Financial planning lessons

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My financial planning knowledge comes from 30 years of budgeting, tax planning and investment experience starting out poor and working my way up to my current financial status. I could not have accomplished what I accomplished without the financial planning lessons that I learned through experience.

I have worked in business for over 30 years and have been active in the investment arena for over 28 years. I mainly want to tell my story of how I executed my financial plan with hopes that you can gain some insight into what it takes to build a successful financial plan.

Retirement Planning is a Critical Piece of Your Financial Plan

One of the things we are all taught is to work and put away for retirement and in this financial planning lesson I have to tell you I truly believe that is a worthy and necessary goal because none of us wants to work for the rest of our life.

Your 401K May be Your Largest Income Producer in Retirement

If you are in the workforce and your company has a 401K plan your first step is to get involved with that plan and contribute as much as you can afford to contribute. This will have a tremendous impact on your finances. Most plans have a matching component up to a certain percentage and I urge you to contribute up to that percentage if at all possible. Otherwise you are missing out on free money. There are many plans that contribute 50% on the dollar up to 6% of your annual salary. Imagine you put in $500.00 the company puts in $250.00 plus you earn interest on the money, it's hard to find that kind of return on your money anywhere else.

The 401k is a form of investing for your retirement. Usually companies set up the 401K plan and allow employees to contribute up to 15% of their salary. You can choose to have the money taken from your check before taxes or after taxes. Investing the money before taxes helps you because you get the full benefit of your money before the IRS taxes you. The company will usually match what you put in up to 6% at .50 on the dollar.

You put in $500 the company will give you $250. That's an amazing return on your money, better than most investments and better than most pension plans. Investing your money this way is great because money that you would normally be paying to the IRS is sitting in your account earning interest.

I know it can be tough when you are first starting out but if you just invest 3% to start it's better than investing nothing and as you get pay increases you can put a part of the increase into the 401K plan until you reach 15%.

If you are earning $500 a week and are in the 28% tax bracket and you don't invest in the plan you will pay $140.00 in taxes. However, if you invest 3% ($15.00) of that $500.00 in a 401K plan you would only pay $135.80. Therefore, your 3% investment is only costing you $10.80 but you are investing $15.00. In effect the IRS is paying $4.20 on your behalf and on top of that the company is going to give you $7.50. Ok so you invested in effect $10.80 and now you have $23.00 that's 108% return on your money. I don't know about you but I don't know a lot of places where you can get this kind of a return on your money. If you do this right and leave the money in the plan and let it grow you shouldn't have to pay back the tax money because when you retire you should be in a lower tax bracket. Also you will earn interest on all your money.

In effect you are only spending 2.04% to invest in yourself. The truth is you can't afford not to invest in your future. The beauty of the plan is your money earns interest tax free causing it to grow faster than most other investments. You would have to pay capital gains tax each year on most other investments thus reducing your overall return.

The return that you get in this type of investment is phenomenal because of the compounding of the interest and the fact that you don't have to pay capital gains tax on it until you retire. The rule of thumb you can use to figure out when your money will double is called the rule of 72. To figure out when your money will double you start with 72 and divide it by the interest rate that you are earning. For example if you invest $5000 and you are earning 10% interest the formula would be; 72/10=7.2 years. In 7.2 years you would have $10,000.

You need to understand that this is truly a retirement plan and as such your money is tied up until retirement with the exception of a few special circumstances such as to pay for education, your primary home, or a hardship such as a serious illness (check with your tax preparer).

If you withdraw money before you are 59 1/2 you will have to pay a 10% penalty as well as normal taxes on the withdrawal. I strongly urge you to do everything you can to avoid a withdrawal because you give back most of the benefit you gained from investing in the 401K.

Some plans will allow you to take out a loan against your funds in the plan but there are rules that have to be followed. The loan generally has to be paid back within five years and if you leave the company you could potentially have to pay the money back in as little as 60 days. Again I urge you to use this type of loan as a last resort because your earnings in the fund are much greater than the interest you will be paying yourself when you pay it back.

I personally like the 401K better than a pension plan because I think you have more input than you do in a pension plan. Some pension plans don't require you to make a contribution so on the surface they may seem better because you aren't contributing but you really need to look at the long term return. However, usually when you don't have to make a contribution to a pension plan it simply means your income is reduced by this amount so in the long run the contribution amount is about the same in both plans. Again in my opinion you have more of a choice in a 401k than you do in a pension plan.

An IRA is a Great Substitute for A 40K If You Don't Have Access to a 401K

There is also IRAs that allow you to contribute tax free dollars and the government will allow a tax deduction if you meet certain criteria (see your tax professional for details). The IRA helps you because it allows you to receive payments for the rest of your life if you choose that option.

What is an Individual Retirement Account

An IRA provides you the ability to invest either tax free or tax deferred. There are many different types of accounts but the most common are the traditional and the Roth. The type of individual retirement account you choose depends largely on your investment goals.

Traditional Individual Retirement Account

The traditional individual retirement account allows you to invest tax deferred up to $4000 per year or $5,000 if you are over 50. The amount that you invest is deducted from your taxable income ultimately reducing your tax liability. When the money is withdrawn it is subject to normal taxes and a 10% penalty if withdrawn prior to age 59 1/2. The 10% penalty is waived if the money is used to purchase a house or for approved educational expenses, but you will have to pay normal taxes. The individual retirement account is a great investment tool and provides great flexibility for important expenses. I think the individual retirement account is a great tool for someone who doesn't have access to a 401K investment account.

The Roth Individual Retirement Account

Roth individual retirement accounts were created in 1997 primarily to help the middle class. The Roth is not tax deductible but the funds can be withdrawn without tax liability or penalty except for the interest earned. After five years all contributions including interest can be withdrawn without tax or penalty. You also get the same benefit for a home purchase and education as a traditional individual retirement account.

If you are single you can invest as much as you like in a Roth account if your earnings don't exceed $95,000 for the year. There are stricter limits on the amount you can contribute once you earn a $110,000 as a single filer. The limits for married couples filing jointly starts at $150,000 and gets stricter at $160,000 (see your tax preparer for complete details).

If you qualify for a Roth individual retirement account it has some very attractive features such as the higher limits on deposits, the flexibility of withdrawals, and the fact that you don't have to pay tax on the money when you withdraw it. If you decide to roll your traditional individual retirement account into a Roth individual retirement account you need to make sure you are prepared to pay the tax on the rollover because it will be treated as if you withdrew the money from your traditional individual retirement account. This is a decision you have to make based on your personal situation, your needs and your tax status. To invest in a Roth IRA you must have earned income. You can use a Roth IRA even if you have a 401K or other retirement plan. Contributions must be made by the tax deadline each year. You have the flexibility to invest in whatever investment vehicle you choose.

If You Don't Like The 401K or The IRA An Annuity May Be For You

If you don't have access to a 401K plan and you don't like the IRA then you may want to consider an annuity. An annuity is another tax advantage vehicle that allows you to invest your money before taxes as long as you meet certain criteria (consult your tax professional for details). An annuity gives you options to receive payment at retirement either in a lump sum or life time payments. This is a decision you can make based on your tax status at retirement time.

An annuity is a very important financial planning tool. Depending on your personal financial situation you may be interested in purchasing an annuity or you may have one and need to think about how to collect the money without paying too much in taxes.

What is an annuity?

It's an agreement for one entity to pay another a stream or series of payments. Usually insurance companies write them but a charity or a trust can.

Categories:

Fixed or Variable

Deferred or Immediate

Fixed Period, Fixed Amount, or Lifetime Qualified or Nonqualified Tax status

Single Premium payment arrangement or flexible premium payment

Features:

Tax Consequences

Most investments incur capital gains tax each tax year. However, earnings, capital gains and income from annuities aren't taxable until you withdraw money. 401Ks and IRAs offer the same tax deferral but there is a limit on the amount you can contribute on an annual basis. With an annuity there is no limit on the amount you can contribute. It's a lot easier to withdraw funds from them than from 401ks and IRAs.

Asset Protection

If you are receiving payments from an insurance company the best a creditor can do is collect the payments as you receive them because technically the payments that you made to the insurance company belongs to the insurance company not you. The creditor can't take the money you paid.

Some state laws and court cases also protect some or all of the payments. Your money in tax-favored retirement plans, such as IRAs and 401ks are generally protected.

Of course one of the best ways to protect your assets from creditors is to pay your bills on time. However, anybody can run into tough times when they have problems paying their bills. You have to be careful because when this happens to you there are many companies out there that promise to help you fix your credit but in reality they are just after your money. You can improve your own credit score by monitoring the three main credit bureaus. When you find a mistake you can file a dispute claim with the credit bureau to get it cleared up usually within 30 days. You can also get protection against identity theft. By monitoring your credit on a regular basis you will know if someone tries to open an account in your name.

Investment Options

You can invest in a fixed rate plan which would earn a fixed interest rate, just like a bank Certificate of Deposit (CD). A variable rate plan would invest in stocks, bonds or other mutual funds. Some may offer a feature that guarantees your investment will never fall below its value on its most recent policy anniversary. This would be referred to as a floor.

Income Options

Because these instruments are similar to life insurance policies you can receive payments for the rest of your life. They accomplish this by taking money from your investment, your investment earnings and from the money from other's who didn't live as long as you. Like insurance companies they use actuarial tables to forecast your average life span to determine how much to pay out. When they guess right they win and when they guess wrong the annuitant wins. Over the long run they always come out ahead. Don't get an annuity confused with a whole life insurance policy because there is a big difference. With a whole life insurance policy the interest you earn is very low so you primarily pay enough during your life so when you die your beneficiary receives the face value of the policy. However, this is not a very good investment.

Benefits to Your Estate

You can purchase a guarantee period with your annuity so in the unlikely event you die immediately after your payments start your heirs can still get your money for a specified period usually 10 to 20 years. Another benefit is annuity payments that pass on to beneficiaries are not subject to probate or a part of your will.

Financial Planning Lessons help you learn in a very easy to understand way how to create you own personal financial plan.

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