies indicate the following comparative odds of becoming disabled vs. dying at a given age:

At Age 27 = 2.7 times greater At Age 42 = 3.5 times greater At Age 52 = 2.2 times greater
How Do I Know How Much Disability Insurance I Need To Purchase? Calculating the amount of disability insurance that may need to be purchased is a process similar to the calculation performed in determining life insurance need. The first step is to determine the amount of income that is required for family support. You may want to inflate this number somewhat to make allowance for potentially higher living expenses in the event of a disability, such as extra help around home; additional medical services, etc.

40

The second step is to offset this need with any income available from sources other than employment (wages of other family members, rental or investment income, etc.). This calculation will give you a good idea of how much disability insurance you will need to purchase. Most carriers limit coverage to approximately 60% to 65% of pre-disability earnings. Your premiums will be based on your age, sex, occupation, income and the policy provisions you select. Also, keep in mind that if you are paying your disability premium from your personal resources, when the benefits are paid to you, they will not be taxable. If, however, your employer is paying the premiums on your behalf, benefits will be taxable when received.

Property and Liability Insurance

The third and final application of Risk Transfer through insurance that we will address relates to the catastrophic losses of real and personal property caused by such hazards as fire, theft, vandalism, storms and the liability of legal actions.

Homeowners Insurance
What Kind of Policy Do I Need To Carry On My Home? Your home is usually your biggest and most expensive asset, and represents a significant risk of loss, so it is very important that it be adequately insured.

41

There are four types of Homeowners Policies. HO-1, HO-2, HO-3, and HO-8 are available to resident owners only. HO-4 is for renters, and HO-6 is for condominium owners. Ho-3 is the most complete coverage, and the most frequently-sold policy.

How Are These Policies Structured All of these policies contain two sections, and sometimes a rider:
o

Section I Property Loss Exposure which covers a loss of any of the following due to a peril stated in the policy: A. - Dwelling B. - Other Structures C. - Personal Property D. - Loss of Use

Section II Liability Loss Exposure (E) which covers personal liability (lawsuit protection) and Medical Payments to Others (F)

The Personal Property Floater (PPF) is a rider which provides additional protection for items not adequately covered in a standard homeowners policy, such as furs, jewelry, photography equipment, silverware, art, antiques, musical instruments, and collections

Who Is Covered Under This Policy?

o

Persons named in the policy and members of their family who are residents of the household, including students and their possessions away at college.)

Guests of the insured for property losses occurring at the insured house (if the insured wants the coverage to apply.) 42

On What Is Coverage Based? Generally coverage on the dwelling includes the amount necessary to repair, rebuild or replace an asset at todays prices is covered, if the homeowner keeps the home insured for at least 80% of the amount it would cost to rebuild currently, excluding land value. In periods of inflation, you should increase coverage annually to keep up with inflation or purchase an inflation rider, which automatically adjusts coverage for inflation. Contents may be covered on actual cash value basis, or on a replacement cost basis (also taking depreciation into account.) Full re-imbursement may be available for a higher premium Are there Other Things I Should Consider In Structuring My Policy?
o

It is very important that you keep a complete and current inventory of items covered, to include pictures (video, if possible); and receipts to document cost. This inventory should be kept in a safe place away from the insured premises.

You may wish to consider purchasing an Inflation Rider that will increase the cost of your policy somewhat, but will keep your coverage at current levels.

Some covered items will require an additional policy rider in order to be adequately covered, such as your home computer; antiques or art; furs, jewelry and some collectibles.

Earthquakes and floods are generally excluded from the basic policy. If you live in an area where this occurrence is a possibility, you should seek separate coverage for these perils.

43

Automobile Insurance
How Are Auto Policies Structured? State law determines whether auto coverage will be handled on a standard policy basis or the "no-fault" basis. What Factors Affect My Auto Premium Rates? Some of the factors affecting premium are:
o

Geographic Location of Coverage ("Rating Territory") - Some geographic locations have worse claims experience than others; therefore, premiums are higher in these areas.

Use of the Insured Auto Rates are higher for autos driven to work. Total miles driven may also be considered a risk-increasing factor.

Personal characteristics of Drivers Age, sex, marital status all affect premiums. Young drivers are in higher classes than others.

Type of Auto to be Insured An autos classification as "standard", "intermediate" or "high" performance affects premium. Premiums are also higher on sports vehicles and vehicles with rear engines.

Driving Record A driver with traffic tickets, accidents or arrests for DUI will incur higher rates than safe drivers.

44

Investment Planning
The Basics
People make investments for a number of reasons. Most are accumulating funds to achieve some specific goal. Most financial goals involve investing capital so that it will grow as much as possible over a period of time. For this reason, it is very important to understand the basics of investment planning in order to invest wisely.

Get Started
Ask yourself these questions:

What will be the source of my investment capital? (Where will the money come from to invest?) The most common source of capital is any excess of family income over family expenses. Other sources may include inheritances, gifts, growth of investments or business interests, or distributions from retirement plans, etc. These investment sources may include lump sums or periodic investing or both.

What is (are) my investment goal(s)? There may be one or more goals that you wish to fund. Remember, for a goal to be meaningful, it must be specific and have a time horizon. Some common financial goals include creating a current income stream; saving for a down payment on a residence or vacation home; saving for childrens college education; accumulating sufficient capital to start a business; or funding major home improvements. But the most frequently mentioned reason for investing among Americans surveyed is saving for retirement. 45

What is my time horizon? Are you investing for a few months; a few years; or for the distant future? The answer to this question will have an impact on the appropriate investment selections.

How much will be needed to fund my goal(s)? Future Value methods may be used to determine how much is needed.

Once these questions are answered, the next step will be to determine which investment vehicles will best achieve these goals.

Selecting an Investment
Although there are numerous factors that may be considered, some of the most important are:

Risk Rate of Return Impact of Taxes on Return Marketability and Liquidity Diversification

1) Risk There are many kinds of risk in investing. Some forms of risk may be more important to you as an investor than others. If you learn to identify each of these types of risk, you can then determine which of these have importance as you structure your investment portfolio.

46

Risk of Principal If the investment selected performs poorly, the amount of money which was invested can be lost, in part or in whole.

Market/Volatility Risk The value of the investment selected may move up or down due to changes in the particular financial market your investment is participating in.

Purchasing Power Risk This is uncertainty over the future purchasing power of the income and principal from a selected investment. This is created by changes in the general price level of the economy.

Interest Rate Risk Investments which are providing fixed income (such as bonds, CDs, etc). will experience changes in price as interest rates increase and decrease. In general, a rise in market interest rates tends to cause a decline in market prices for existing securities and conversely, a decline in interest rates tends to cause an increase in market prices for existing securities, thus creating an inverse relationship with the general level of interest rates.

Example You have purchased a bond paying 5% with a 5-year maturity. It is now year three of the five-year period, and you wish to sell your bond. However, interest rates are now at 7%. How easy will it be for you to find a purchaser for your 5% bond when there are many 7% bonds available on the market? Not very easy! You would probably have to "discount" your 5% bond (that is, sell it for less than you purchased it) in order to attract any buyers; therefore, the value of your bond has decreased, in an inverse relationship to interest rates

47

which have increased over that same time period.

Tax Risk This involves the potential tax consequences involved with a particular investment to include federal and state income, estate, inheritance and gift taxes.

2) Rate of Return Expected future return is what causes an investor to select an investment. And, since the purpose of investing is to earn a return sufficient to fund your goal(s), you should understand how you would receive this return. It may take a variety of forms to include interest, dividends, rental income, business profits, and capital gains. The total amount of earnings on an investment is "total return". And this is generally broken down into two main components:

Current Income income received regularly over the course of the investment (dividends, interest or rent)

Capital Gains the increase in the market value of the specific investment vehicle. This return is generally not received or recognized until the asset is sold.

Another factor affecting Rate of Return is the potential effect of compounding (earning interest on interest). If interest, dividends, etc. are allowed to remain in the investment and in turn, receive the benefit of future growth, the result is

compounding.

48

The interaction between these first two factors creates the Risk/Return Trade Off. The amount of risk associated with a given investment vehicle is directly related to its expected return. This is known as the "Universal Rule of Investing". So, theoretically, the more risk you are willing to take, the higher return you should expect to receive. To give you some perspective, a "risk-free" rate of return would be an investment that provides a positive return with zero risk (i.e. a 90-day US Treasury bill). This is often used as a benchmark against which other investments are measured. As risk is increased, so should return potential. 3) Impact of Taxes on Return It has been said that it doesnt matter what you get; only what you get to keep! For this reason, it is very important to differentiate between the Return received from an investment and its "after-tax" Return. There are several considerations here:

An investment may yield income that is currently taxable as ordinary income, such as interest on Certificates of Deposit, corporate bonds, etc. In this case, the After-Tax Yield is going to be less than its Current Yield (interest rate). This can be determined by multiplying the current yield by "1" minus the investors income tax rate.

Example If Mr. Fletcher, who is in the 28% tax bracket, invested in a Certificate of Deposit which was paying 6% interest, his After-Tax

49

Yield would look like this: After-Tax Yield = Current Yield (1 Tax Rate) = .06 (1 - .28) = .06 (.72) = .0432, or 4.32% So, Mr. Fletcher really didnt make 6% on his investment; he made 4.32%, because the rest went to pay taxes.

An investment may yield income that is tax exempt, such as interest from some municipal bonds. So, the after-tax yield for a fully tax-exempt investment equals the Current Yield.

Example So, this time, if Mr. Fletcher, who is still in the 28% tax bracket, invested in a municipal bond paying 5%, his After-Tax Yield would still be 5%, since there is no tax implication.

An investment may yield returns that are taxable only when realized and recognized as capital gains. This time, Mr. Fletcher, purchased shares common stock of ABC Pharmaceutical Company. The stock has paid no dividends, but it has increased in price from $10 per share to $20 per share during the past

50

year. In this situation, Mr. Fletcher will not have a taxable event until he sells his shares, since he has not "realized" his capital gain of $10 per share yet. Further, due to favorable capital gains treatment, when the shares of stock are finally sold, the tax rate will be lower than the tax rate would have been had the shares produced dividends which would have been taxed as ordinary income. These were very simple examples, when in fact, the implications of tax treatment of investment income can be very complex. Your professional tax and investment adviser will assist you in determining the impact of your investment positioning on your personal tax situation.

4) Marketability and Liquidity These terms are sometimes used synonymously, but they are not the same thing.

Marketability refers to the degree to which there is an active market in which an investment can be readily traded.

Liquidity refers to the ability to readily convert an investment into cash without losing any of the principal invested. An investment with liquidity has a highly stable price. Some investments are neither marketable nor liquid; others are marketable, but not liquid; or liquid, but not marketable; while others are both marketable and liquid.

51

Example Checking and savings accounts do not have a market where they can be readily bought and sold; therefore, they have limited marketability; but they are very liquid. Stocks which are traded on one of the exchanges have high marketability, since they can generally be sold with little or not difficulty or waiting; however, a sale may result in loss of principal, which would not create pure "liquidity". Real estate has neither liquidity nor marketability because it generally takes a significant amount of time to sell real estate, and it cannot necessarily be sold at its original purchase value.

Although marketability and liquidity are desirable, it is often necessary to have a "trade-off", since highly marketable or liquid assets usually yield less than less marketable or illiquid investments. So, an important question for you to consider, is "Is marketability or liquidity important enough to give up some yield?" This, of course, depends on your overall situation. 5) Diversification Diversification is an important investment policy to consider in constructing a portfolio. It refers to the defensive strategy of spreading investment dollars into several different investments in order to minimize risk. There are numerous types of diversification. You might diversify between stocks and bonds (equity and debt); between liquid and non-liquid investments; between one investment objective and another; etc.

52

The principal of diversification is that the prices or values of all differing investment opportunities do not go up or down at the same time or in the same magnitude, so an investor can protect at least a portion of his/her investment assets by diversifying.

Kinds of Investments
There are many investment vehicles available. But in general, all forms of investments may be divided into "Debt" and "Equity" investments. Anytime you allow someone to use your money to make money, it is considered a "debt" investment. This category would include bank certificates of deposit; bonds (of all types); fixed annuities; cash value of whole or universal life insurance; notes receivable; etc. "Equity" investments actually allow you to take an ownership position and include stocks, real estate, tangible assets such as gold; and collectibles such as art, antiques, etc. Debt investments usually involve little, if any, risk of principal, and low to moderate returns. These returns are derived from interest and/or dividends. Equity investments expose all of your investment capital to the risk of losing your principal, and generally derive most of their investment return from appreciation of the value of the underlying asset (capital gains).

53

1) Debt Investments
What kinds of debt investments (fixed income securities) should you consider for your portfolio, and how will they impact your investment return? Fixed income securities promise the investor a stated amount of income periodically. The most common fixed income investments include: Government Securities Treasury Bills Commercial Papers Public Sector Unit Bonds

Bonds
What Are the Investment Characteristics of Bonds? A bond is a fixed income security that provides investors with secure and regular sources of current income. It is a negotiable long-term debt instrument of the issuer that carries certain obligations. There is no ownership position in bonds. Interest is usually paid semi-annually. Bonds can also generate a capital gain if the bond is sold prior to its maturity for more than its original par value (the value which will be paid in full at maturity.)

What Types of Bonds are there? Bonds may also be classified as "callable" or "non-callable". Callable bonds contain a provision allowing its issuer to retire the bond earlier than its maturity date. This right must be specified in the original bond offering, and most callable bonds prohibit recall during a specified period of time. The issuing corporation can usually exercise the call provision at any time after a specified date. A "call premium" (such as one years interest) is generally payable to the investor, if the bond is called. 54

Some of the different types of bonds issued in the Indian Market are as follows: 1) RBI Relief Bonds: These are bonds issued by the Reserve Bank Of India and are fully backed by the faith and credit of the Indian Government. they are sold in Rs. 1000 denominations and all issues are non-callable. The interests earned on these bonds are exempt from income tax. 2) Infrastructure Bonds/ Tax Saving Bonds: This bond is issues specifically for infrastructure development on the country. The individuals investing in such types of bonds get rebate under Section 88. The Government has given permission only to IDBI and ICICI to issue such bonds. The interest received from these bonds is subject to tax. 3) Encash Bonds: This bond is designed to give instant liquidity anytime after one year, across the counter, to the investors in case of need. NRIs are not eligible to invest in this bond. 4) Regular Income bonds: This bond is designed in such a way that an individual will get the interest payment regularly till the maturity of the bond. The payment options generally are monthly, quarterly, halfyearly or yearly. 5) Floating Rate Bond: This bond is designed to provide returns to the investors linked to the yields on Government of India securities.

55

2) Equity Investments
What kinds of equity investments should you consider for your portfolio, and how will they impact your investment return, as well as your risk exposure? In order to assist you with your understanding of these equity vehicles, we will now take a closer look at several of these.

Common Stocks Real Estate Puts and Calls/Options Commodities

Common Stocks
What Are the Investment Characteristics of Common Stock? When you purchase a "share" of stock, you become a fractional owner interest in that company. As a common stockholder, you will actually have an ownership position in the company. You may receive dividend income, but only after all other debt obligations have been met by the company. Also, if the value of your share of stock increases over the time you hold it, you will experience a capital gain at the time you sell your share of stock. But, in the event the company does not meet its financial objectives, there may be no dividends paid, and the value of your share of stock may stay the same, or even decrease. There is no guarantee that there will be a return on your investment. As a shareholder, you will have the right to vote on company decisions.

56

Why Should I Consider Investing In Stocks? Most investors who purchase common stock do so based on their potential for relatively high returns, but there are other factors to consider.

An investment may yield income that is tax exempt, such as interest from some municipal bonds. So, the after-tax yield for a fully tax-exempt investment equals the Current Yield.

Are There Different Kinds of Stocks? Stocks may be categorized in many ways. Classification by type is probably the most common method of categorizing.
o

Blue Chip Stocks These are stocks of high quality with long and stable
records of earnings and dividends. They are well-established and hold strong financial credentials (i.e. General Electric, Coca Cola, WalMart)

Growth Stocks These are stocks which experience high rates of

growth in operations and earnings.

Income Stocks These are stocks that are selected primarily for the
dividends they pay. They have been able to demonstrate a stable stream of earnings.

Speculative Stocks These are stocks of companies which may be

expected to have significant immediate growth, such as a company which may have recently developed a new patent, etc. There is usually no proven record of earnings, and these are considered high-risk companies.

57

Cyclical and Defensive Stocks - Cyclical stocks are those whose

movement tends to follow the business cycle of the economy as a whole. When the economy as a whole is expanding, the prices of these stocks are increasing. These are industries such as automotive, lumber, steel, etc. Defensive or "counter-cyclical" stocks, on the other hand, can be expected to remain stable throughout the periods of contraction in the business cycle. They are usually dividend stocks and their earnings tend to keep market prices up during periods of economic decline.

Another method of categorizing stocks is by "Market Capitalization" or Size. This uses the stocks market price multiplied by the number of shares outstanding, resulting in the placement of the stock within one of three categories by size:
o

Small Cap Stocks with market caps of less than $750 million. (These stocks may provide an above-average return, but not without more significant risk.)

Mid Cap Stocks with market caps of from $750 million to $3 to $4 billion. (These stocks are generally considered to offer good returns without significant price volatility.)

Large Cap stocks with market caps of more than $3 - $4 billion

How is Stock Performance Measured? Although there are many theories dealing with stock selection and timing of purchases and sales, you must remember that investing is not a science. There are many helpful tools available in designing a portfolio, but there is no way of predicting with any certainty what will happen in the stock market, especially over short periods of time. Historical rate of return cannot predict future return!

58

There is some terminology you will need to understand in evaluating and selecting corporations for stock purchases for your portfolio.
o

Earnings Per Share - Since both present and future dividends are dependent upon earnings, a stocks market price tends to keep pace with the growth (or decline of its earnings per share). This is computed by taking net corporate profits after taxes, subtracting any preferred dividends and dividing the remainder by the number of common shares outstanding.

Net Asset Value Per Share This is also known as "Book Value per Share", and attempts to measure the amount of assets a corporation has working for each share of common stock. It is computed by subtracting the companys liabilities and preferred stock from the value of its assets. and then dividing by the number of shares outstanding.

Price-Earnings Ratio ("P/E") This is the market price of the stock divided by the current per share earnings of the corporation.

Yield - This generally refers to the percentage that the annual cash dividend bears to the current market price of the stock.

Beta This indicates the price volatility in relation to the Market as a whole (usually measured against the Standard and Poors 500) which has a Beta of 1.0. Low Beta stocks (less than 1.0) are less volatile than the Market as a whole; and high Betas (over 1.0) are more volatile. Betas may also be positive or negative. Positives more in the same direction as the Market; while negatives move in the opposite direction.

59

Other Equity Investments

Although Common Stocks are, by far, the most frequently used equity investment in portfolios, and there are numerous other equity investments which may warrant consideration for your portfolio.

What Equity Investments Other Than Common Stocks Should I Consider for my Investment Portfolio? Real Estate Real estate has historically been useful in a portfolio for both income and capital gains. Home ownership, in itself, is a form of equity investment, as is the ownership of a second or vacation home, since these properties generally appreciate in value. Other types of real estate, such as residential and commercial rental property, can create income streams as well as potential long-term capital gains. There are numerous additional equity investments; however, the majority are highly speculative and require specialized knowledge and expertise, and generally should not be undertaken by an inexperienced investor without appropriate qualified professional advice and assistance. Put and Call Options A "call" is an option allowing the investor to purchase a certain stock at a set price at any time within a specified period. A "put", on the other hand is an option allowing the investor to sell a certain stock to someone at a set price at any time within the specified period. These are usually bought when the investor wants to speculate on whether a particular stock is going to go up or down. These are also considered high-risk investments.

60

Commodity Futures Trading A futures contract is an agreement to buy or sell a commodity (wheat, corn, oats, soybeans, copper, silver, lumber, etc.) at a price stated in the agreement on a specified future date.

3) Mutual Funds Investments

What Are Mutual Funds? Mutual funds are large professionally managed portfolios that are formed by many individual investors who collectively pool their resources in order to achieve a high level of diversification. More investors, by far, invest in mutual funds than in any other type of investment product. There are two types of mutual funds: Open-End Investment Companies In these funds, investors buy and sell shares from the fund itself. There is no limit to the number of shares a fund can sell, and buy and sell transactions are carried out at prices based on the current value of all the securities in the funds portfolio. Net Asset Value (NAV) is based on the current value of all securities held in the funds portfolio, and represents the price at which the investor can sell his/her shares. Closed-End Investment Companies Closed end companies operate with a fixed number of shares outstanding and do not regularly issue new shares. These shares are listed and traded on an organized securities exchange, and trades may be at a discount or premium.

61

Why Should I Consider Investing in Mutual Funds? Through mutual funds, small investors are able to enjoy a much higher degree of diversification than they would be able to attain though individual stock or bond purchases on their own. Most mutual fund accounts can be opened with small initial investments (some as low as $250). In addition, experienced professional managers select the securities to be purchased and make timing decisions concerning buying and selling on the most advantageous basis. In addition, funds are highly marketable, and mutual funds offer numerous services to meet individual investor needs. Funds are easy to acquire or sell, and there is very little paperwork or record-keeping required of the investor. Finally, the return on many funds has exceeded the average return of many other comparable investments.

How Do I Make Money In a Mutual Fund? Mutual funds have three potential sources of return:

1. Dividend Income The underlying stocks in the fund may pay a

dividend, and the mutual fund investor receives his/her proportionate share of those dividends. (This is considered taxable income.)

2. Capital Gains Distributions The fund may sell one of its stock
holdings at a profit, and the individual fund investors will again receive a proportionate share of this capital gain. (This is also a taxable event, and may or may not qualify for favorable taxable gains treatment.).

62

3. Increase in Share Value Above Purchase Price The share of the mutual fund itself may increase in value over the purchase price. This gain is not realized until the share of the fund is ultimately sold, at which time it will receive capital gains treatment for tax purposes. The overall return (gain or loss) of the fund is based on these three sources.

What Types of Investments are Available Through Mutual Funds? Almost any type of investment is available through mutual funds. A funds investment objective must be disclosed in its prospectus. The most common fund objectives are: Growth Funds The objective is capital appreciation achieved through long term growth and capital gains. Balanced Funds These funds hold a balanced portfolio of both stocks and bonds, in order to generate a well-balanced return of current income and long term capital gains. Money Market Funds These funds include a portfolio of short-term money market instruments and have high liquidity, but limited investment return. Sector Funds These funds concentrate in one ore more specific industries that make up the targeted sector such as technology, health, energy, etc.

63

What Services Are Offered By Mutual Funds? Numerous services are offered by mutual funds to include: 1) Automatic Investment Plans Investors may direct specific amounts of money from paychecks or bank accounts into the mutual fund on a regular basis (usually monthly). 2) Automatic Re-Investment Plans Dividends and other distributions are automatically used to buy additional shares in the fund. 3) Regular Income For shareholders wishing to receive monthly income, a predetermined amount can be withdrawn on a regular basis, with a check mailed to the investor. This may be a fixed amount or tied to interest and dividend earnings.

4) Conversion Privileges Investors investing in a "family" of funds may switch from one fund to another, if their investment objective should change or if they feel the change would enhance their investment performance. These switches are usually made without additional sales charge. (This switch would, however, trigger capital gains taxation, if applicable.)

64

Retirement Planning

The Basics Risk Management Planning can help you to address many of the possible risks you will encounter on your way to achieving your financial goals. However, there is one risk, which must be dealt with aside from your Risk Management planning. This is the risk of living too long, or outliving your income. As we have previously discovered, the planning and accumulation for retirement is generally the most important accumulation goal which you will address in your personal financial planning. The biggest pitfalls to sound retirement planning are generally considered to be:

Starting too late (PROCRASTINATION) Failing to commit sufficient resources to this goal Investing too conservatively

Retirements planning, just like the other areas of planning, begin with a thorough self-assessment which will help you determine your course of action.

Setting Retirement Goals? . . . . . Where Am I Going?

First, you must ask yourself, "What will my financial needs be during retirement?" Some financial planners use as a target rule-of-thumb of 70% - 75% of pre-retirement income. This, of course, assumes that your financial needs will decrease in retirement. And, sometimes this is true. Expenses may be lower for example, for those who plan 65

to pay off their existing mortgage and/or other debt obligations prior to retirement. Also, it is assumed that at retirement, costs relating to dependent children are gone. These assumptions may or may not be applicable to your situation. Some planning candidates actually want to increase their income at retirement, so that they will have funds for travel, hobbies, etc. A review of your current budget, keeping in mind what changes (up or down) you think may be applicable to your situation, should give you a good idea of your financial needs (in todays dollars).

. . . .When Am I Going To Get There?

The next question should be, "When do I plan to retire?" Your answer may be at age 59 (the earliest normal date that qualified retirement funds, IRAs, etc. can be withdrawn without penalty); or it may be at age 65 (frequently considered the "standard" retirement age); or something earlier or later. One important point to keep in mind, the earlier you plan to retire, the more ambitious your accumulation program must be now!

. . . .Where Am I Now?
Once you have determined your financial needs in todays dollars and your target retirement date, you are ready to calculate the amount of "future" dollars you will need to accumulate in order to retire. The first step is to determine what available sources you have at present to contribute to the funding of this goal. These resources may be in form of a future income stream (Social Security or a pension benefit from your employer) or in the form of 66

accumulations such as savings accounts or other personal investments. These amounts are also converted to "future values" and applied against your needs. The remaining balance or shortfall is the amount you will need to save between now and your desired retirement date.

How Am I Going To Get There?

You may be having a difficult time trying to grasp the concept of future dollars. You are not alone. Many people have a difficult time understanding future impact; both in terms of how inflation will affect your future needs; and how the compounding of interest over long periods of time can help you to accomplish a financial goal. Inflation is the rate at which the general level of prices of goods and services is increasing. Even projecting a meager level of 3% per year, if you are planning on retiring in 20 years; and you have estimated your needs in todays dollars at Rs.50,000, this means that by retirement, that inflation-adjusted need will be Rs.90,000! Taking this a step further, twenty years into your retirement that Rs.90,000 will have become Rs.160,000! This inflation factor must be taken into account in all or your planning efforts or you will find your resources seriously lacking. On your side, however, is the power of the compounding of interest. To give you a rule of thumb, which does not require a complicated financial calculation, the Rule of 72 can provide a quick way to estimate the future value of your present assets. This method tells you how long it will take for a sum to double in value at various compound rates. You simply divide the number "72" by the applicable interest rate (rounded to the nearest whole number). The result is the number of years it will take your original sum to double.

67

Example

If your current investment account is earning an annual rate of return of 6%, you divide 72 by 6, and get "12." It will take your account 12 years at this rate to double. If, however, you are receiving an annual return of 12% on your money, you divide the 72 by 12, and the result is that your money will double in 6 years!

Can I Get There From Here?

Sadly, many planning candidates -- upon consideration of the amount of savings necessary to provide their retirement goal -- discover that "they cant get there from here." If the savings and/or investment return goal is beyond your reasonable capabilities, several options exist.

You may need to re-evaluate your income needs in retirement, and make an appropriate reduction. This, of course, results in a lowering of future living standards. OR

You may need to adjust your current standards of living downward in order to free up additional dollars, which can then be committed to your savings program, thus increasing your accumulation potential. OR

You may need to adjust your time horizon to reflect a later date of retirement than originally planned. OR

You may re-assess and re-allocate your current retirement investments in order to increase the return available to you, while could improve your ultimate funding balance. 68

At any rate, this whole process must be updated and verified periodically as you proceed toward retirement in order to make sure that there have been no material changes in your planning assumptions.

What Are The Most Common Roadblocks to a Successful Retirement?

Some of the most common roadblocks to financial success are:

The tendency to spend all that we make without making any dollars available for saving

Prioritization of other savings goals above retirement (Even if you are saving,
you may be savings funds first as a down payment on a new home; for the college education of your children, etc.)

Unexpected expenses, such as medical; major home repairs; etc. (Some of these
issues can be dealt with through appropriate Risk Management strategies; others cannot.)

Disruption of family status through divorce, death, etc. (Again, an adequate

Risk Management program can anticipate and prevent loss for some of these circumstances; but no all).

Repeated changes of employment (These changes can prevent you from becoming vested; that is, having the right to complete access to your benefits if you should leave your employment.)

PROCRASTINATION Always having a "good reason" not to begin your

savings plan ("Im afraid of the stock market right now"; "I cant afford to start participating in the retirement plan until I get my credit cards paid off", etc.)

69

What Are My Potential Sources of Retirement Income?

Sources of income for retirement are often compared to a three-legged stool. Each of the legs helps to hold up or support your retirement funding. These three legs are Social Security, employer sponsored pension and retirement plan(s), and your personal savings. Now, for a closer look at each of these:

Pension Plans and Retirement Programs

In recent years, employer-sponsored plans (especially those that are totally funded by the employer) have diminished, partly due to the rapidly rising cost of employee benefits and partly due to the ever-increasing and changing reporting and plan requirements imposed by the federal government. If your employer is currently sponsoring a retirement plan, it is important to be aware of what your benefits will be, and how they are structured. Again, this information will be needed to accurately complete your Retirement Planning Calculations (above). There are two basic types of Qualified Retirement Plans, which may be offered by your employer.

Defined Benefit Defined Contribution

A Defined Benefit Plan specifies the amount of benefit which you will receive at retirement It may be stated as a specific dollar amount (i.e. Rs.700 monthly, 70

beginning at age 65); or it may be stated as a percentage or number of units based on your length of service, salary, and other criteria (i.e. 50% of your average monthly salary during the last three years of employment). If you are a participant in this type of plan, it makes your retirement calculations easier, since you know with some certainty what benefit you will be receiving from your plan. A Defined Contribution Plan specifies the amount of contribution that will be made over the accumulation period. But the amount of benefit that will be available is unknown, since it will be affected by time, the investment return and the amount of future contributions. For example, an employers plan may specify that it will contribute 3% of your annual salary each year to the plan on your behalf. But the amount available to you at your retirement will be based on when you retire, how well the plans investments have done over the years, and your actual earnings history which establish the 3% contribution. Both of these plans are considered "Qualified Plans" under Federal Tax Laws. As such they provide several benefits to encourage participation. The first is that any contributions made to the plan are considered tax-deductible to your employer, and not considered taxable income for you... The second, and most important, is that all of the growth within this Qualified Plan will be tax-deferred until such time as you withdraw the money for retirement use. Of course at that time, all withdrawals (both principal and interest) will be fully taxed as ordinary income. Generally, both of these Qualified Plans are completely funded by your employer. However, the trend in recent years has been to replace or supplement these traditional types of pension plans with plans in which the employees share in the cost.

71

In addition to these plans, there are also numerous other versions of the Qualified Plan that may be sponsored by your employer. These include Straight Profit Sharing Plans, Simple Plans, and Target Benefit Plans. All of these plans work similarly to the other Qualified Plans and may or may not allow employee contributions. There may also be other plans such as Stock Options or payroll deduction savings plans.

Annuities
There are numerous ways to save for retirement. One commonly used vehicle is the Deferred Annuity. An annuity is an investment contract issued by a life insurance company in which an investor invests a sum of money in the annuity contract, with the sum plus investment earnings to be returned to the investor at a later time as a lump sum or as a guaranteed income stream. During the deferred or accumulation phase, funds deposited in this annuity grow on a tax-deferred basis, just like in the Qualified Retirement Plans. Annuities may be:

Single Premium or by installment payment (usually monthly) Fixed or Variable in investment nature (fixed guaranteeing the return of principal and a flat rate minimum rate of interest; with variable, like variable life, offering the investor the opportunity to select investments from among a number of investment options.)

72

An annuity is like other tax-qualified savings vehicles, in that there is a 10% penalty if funds are withdrawn prior to age 59 . When you are ready to begin the withdrawal phase of an annuity, you will have several choices. These options parallel those that are usually available in the withdrawal phase of your employers Qualified Plan. Selecting A Retirement Income / Annuity Pay-Out Most Qualified Retirement Plans offer a number of pay-out options upon retirement. One option may be a lump sum, representing your entire retirement account balance. When this option is selected, income taxes will be due in the year of receipt on the entire amount. Some retirees find this option attractive, if they are going to be in a very low tax bracket for that year, and their personal retirement goals require a large lump sum of available cash. In addition to the lump sum or rollover option, most plans offer one or more structured pay-outs, which offer income streams for life or for specific periods of time. It is very important to understand these options since the option you select may greatly affect your cash flow in retirement. And, in almost all cases, once you have selected and have begun to receive a payout under one of these options, you will not be allowed to change your option. Some of the most commonly offered payout streams are as follows:

Straight Life Annuity Payment payment stream is guaranteed over the lifetime of the annuitant, whether that is one month or 50 years. Even if the annuitant dies early in the payment stream, there is no residual benefit. This option provides the highest payout of all the annuitized options. 73

Example

Mrs. Brown, age 65, has accumulated Rs.500,000 in her deferred annuity, and is now ready to select a pay-out. She selects the Straight-Life Option because it will pay her Rs.4500 per month. Unfortunately, Mrs. Brown dies at age 68, having only received three years of payout. Since she selected the Straight Life payout, the payments will cease upon her death without any residual value being available for her heirs.

Annuity Certain This annuity pays for on the period selected. It has no connection to the life span of the annuitant.

Example

Had Mrs. Brown selected a 10-Year-Certain payout, her monthly income would have been Rs.5500. If she died at age 68, the result would have been the same as with the Life Annuity with 10-YearsCertain. The payout would have continued for the remainder of the 10-year period. However, had she lived beyond the 10 years, she would have had no further income after the 10-year period.

Refund Annuity This annuity guarantees payment for lifetime of the annuitant, and beyond that, guarantees payment until an amount at least as

74

large as the purchase payment is reached. In essence, this creates a full "refund" of premium.

Example This option would have paid Mrs. Brown Rs. 3500 per month, and it would have continued as long as she lived, regardless how long that might be; however, if she did, indeed, die at age 68, the payments would have stopped and the purchase price of the annuity have been paid to the nominee/beneficiary of Mrs. Brown. This amount received by the nominee is tax free.

Joint and Survivor Annuity Payments under this option are based on the lives of more than just the annuitant; usually, it is the annuitant and a spouse. Payments will continue on a full or partial basis as long as either annuitant is living. This option is frequently used in pension plan to insure that surviving spouses will continue to receive all or part of the retirement income flow of his/her spouse.

Example

In this case, if Mrs. Brown had a husband (age 65) and had selected the Joint and 100% Survivor option, her payout would have been

75

Rs. 3000 . This amount would have been paid for as long as either Mrs. or Mr. Brown was living.

As you can see, there is a difference between the payment levels of these various options. The more contingencies an insurance company is asked to accommodate the lower the income flow. For example, the simplest form of payout is the straight life annuity. The only contingency here is how long one person (the annuitant) will live. This option provides the highest payout of any life-contingent option. With the addition of an additional annuitant; a time period that is guaranteed; or especially if the company has to guarantee a full refund, the payment flows shrink accordingly. The ten year only option offered a higher payout, however, there would have been no benefits beyond the ten year period; and at age 65, Mrs. Brown (under normal circumstances) would have had a life expectancy considerably beyond this 10 year period. If you will be selecting a retirement payout from among these options, your own personal circumstances will dictate which choice is best for you. But there is sometimes a way to "have your cake and eat it, too". How Are Distributions from Retirement Savings Taxed? The tax treatment depends on how the distribution is paid; that is, as a lump sum distribution, an "annuitized" (structured and guaranteed) monthly payment; or as flexible withdrawals. Lump sum distributions are non taxable. Periodic payments received from an Employers Pension or Retirement Plan is also considered ordinary income, as they are received. But annuity payments will be treated as part principal and part interest, with only the interest portion being taxable.

76

Case
Computation of income of Mr. X before financial planning
Particulars INCOME FROM SALARY Salary Received Less: Standard Deduction u/s 16 (i) 475,000.00 30,000.00 445,000.00 Amount Taxable Amount

INCOME FROM OTHER SOURCES Bank Interest 28,750.00

GROSS TOTAL INCOME Less: DEDUCTIONS UNDER CHAPTER VI- A U/s 80 - L : Bank Interest NET TAXABLE INCOME ROUNDED OFF TAX ON ABOVE Less: Tax Deducted at source Salary Interest 95,500.00 2,947.00

473,750.00

12,000.00 461,750.00 461,750.00 112,525.00

98,447.00

Balance Payable 77

14,078.00